G r o wth and Abandonment Options
Your R&D division has just synthesized a material that will superconduct electricity at room tem- perature; you have given the go-ahead to try to produce this material commercially. It will take five years to find out whether the material is commercially viable, and you estimate that the probability of success is 25%. Development will cost $10 million per year, paid at the beginning of each year. If development is successful and you decide to produce the material, the factory will be built imme- diately. It will cost $1 billion to put in place, and will generate profits of $100 million at the end of every year in perpetuity. Assume that the current five-year risk-free interest rate is 10% per year, and the yield on a perpetual risk-free bond will be 12%, 10%, 8%, or 5% in five years. Assume that the risk-neutral probability of each possible rate is the same. What is the value today of this project?
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