Chapter 14 Advanced Solutions

Chapter 26
Real Options
ANSWERS TO END-OF-CHAPTER QUESTIONS
26-1 a. Real options occur when managers can influence the size and risk of a project’s cash
flows by taking different actions during the project’s life. They are referred to as real
options because they deal with real as opposed to financial assets. They are also
called managerial options because they give opportunities to managers to respond to
changing market conditions. Sometimes they are called strategic options because
they often deal with strategic issues. Finally, they are also called embedded options
because they are a part of another project.
b. Investment timing options give companies the option to delay a project rather than
implement it immediately. This option to wait allows a company to reduce the
uncertainty of market conditions before it decides to implement the project. Capacity
options allow a company to change the capacity of their output in response to
changing market conditions. This includes the option to contract or expand
production. Growth options allow a company to expand if market demand is higher
than expected. This includes the opportunity to expand into different geographic
markets and the opportunity to introduce complementary or second-generation
products. It also includes the option to abandon a project if market conditions
deteriorate too much.
c. Decision trees are a form of scenario analysis in which different actions are taken in
different scenarios.
26-2 Postponing the project means that cash flows come later rather than sooner; however,
waiting may allow you to take advantage of changing conditions. It might make sense,
however, to proceed today if there are important advantages to being the first competitor
to enter a market.
26-3 Timing options make it less likely that a project will be accepted today. Often, if a firm
can delay a decision, it can increase the expected NPV of a project.
26-4 Having the option to abandon a project makes it more likely that the project will be
accepted today.
Answers and Solutions: 26 - 1

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
26-1 a. 0 1 2 20
├─────┼─────┼──────    ────┤
-20 3 3 3
NPV = $1.074 million.
b. Wait 1 year:
PV @
0 1 2 3 21 Yr. 1
r= 13%
Tax imposed | | | |    |
50% Prob. 0 -20 2.2 2.2 2.2 15.45
Tax not imposed | | | |    |

50% Prob. 0 -20 3.8 3.8 3.8 26.69
Tax imposed: NPV @ Yr. 1 = (-20 + 15.45)/(1.13) = -4.027

Tax not imposed: NPV @ Yr 1 = (-20 + 26.69)/ (1.13) = 5.920
Expected NPV = .5(-4.027) + .5(5.920) = 0.947
Note though, that if the tax is imposed, the NPV of the project is negative and therefore
would not be undertaken. The value of this option of waiting one year is evaluated as
0.5($0) + (0.5)($ 5.920) = $2.96 million.
Since the NPV of waiting one year is greater than going ahead and proceeding with the
project today, it makes sense to wait.

26-2 a. 0 10%
1 2 3 4
├─────┼─────┼─────┼─────┤
-8 4 4 4 4
NPV = $4.6795 million.
b. Wait 2 years:
PV @
0 1 2 3 4 5 6 Yr. 2
| r = 10% | | | | | |
10% Prob. 0 0 -9 2.2 2.2 2.2 2.2 $6.974
| | | | | | |
90% Prob. 0 0 -9 4.2 4.2 4.2 4.2 $13.313
Low CF scenario: NPV = (-9 + 6.974)/(1.1)2 = -$1.674

High CF scenario: NPV = (-9 + 13.313)/(1.1)2 = $3.564
Expected NPV = .1(-1.674) + .9(3.564) = 3.040
If the cash flows are only $2.2 million, the NPV of the project is negative and, thus,
would not be undertaken. The value of the option of waiting two years is evaluated as
0.10($0) + 0.90($3.564) = $3.208 million.
Since the NPV of waiting two years is less than going ahead and proceeding with the
project today, it makes sense to drill today.

