Reference no: EM132944195

Question - Boxer Ltd manufactures plywood sheets used in the building industry. The selling price per sheet is £10.60 in the economy's good state and £7.30 in the bad state. The risk-neutral probability of each of these states is 0.5. Boxer can sell all the sheets that it produces.

The sheets can be made from either two types of wood, pine and fir. The cost per sheet using pine is £10.10 in the good state and £6.80 in the bad state.

The cost per sheet using fir is £9.10 in the good state and £8.50 in the bad state.

Boxer is committed to producing one million sheets during the current year (year 1) using pine and is planning its production for year 2. Assume a risk-free rate of zero.

(i) If Boxer produces one million sheets using pine in year 2, what is the expected present value of the year 2 net cash flow? What is its expected present value if Boxer uses fir?

Assume now that at the end of year 1, Boxer will know the economy's state in year 2.

(ii) Assume that Boxer produces one million sheets in year 2 and can either continue using pine, or switch to using fir. What is the expected value of the option to switch? Explain.

(iii) Suppose that in year 2, Boxer can choose to increase its production to 1.5 million sheets, using either pine or fir for the additional production. The cost of this expansion will be £600,000 regardless of which raw material is used. What is the expected value now of the option to expand using pine? What is the expected value now of the option to expand using fir?

(iv) Suppose that the option to switch to production using fir requires machinery to be modified now. What is the maximum amount Boxer should pay to modify the machinery? Explain.