A project requires $150 million investment. If you invest today, the present value of future cash flow is worth $180 million. You can wait for one year to observe the demand of the market; however, you forgo the cashflow in year 1. Assume if the demand is high, there will be a cash flow of $22 million in year 1 and the present value of future cash flows at the end of year 1 is $220 million; if the demand is low, there will be a cash flow of $12 million in year 1 and the present value of future cash flows at the end of year 1 is $120 million. You need to use risk-neutral valuation method to decide either invest today and start to collect the cash flow or delay it for one year. Annual risk-free rate is 3%. (a) What’s the risk-neutral probability of high demand?
(b) What’s the value of timing option?
(c) Do you want to wait for one year or invest today? Why?