26-3 a. 0 1 2 20
13%
├─────┼─────┼──────    ────┤
-300 40 40 40
NPV = -$19.0099 million. Don’t purchase.
b. Wait 1 year:
NPV @
0 1 2 3 4 21 Yr. 0
r = 13%
| | | | |    |
50% Prob. 0 -300 30 30 30 30 -$78.9889
| | | | |    |
50% Prob. 0 -300 50 50 50 50 45.3430
If the cash flows are only $30 million per year, the NPV of the project is negative.
However, we’ve not considered the fact that the company could then be sold for $280
million. The decision tree would then look like this:
NPV @
0 r = 13% 1 2 3 4 21 Yr. 0
| | | | |    |
50% Prob. 0 -300 30 30 + 280 0 0 -$27.1468
| | | | |    |
50% Prob. 0 -300 50 50 50 50 45.3430
The expected NPV of waiting 1 year is 0.5(-$27.1468) + 0.5($45.3430) = $9.0981

million.
Given the option to sell, it makes sense to wait 1 year before deciding whether to
make the acquisition.

26-4 a. 0 1 14 15
12%
| |    | |
-6,200,000 600,000 600,000 600,000
Using a financial calculator, input the following data: CF0 = -6,200,000;

CF1-15 = 600,000; I/YR = 12; and then solve for NPV = -$2,113,481.31.
b. 0 12% 1 14 15
| |    | |
-6,200,000 1,200,000 1,200,000 1,200,000
Using a financial calculator, input the following data: CF0 = -6,200,000;

CF1-15 = 1,200,000; I/YR = 12; and then solve for NPV = $1,973,037.39.
c. If they proceed with the project today, the project’s expected NPV = (0.5  -
$2,113,481.31) + (0.5  $1,973,037.39) = −$70,221.96. So, Hart Enterprises would not
do it.
d. Since the project’s NPV with the tax is negative, if the tax were imposed the firm
would abandon the project. Thus, the decision tree looks like this:
NPV @
0 1 2 15 Yr. 0
r= 12%
50% Prob. | | |    |
Taxes -6,200,000 6,000,000 0 0 -$ 842,857.14
No Taxes | | |    |
50% Prob. -6,200,000 1,200,000 1,200,000 1,200,000 1,973,037.39
Expected NPV $ 565,090.13
Yes, the existence of the abandonment option changes the expected NPV of the project
from negative to positive. Given this option the firm would take on the project because
its expected NPV is $565,090.13.

e. NPV @
0 1 Yr. 0
r = 12%
50% Prob. | |
Taxes NPV = ? -1,500,000 $ 0.00
+300,000 = NPV @ t = 1 wouldn’t do
No Taxes | |
50% Prob. NPV = ? -1,500,000 2,232,142.86
+4,000,000 = NPV @ t = 1 Expected NPV $1,116,071.43
If the firm pays $1,116,071.43 for the option to purchase the land, then the NPV of the
project is exactly equal to zero. So the firm would not pay any more than this for the
option.

26-5
a.
0 1 2
r = 10%
40% Prob. | | |
Good -20,000 25,000 25,000 NPV = 23,388
Bad | | |
60% Prob. -20,000 5,000 5,000 NPV = -11,322
ENPV = 23,388 (0.40) – 11,322 (0.60) = $2,562
b.
0 r = 10% 1 2 3 4
40% Prob. | | | | |
Good -20,000 25,000 25,000 25,000 25,000
-20,000 (r = 6%)
Bad | | | | |
60% Prob. -20,000 5,000 5,000 0 0
The PV of the 20,000 payment in year 2 at the risk free rate is 20,000/(1.06)2 = 17,800.
The PV of the 4 cash flows of 25,000 in years 1 through 4 at the cost of capital of 10%
is 79,247.
The NPV of the top row is 79,247 – 20,000 – 17,800 = 41,447.
The NPV of the bottom row is still -11,332, as it was in part a.
The expected NPV, E[NPV], is 41,447 (0.40) -11,332 (0.60) = $9,786.
E[NPV] = 23,388 (0.40) – 11,322 (0.60) = $2,562. This is the expected NPV of the
project including the growth option. The value of the growth option itself is the
difference:
Value of growth option = 9,786 – 2,562 = 7,224.

26-6 P = PV of all expected future cash flows if project is delayed. From Problem 14-1 we
know that PV @ Year 1 of Tax Imposed scenario is $15.45 and PV @ Year 1 of Tax Not
Imposed Scenario is $26.69. So the PV is:
P = [0.5(15.45)+ 0.5(26.690] / 1.13 = $18.646.

