You own a small manufacturing plant that currently generates revenues of $2 mill

Question

You own a small manufacturing plant that currently generates revenues of $2 million per year. Next year, based upon a decision on a long-term government contract, your revenues will either increase by 20% or decrease by 25%, with equal probability, and stay at that level as long as you operate the plant. Other costs run $1.6 million dollars per year. You can sell the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%. What is the value of the option to sell the plant?

Explanation / Answer

If there is no details regarding the number of years the plant works, the plant could be sold for $5million to conglomerate as it is profitable option. because having a 50% probablity the plant would function well when the revenue increases and it runs at loss when the revenue decreases. Hence selling it to the conglomerate is a suitable option.

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