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As a financial analyst at Goldman Sachs, you are evaluating an option to purchase an equipment...

  1. As a financial analyst at Goldman Sachs, you are evaluating an option to purchase an equipment to expand the product line for the company. There are two machines meeting the company's investment criteria, Machine H and Machine L. Machine H costs more than Machine L but has the flexibility to be modified if the demand for the product is low while machine L cannot be modified. The following is the financial information about these two machines.

The project with Machine L is worth $25 million today and will be $30 million one year from today with high demand and $20 million with low demand. Machine H can be modified and sold off for $24 million if the demand is low. (Assume 10% of interest rate) Please answer the following questions.

a. What is the risk neutral probability of up move? (sample answer: 45.50%)

b. How much will machine H cost more than machine L? (sample answer: $2.50 million)

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