X = $20.
t = 1.
rRF = 0.08.
2 = 0.0687.
d1 = ln[18.646/20] + [0.08 + .5(.0687)](1) = 0.1688

(.0687)0.5 (1)0.5
d2 = 0.1688 - (.0687)0.5 (1)0.5 = -0.0933
From Excel function NORMSDIST, or approximated from the table in Appendix A:

N(d1) = 0.5670
N(d2) = 0.4628
Using the Black-Scholes Option Pricing Model, you calculate the option’s value as:
V = P[N(d1)] - Xe  rRF t [N(d2)]

= $18.646(0.5670) - $20e(-0.08)(1)(0.4628)
= $10.572 - $8.544
= $2.028 million.

26-7 P = PV of all expected future cash flows if project is delayed. From Problem 14-1 we
know that PV @ Year 2 of Low CF Scenario is $6.974 and PV @ Year 2 of High CF
Scenario is $13.313. So the PV is:
P = [0.1(6.974)+ 0.9(13.313] / 1.102 = $10.479.

X = $9.
t = 2.
rRF = 0.06.
2 = 0.0111.
d1 = ln[10.479/9] + [0.06 + .5(.0111)](2) = 1.9010

(.0111)0.5 (2)0.5
d2 = 1.9010 - (.0111)0.5 (2)0.5 = 1.7520

N(d1) = 0.9713
N(d2) = 0.9601
V = P[N(d1)] - Xe  rRF t [N(d2)]

= $10.479(0.9713) - $9e(-0.06)(2)(0.9601)
= $10.178 - $7.664
= $2.514 million.
26-8 P = PV as of time zero of all expected future cash flows if the project is repeated starting
in year 2. Note it includes both the good cash flows and the bad cash flows since as of
now, we don’t know which outcome will result, and P excludes the $20,000 investment
in the franchise.
0 r = 10% 1 2 3 4
40% Prob. | | | | |
Good 25,000 25,000
Bad | | | | |
60% Prob. 5,000 5,000
EPV of cash flows (as of time 0) = 35,858(0.40) + 7,172(0.60) = $18,646 = P.
The strike price, X, is the cost to extend the franchise at the end of year 2, and is $20,000.

The time to expiration is the time you decide whether or not to extend the franchise, and
is at the end of year 2.
P = $18,646
X = $20,000
t = 2.
rRF = 0.06.
σ2 = 0.2025
Although the problem stated to assume the variance of the project’s rate of return was
0.2025, we’ll also calculate it using the direct method. First calculate the rates of return
using the decision tree. To do this, calculate the present values of the two branches as of
the exercise date, year 2, and the rates of return assuming the initial value of the
investment was P = $18,646.
0 1 2 3 4
40% Prob. | | | | |
Good 43,388 = PV of two 25,000 cash flows
Bad | | | | |
60% Prob. 8,678 = PV of two 5,000 cash flows
Annual rate of return in good state = [43,388/18,646]1/2 -1 = 52.54%

Annual rate of return in bad state = [8,678/18,646]1/2 – 1 = -31.78%
The expected value of these two returns is 52.54(0.40) – 31.78(0.60) = 1.95% [Note: this
isn’t 10% as you might hope! The 2-year returns are 43,388/18,646 – 1 = 132.69% in
the good state and 8,678/18,646 – 1 = -53.46% in the bad state. The expected value of
these is 132.69% (0.40) - 53.46% (0.60) = 21.0%, which is exactly 10% compounded
twice: 0.21 = (1.10)2 – 1.]
The variance is
σ2 = (0.5254 - 0.0195)2(0.40) + (-0.3178 – 0.0195)2 (0.60) = 0.1706

To calculate the variance of the project’s returns using the indirect method, first calculate
the standard deviation of the value at year 2. The value is either 43,388 (probability
40%) or 8,678 (probability 60%).
Expected value at year 2: 43,388(0.4) + 8,678(0.6) = 22,562.

