Option Value

Hi John,

Please could you kindly guide me how should I approach this question.

S co have invent a product that can be developed over next 12 months. Annual demand of this product is 120,000 units at a contribution of $16 and has a life of 5 years once fully developed. It is envisaged that price inflation will be 2% but the standard deviation of contribution per unit will be 30%

Once fully developed company will need to spend$600000 on retooling one of its factories in order to undertake production though given volatility to prices in this market, it is by no means certain that S will chose to enter into production if prices have fallen dramatically

RFR =5% and Ke=12%

The question is asking to calculate the max development cost that S should be prepared t o pay today to create an option to develop the project stating any necessary assumption?

I know that assumptions part is about differnt types of option i-e Option to expand, to delay, option to withdraw or to redeploy however I m a bit clueless of how should I calculate the Development cost? Do I use the Black sholes model and if I m using this the Current price I will use is 16 and exercise price will be what then? do I need to inflate the 16 for next five years? or do I use exercise price as $6000,000 and discount it at current cost of capital to get the current price and then use black sholes model.

please just your little wisdom will help me to approach this question correctly..