Chapter 22, Problem 9PS

Timing options Look back at the Malted Herring option in Section 22-2. How did the company’s analysts estimate the present value of the project? It turns out that they assumed that the probability of low demand was about 45%. They then estimated the expected payoff as (.45 × 176) + (.55 × 275) = 230. Discounting at the company’s 15% cost of capital gave a present value for the project of 230/1.15 = 200.

1. a. How would this present value change if the probability of low demand was 55%? How would it change if the project’s cost of capital was higher than the company cost of capital at, say, 20%?
2. b. Now estimate how these changes in assumptions would affect the value of the option to delay.