Standard deviation = [(43,388-22,562)2(0.40) + (8,678 – 22,562)2(0.60)]1/2 = 17,004.
Then calculate the coefficient of variation:

CV = 17,004/22,562 = 0.7537.
σ2 = ln(CV2+1)/t = ln(0.75372+1)/2 = 0.2249

so σ2 = 0.2249
Notice that in this case the direct method and the indirect method give very similar results
for σ.
P = $18,646
X = $20,000
t = 2.
rRF = 0.06.
σ2 = 0.2025
d1 = ln[18.646/20] + [0.06 + .5(0.2025)](2) = 0.3966

(0.2025)0.5 (2)0.5
d2 = 0.3966 - (0.2025)0.5 (2)0.5 = -0.2398

N(d1) = 0.6542
N(d2) = 0.4053
V = P[N(d1)] - Xe  rRF t [N(d2)]

= $18.646(0.6542) - $20e(-0.06)(2)(0.4053)
= $12.198 - $7.189
= $5.009 thousand.

SOLUTION TO SPREADSHEET PROBLEMS
26-9 The detailed solution for the problem is available in the file, Ch 26 P9 Build a Model
Solution.xls, on the textbook’s Web site.

MINI CASE
Assume that you have just been hired as a financial analyst by Tropical Sweets Inc., a mid-
sized California company that specializes in creating exotic candies from tropical fruits
such as mangoes, papayas, and dates. The firm's CEO, George Yamaguchi, recently
returned from an industry corporate executive conference in San Francisco, and one of the
sessions he attended was on real options. Since no one at Tropical Sweets is familiar with
the basics of real options, Yamaguchi has asked you to prepare a brief report that the
firm's executives could use to gain at least a cursory understanding of the topics.
To begin, you gathered some outside materials the subject and used these materials to
draft a list of pertinent questions that need to be answered. In fact, one possible approach
to the paper is to use a question-and-answer format. Now that the questions have been
drafted, you have to develop the answers.
a. What are some types of real options?
Answer: 1. Investment timing options

2. Growth options
a. Expansion of existing product line
b. New products
c. New geographic markets
3. Abandonment options
a. Contraction
b. Temporary suspension
c. Complete abandonment
4. Flexibility options.
b. What are five possible procedures for analyzing a real option?
Answer: 1. DCF analysis of expected cash flows, ignoring option.

2. Qualitatively assess the value of the real option.
3. Decision tree analysis.
4. Use a model for a corresponding financial option, if possible.
5. Use financial engineering techniques if a corresponding financial option is not
available.
Mini Case: 26 - 13
c. Tropical Sweets is considering a project that will cost $70 million and will
generate expected cash flows of $30 per year for three years. The cost of capital
for this type of project is 10 percent and the risk-free rate is 6 percent. After
discussions with the marketing department, you learn that there is a 30 percent
chance of high demand, with future cash flows of $45 million per year. There is
a 40 percent chance of average demand, with cash flows of $30 million per year.
If demand is low (a 30 percent chance), cash flows will be only $15 million per
year. What is the expected NPV?
Answer: Initial Cost = $70 Million

Expected Cash Flows = $30 Million Per Year For Three Years
Cost Of Capital = 10%
PV Of Expected CFs = $74.61 Million
Expected NPV = $74.61 - $70
= $4.61 Million
Alternatively, one could calculate the NPV of each scenario:

Demand Probability Annual Cash Flow
High 30% $45
Average 40% $30
Low 30% $15
Find NPV of each scenario:

PV High: N=3 I=10 PV=? PMT=-45 FV=0
PV= 111.91
NPV High = $111.91 - $70 = $41.91 Million.
PV Average: N=3 I=10 PV=? PMT=-30 FV=0
PV= 74.61
NPV Average = $74.61 - $70 = $4.71 Million.
PV Low: N=3 I=10 PV=? PMT=-15 FV=0
PV= 37.30
NPV Low = $37.30 - $70 = -$32.70 Million.
Find Expected NPV:

