Question: a) You can acquire an existing business for $2 million. You are uncertain about future demand. There is a 40 percent chance of high demand, in which case the present value of the business will be $3 million. There is a 25 percent chance of moderate demand, and the associated present value is $1.5 million. Finally, there is a 35 percent chance of low demand, in which case the present value is $1 million. What is the expected net present value of the business? Should you invest? Explain.
b) Suppose that if you buy the business described in Part B, you can expand the business by investing another $500,000 after you learn the true future demand state. This would make the present value of the business $4 million in the high-demand state, $2.5 million in the moderate demand state, and $1.0 million in the low demand state. What is the net present value of the business if you consider the option to expand? How valuable is the option to expand?