Pegasus Inc. wants to estimate the present value of a project. All pro- duction and sales take place one year from now, and there is no option to...

Pegasus Inc. wants to estimate the present value of a project. All pro-

duction and sales take place one year from now, and there is no option to

shut down production. The project will produce 50 (million) widgets in

all states of the world. The price of widgets next year will depend upon

demand conditions. If demand is high, each widget will sell for $200. If

demand is low, each widget will sell for $100. There are two inputs into

the production process: labor and oil. Labor costs at time 1 are equal to

$20 per widget. The folks over in production indicate that each widget

produced requires one barrel of oil at time 1. The folks over in marketing

and sales indicate that the performance of the stock market is a

perfect

predictor of demand for widgets, i.e., the demand for widgets is high when

the market return is high. You have been asked to value the project. The

following pieces of information may be useful to you.

There are no taxes. The historical equity beta for Pegasus is 1.2. Pegasus

has historically maintained a debt to equity ratio of 1/2. The spot price

of oil one year from now will be either $50 or $40 depending on condition

of world oil markets. The forward price for barrel of oil, deliverable one

year from now, is $45. One unit of the (market) S&P 500 index can be

purchased for $1000 today. The S&P will be worth either $1500 or $900

next year. The risk-free rate is 5%. The historical average return on the

market portfolio is 12%.

What is the most you would be willing to

pay for the rights to the project?