E(NPV)=.3($41.91)+.4($4.61)+.3(-$32.70)
E(PV)= $4.61.
Mini Case: 26 - 14
d. Now suppose this project has an investment timing option, since it can be
delayed for a year. The cost will still be $70 million at the end of the year, and
the cash flows for the scenarios will still last three years. However, Tropical
Sweets will know the level of demand, and will implement the project only if it
adds value to the company. Perform a qualitative assessment of the investment
timing option’s value.
Answer: If we immediately proceed with the project, its expected NPV is $4.61 million.
However, the project is very risky. If demand is high, NPV will be $41.91
million. If demand is average, NPV will be $4.61 million. If demand is low, NPV
will be -$32.70 million. However, if we wait one year, we will find out additional
information regarding demand. If demand is low, we won’t implement project. If
we wait, the up-front cost and cash flows will stay the same, except they will be
shifted ahead by a year.
The value of any real option increases if the underlying project is very risky or if
there is a long time before you must exercise the option.
This project is risky and has one year before we must decide, so the option to wait
is probably valuable.
Mini Case: 26 - 15
e. Use decision tree analysis to calculate the NPV of the project with the investment
timing option.
Answer: The project will be implemented only if demand is average or high.

Here is the time line:
0 1 2 3 4
High $0 -$70 $45 $45 $45
Average $0 -$70 $30 $30 $30
Low $0 $0 $0 $0 $0
To find the NPVC, discount the cost at the risk-free rate of 6 percent since it is known
for certain, and discount the other risky cash flows at the 10 percent cost of capital.
High: NPV = -$70/1.06 + $45/1.102 + $45/1.103 +$45/1.104 = $35.70

Average: NPV = -$70/1.06 + $30/1.102 + $30/1.103 +$30/1.104 = $1.79
Low: NPV = $0.
Expected NPV = 0.3($35.70) + 0.4($1.79) + 0.3($0) = $11.42.
Since this is much greater than the NPV of immediate implementation (which is
$4.61 million) we should wait. In other words, implementing immediately gives an
expected NPV of $4.61 million, but implementing immediately means we give up the
option to wait, which is worth $11.42 million.
f. Use a financial option pricing model to estimate the value of the investment
timing option.
Answer: The option to wait resembles a financial call option-- we get to “buy” the project for
$70 million in one year if value of project in one year is greater than $70 million.
This is like a call option with a strike price of $70 million and an expiration date of
one year.
X = Strike Price = Cost Of Implement Project = $70 Million.
RRF = Risk-Free Rate = 6%.
T = Time To Maturity = 1 year.
P = Current Price Of Stock = Current Value Of The Project’s Future Cash Flows.
σ 2 = Variance Of Stock Return = Variance Of Project’s Rate Of Return.
Mini Case: 26 - 16
We explain how to calculate P and σ2 below.
Just as the price of a stock is the present value of all the stock’s future cash flows, the
“price” of the real option is the present value of all the project’s cash flows that occur
beyond the exercise date. Notice that the exercise cost of an option does not affect
the stock price. Similarly, the cost to implement the real option does not affect the
current value of the underlying asset (which is the PV of the project’s cash flows). It
will be helpful in later steps if we break the calculation into two parts. First, we find
the value of all cash flows beyond the exercise date discounted back to the exercise
date. Then we find the expected present value of those values.
Step 1: Find the value of all cash flows beyond the exercise date discounted back to
the exercise date. Here is the time line. The exercise date is year 1, so we discount
all future cash flows back to year 1.
0 1 2 3 4
High $45 $45 $45
Average $30 $30 $30
Low $15 $15 $15
High: PV1 = $45/1.10 + $45/1.102 + $45/1.103 = $111.91

Average: PV1 = $30/1.10 + $30/1.102 + $30/1.103 = $74.61
Low: PV1 = $15/1.10 + $15/1.102 + $15/1.103 = $37.30
The current expected present value, P, is:

P = 0.3[$111.91/1.1] + 0.4[$74.61/1.1] + 0.3[$37.30/1.1] = $67.82.
For a stock option, σ2 is the variance of the stock return, not the variance of the stock
price. Therefore, for a real option we need the variance of the project’s rate of return.
There are three ways to estimate this variance. First, we can use subjective judgment.
Second, we can calculate the project’s return in each scenario and then calculate the
return’s variance. This is the direct approach. Third, we know the projects value at
each scenario at the expiration date, and we know the current value of the project.
Thus, we can find a variance of project return that gives the range of project values
that can occur at expiration. This is the indirect approach.
Mini Case: 26 - 17
Following is an explanation of each approach.
Subjective estimate:
The typical stock has σ2 of about 12%. Most projects will be somewhat riskier than
the firm, since the risk of the firm reflects the diversification that comes from having
many projects. Subjectively scale the variance of the company’s stock return up or
down to reflect the risk of the project. The company in our example has a stock with
a variance of 10%, so we might expect the project to have a variance in the range of
12% to 19%.
Direct approach:
From our previous analysis, we know the current value of the project and the value
for each scenario at the time the option expires (year 1). Here is the time line:
Current Value Value At Expiration

