Contemporary Engineering Economics 6th Edition by Chan Park

Exercise 2

A firm has decided to hedge itself through the use of strategic options. It has the option to choose among three strategies:
• It has the option to contract 10% of its current operations at any time over the next three years, thereby creating an additional $25 million in savings after this contraction.
• It has the option to expand its current operation by 30% (resulting in 30% increase in project value) with a $20 million implementation cost.
• It has the option to abandon its current operations and then sell its intellectual property for $100 million.
The value of the current operation is $100 million, the implied volatility of project return is 15%, and the risk-free rate is 5%.
(a) What is the value of just having the contract option
(b) What is the value of just having the abandonment option
(c) What is the value of just having the expansion option
(d) What is the combined value of having all three options together