60.1K

Verified Solution

Link Copied!

Please only answer QUESTION 2 part b. I am having trouble finding how you calculate the risk-neutral probability. Also, show how you calculate the probability of an increase for PV of abandonment. How did you solve for P -- please show the algebra involved. Please go step by step as to how you solved this. Thanks!

1. Suppose you have to choose between two technologies for production of a Wankel engine outboard motor: Technology A uses computer-controlled machinery custom-designed to produce the complex shapes required for Wankel engines in high volumes and at low cost. But if the Wankel outboard does not sell, this equipment will be worthless. Technology B uses standard machine tools. Labour costs are much higher, but the machinery can be sold for $10 million if the engine does not sell. Payoffs from Producing Outboard ($ millions) Technology A Technology B 18.5 18 8.5 8 Buoyant demand Sluggish demand Assume that the present value of the project is $11.5 million at year 0 if Technology A is used. a. What is the present value in year 0 if Technology B is used, ignoring the abandonment value? The risk-free rate is 7 percent. b. Calculate the abandonment option value of Technology B. Assume that, if you abandon Technology B. you receive the $10 million salvage value but no operating cash flows. 2. Consider the data given in the previous question. We will assume that Technology A has a salvage value of $7 million, rather than zero. The present value of the project with Technology A is $11.5 million at year 0, assuming no abandonment. The risk-free rate is 7 percent. a. Construct a one-year binomial tree for this project, with one up or down step every three months (four steps in total). The up steps are +25 percent, the down steps are -16.7 percent. b. Suppose abandonment can only occur at year 1. In what circumstances would you abandon then? What is abandonment value at year 0

Answer & Explanation Solved by verified expert

See Answer