Year 0 Year 1
High $67.82 $111.91
Average $67.82 $74.61
Low $67.82 $37.30
The annual rate of return is:

High: Return = ($111.91/$67.82) – 1 = 65%.
High: Average = ($74.61/$67.82) – 1 = 10%.
High: Return = ($37.30/$67.82) – 1 = -45%.
Expected Return = 0.3(0.65) + 0.4(0.10) + 0.3(-0.45)

= 10%.
2 = 0.3(0.65-0.10)2 + 0.4(0.10-0.10)2 + 0.3(-0.45-0.10)2

= 0.182 = 18.2%.
The direct approach gives an estimate of 18.2% for the variance of the project’s
return.
Mini Case: 26 - 18
The indirect approach:
Given a current stock price and an anticipated range of possible stock prices at some
point in the future, we can use our knowledge of the distribution of stock returns
(which is lognormal) to relate the variance of the stock’s rate of return to the range of
possible outcomes for stock price. To use this formula, we need the coefficient of
variation of stock price at the time the option expires. To calculate the coefficient of
variation, we need the expected stock price and the standard deviation of the stock
price (both of these are measured at the time the option expires). For the real option,
we need the expected value of the project’s cash flows at the date the real option
expires, and the standard deviation of the project’s value at the date the real option
expires.
We previously calculated the value of the project at the time the option expires, and
we can use this to calculate the expected value and the standard deviation.
Value At Expiration
Year 1
High $111.91
Average $74.61
Low $37.30
Expected Value =.3($111.91)+.4($74.61)+.3($37.3)

= $74.61.
value = [.3($111.91-$74.61)2 + .4($74.61-$74.61)2
+ .3($37.30-$74.61)2]1/2
= $28.90.
Coefficient Of Variation = CV = Expected Value / value

CV = $74.61 / $28.90 = 0.39.
Here is a formula for the variance of a stock’s return, if you know the coefficient of
variation of the expected stock price at some point in the future. The CV should be
for the entire project, including all scenarios:
σ2 = LN[CV2 + 1]/T = LN[0.392 + 1]/1 = 14.2%.
Mini Case: 26 - 19
Now, we proceed to use the OPM:
V = $67.83[N(d1)] - $70e-(0.06)(1)[N(d2)].
ln( $67.83/$70 )  [( 0.06  0.142/2 )](15)

d1 =
0.5 0.5
(.142 ) (1)
= 0.2641.
d2 = d1 - (0.142)0.5(1)0.5 = 0.2641 - 0.3768

= -0.1127.
N(d1) = N(0.2641) = 0.6041.
N(d2) = N(-0.1127) = 0.4551.
therefore,
V = $67.83(0.6041) - $70e-0.06(0.4551)
= $10.98.
g. Now suppose the cost of the project is $75 million and the project cannot be
delayed. But if Tropical Sweets implements the project, then Tropical Sweets
will have a growth option. It will have the opportunity to replicate the original
project at the end of its life. What is the total expected NPV of the two projects
if both are implemented?
Answer: Suppose the cost of the project is $75 million instead of $70 million, and there is no
option to wait.
NPV = PV of future cash flows - cost
= $74.61 - $75 = -$0.39 million.
The project now looks like a loser. Using NPV analysis:
NPV = NPV Of Original Project + NPV Of Replication Project
= -$0.39 + -$0.39/(1+0.10)3
= -$0.39 + -$0.30 = -$0.69.
Still looks like a loser, but you will only implement project 2 if demand is high. We
might have chosen to discount the cost of the replication project at the risk-free rate,
and this would have made the NPV even lower.
Mini Case: 26 - 20
h. Tropical Sweets will replicate the original project only if demand is high. Using
decision tree analysis, estimate the value of the project with the growth option.
Answer: The future cash flows of the optimal decisions are shown below. The cash flow in
year 3 for the high demand scenario is the cash flow from the original project and the
cost of the replication project.
0 1 2 3 4 5 6
High -$75 $45 $45 $45 -$70 $45 $45 $45
Average -$75 $30 $30 $30 $0 $0 $0
Low -$75 $15 $15 $15 $0 $0 $0
To find the NPV, we discount the risky cash flows at the 10 percent cost of capital,
and the non-risky cost to replicate (i.e., the $75 million) at the risk-free rate.
NPV high = -$75 + $45/1.10 + $45/1.102 + $45/1.103 + $45/1.104

