It costs a risk neutral firm £800 to set up a factory (fixed cost). The factory can produce one unit of output per year forever. The current price of a unit of output is £100. The product price is currently uncertain. In the next period the price will increase or decrease by 50% (with equal probability) and remain fixed forever at the level it has reached. The interest rate is 10%. a) According to NPV, should the firm invest now? This means spending £800 in the current period and selling the first unit of output for £100 today and either £150 forever afterwards or £50 forever afterwards (with equal probability).
It costs a risk neutral firm £800 to set up a
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a) According to NPV, should the firm invest now? This means spending £800 in the current period and selling the first unit of output for £100 today and either £150 forever afterwards or £50 forever afterwards (with equal probability).
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b) What is the real option value of waiting to see whether the price goes up or down? This means investing £800 next period and getting the appropriate price forever.
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c) If the price for deferred investment is higher (the firm has to invest £I > £800 at the beginning of next period) how high can it be before the firm will choose to invest now?
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d) How would your answers change if the firm could wait for two periods, and if the price could change at the end of period 1 and again at the end of 2 (in each case going up or
down by 50% with equal probability) after which it would stay the same forever? (Only solve this part)
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