3. A project with an up-front cost at t=0 of $1500 is being considered by Nationwide PharmaceuticalCorporation (NPC). (All dollars in this problem are in thousands.) The projects subsequent cash flows arecritically dependent on whether a competitors product that is now under development is approved by the Food and Drug Administration. If the FDA rejects the competitive product upon the completion of its development, NPCs product will have high sales and cash flows, but if the competitive product is approved, that will negatively impact NPC. There is a 75% chance that the competitive product will be rejected, inwhich case NPCs expected cash flows will be $550 at the end of each of the next seven years (t = 1 to 7). There is a 25% chance that the competitors product will be approved, in which case the expected cashflows will be only $20 at the end of each of the next seven years (t = 1 to 7). NPC will know only sometime later whether the competitors product is going to be approved.

NPC will proceed with the investment today to take advantage of the untapped market potential and at theend of the projects life, after finding out about the FDAs decision about the demand for competitorsproduct, they will decide whether or not to renew the patent and rerun the project. The project reruns up- front cost (at t = 7) will remain at $1,500, and the subsequent cash flows will remain unchanged and will be received for seven additional years (t = 8 ... 14). They will only rerun the project if the rerun of the project adds value.

Assuming that all cash flows are discounted at 10%, use the black-Scholes model to estimate the value of the option. Assume that the variance from the projects rate of return is 0.2524 and the risk-free rate is 7%. (5 points)