Your company can undertake an investment project today, next year, or the second year. The cost of the investment is $120, and the cost will remain at $120 regardless of when the investment is made. The current gross value of the investment (i.e., the expected discounted value of all subsequent cash flows) is $100, and the value is expected to increase by 50% or decrease by 25% with equal likelihood each period. The expected return on the investment (i.e., the cost of capital) is 12.5% and the risk-free rate is 2.5%. Answer the following:

Suppose that at the end of year one management can choose to either maintain the base scale operation or expand by x=0.35 the scale of the project value by incurring the extra investment outlay Ie=30. Ignoring the option to defer investment (i.e., assuming that the firm invests at t=0), compute the value of the option to expand, Oe.

Suppose that at the end of year one management can choose to either maintain the base scale operation or expand by x=0.35 the scale of the project value by incurring the extra investment outlay Ie=30. Ignoring the option to defer investment (i.e., assuming that the firm invests at t=0), compute the value of the option to expand, Oe.