Assume that the company can purchase an option for this

Assume that the company can purchase an option for this investment. The option allows the company to abandon the investment after 1 year and sell the equipment for 50% of its original cost (i.e., 0.5 x $10,000); OR, it can expand, which will result in twice the cash flow value (i.e., 2 x $12,000, or 2 x $7000). To expand, the company will have to make an additional capital investment of $4500. What should the price of this option be (i.e., if the company has to pay up-front in year 0 for an “option” that allows the flexibility described, what should it pay)? The riskless rate is 2% per year.

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