Suppose Real Option Inc. has a product that generates the following cash flow.

At t=1, the demand can be high or low with equal probability. If demand is high (low) the cash flow is CFH=400 (CFL=200).

At t=2, the demand can also be high or low. If demand was high at t=1, then a high demand at

t=2 arises with probability 0.8. If demand was low at t=1, then a high demand at t=2 arises with probability 0.2. If demand is high (low) at t=2 then CFH=400 (CFL=200). The (risk adjusted) interest rate for this project is 10%.

(a) Draw the event and decision tree.

(b) What is the market price (expected value) of Real Option Inc. at t=0?

Now suppose Real Option Inc. can rent a platform to run a marketing campaign. For this purpose Real Option Inc. must sign a two year contract with the platform provider. The costs for using the platform are 200 per period. Marketing itself does not cost anything and has the following effect. In the high demand state, marketing doubles the demand. In the low demand state it has no effect.

(c) Should Real Option Inc. rent the platform at t=0 and run the marketing campaign?

Contracts can only be signed at t=0. But suppose Real Option Inc. can terminate the contract after the first year by paying a fine of 10.

(d) What is the optimal strategy of Real Option Inc. and the maximum market value of the firm?