Math Problem Solver

Acme Industries is considering building a plant that will have a value after two years. The cash flows from the plant will be $220 million following two good years, $180 million following one good and one bad year, and $110 million following two bad years. The initial cost of the plant is $160 million. After one year, however, the firm has options to change the plant’s capacity. Specifically, the firm has an expansion option to double the capacity by investing another $160 million. The firm also has a contraction option to halve the capacity by liquidating half of its assets to receive a salvage value of $60 million. Assume that the risk-free interest rate is 6% per year and that $1 invested in the market portfolio today will be worth either $1.25 (if the economy is good) or $0.8 (if the economy does poorly). Compute the value of building the plant.