Question: A firm has a capital investment that requires an expenditure of $500 and promises to return $52 per year in perpetuity. The discount rate is 10 percent. Alternatively, it can defer the investment for 1 year. The two possible outcomes are $56 per year in perpetuity or $44 in perpetuity. The risk-free rate is 4 percent.
a. Should the firm undertake the capital investment now, or should it delay making die decision for 1 year?
b. What decision should be made if the risk-free rate is 10 percent, instead of 4 percent? Does your answer make sense in terms of what happens to the value of a call option as the risk-free rate increases?
c. Finally, independent of (b), what decision should be made if everything is the same as in except the two possible outcomes are $56 in perpetuity or $48 in perpetuity? Explain why this occurs.