Black-scholes option pricing model to value

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Reference no: EM131996380

Suppose firm is considering new R&D activity at a cost of $200,000. This factory is expected to produce cash flows of $21,000 per year for 25 years starting a year from today. After three years, (i) the company can make a decision to drop this activity and can resell the equipment at the cost of $50,000 and also (ii) this R&D activity may spin-off another project at a cost of $100,000. The expected cash flows from this project would be $15,000 per year for 22 years with the 1st cash flow coming 1 year after the expansion is complete (4 years from today). The standard deviation of returns on this project of 30% exceeds the standard deviation of returns on the R&D activity of 20%. The return on Treasury strips vary by maturity as follows: 1-year = 3.3%, 2-year = 3.5%, 3-year = 4.0%, 25-year = 5%. The required return on this factory and the possible spin-off is 9.5% per year. Using the Black-Scholes Option Pricing Model to value (i) the abandonment option and (ii) the potential project to be spin off, should the R&D activity be initiated?

Reference no: EM131996380

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