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Investing in market research creates an option

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The managers of Soup Inc. consider the opportunity to open a new soup restaurant in a small college town. As of today, the best estimate of the value of the future cash flows (in present value terms) generated by the soup store is $12,000. Moreover, to make the store fully operational and actually start selling soup, the firm needs to invest $15,000. Thus, it appears that the restaurant is a negative NPV project. However, the managers of Soup Inc. believe that the potential of the restaurant is uncertain and the current estimate of the value of its cash flows of $12,000 might be quite wrong. Therefore, they decide to invest in market research. They will study the market for 2 years and then decide whether to open the restaurant or not (at the end of year 2). Your task is to help the managers of Soup Inc. by providing answers to the following questions:

(Part 1) Investing in market research creates an option. Briefly describe the underlying for the option and the key source of uncertainty. What is the current value of the underlying? What is the strike price for the option?

(Part 2) What is the value of the option created by market research if o is 20% and the continuously compounded
risk-free rate is 5% per year? (Please use time intervals of 3 months for your binomial tree.)

(Part 3) What is your recommendation for the managers regarding the restaurant and market research? Show excel work

Reference no: EM133119290

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