+ $45/1.105 + $45/1.106 - $75/1.063
= $58.02
NPV average = -$75 + $30/1.10 + $30/1.102 + $30/1.103 = -$0.39
NPV average = -$75 + $15/1.10 + $15/1.102 + $15/1.103 = -$37.70
Expected NPV = 0.3($58.02) + 0.4(-$0.39) + 0.3(-$37.70) = $5.94.
Thus, the option to replicate adds enough value that the project now has a positive
NPV.
Mini Case: 26 - 21
i. Use a financial option model to estimate the value of the growth option.
Answer: X = Strike Price = Cost Of Implement Project = $75 million.

RRF = Risk-Free Rate = 6%.
T = Time To Maturity = 3 years.
P = Current Price Of Stock = Current Value Of The Project’s Future Cash Flows.
σ2 = Variance Of Stock Return = Variance Of Project’s Rate Of Return.
We explain how to calculate P and σ2 below.
Step 1: Find the value of all cash flows beyond the exercise date discounted back to
the exercise date. Here is the time line. The exercise date is year 1, so we discount
all future cash flows back to year 3.
0 1 2 3 4 5 6
High $45 $45 $45
Average $30 $30 $30
Low $15 $15 $15
High: PV3 = $45/1.10 + $45/1.102 + $45/1.103 = $111.91

Average: PV3 = $30/1.10 + $30/1.102 + $30/1.103 = $74.61
Low: PV3 = $15/1.10 + $15/1.102 + $15/1.103 = $37.30
The current expected present value, P, is:

P = 0.3[$111.91/1.13] + 0.4[$74.61/1.13] + 0.3[$37.30/1.13] = $56.05.
Mini Case: 26 - 22
Direct approach for estimating σ2:
From our previous analysis, we know the current value of the project and the value
for each scenario at the time the option expires (year 3). Here is the time line:
Current Value Value At Expiration

Year 0 Year 3
High $56.02 $111.91
Average $56.02 $74.61
Low $56.02 $37.30
The annual rate of return is:

High: Return = ($111.91/$56.02)(1/3) – 1 = 25.9%.
High: Average = ($74.61/$56.02)(1/3) – 1 = 10%.
High: Return = ($37.30/$56.02)(1/3) – 1 = -12.7%.
Expected Return = 0.3(0.259) + 0.4(0.10) + 0.3(-0.127)

= 8.0%.
2 = 0.3(0..259-0.08)2 + 0.4(0.10-0.08)2 + 0.3(-0.127-0.08)2

= 0.182 = 2.3%.
This is lower than the variance found for the previous option because the dispersion
of cash flows for the replication project is the same as for the original, even though
the replication occurs much later. Therefore, the rate of return for the replication is
less volatile. We do sensitivity analysis later.
Mini Case: 26 - 23
The indirect approach:
First, find the coefficient of variation for the value of the project at the time the option
expires (year 3).
We previously calculated the value of the project at the time the option expires, and
we can use this to calculate the expected value and the standard deviation.
Value At Expiration
Year 3
High $111.91
Average $74.61
Low $37.30
Expected Value =.3($111.91)+.4($74.61)+.3($37.3)

= $74.61.
value = [.3($111.91-$74.61)2 + .4($74.61-$74.61)2
+ .3($37.30-$74.61)2]1/2
= $28.90.
Coefficient of Variation = CV = Expected Value / value

CV = $74.61 / $28.90 = 0.39.
To find the variance of the project’s rate or return, we use the formula below:
σ2 = LN[CV2 + 1]/T = LN[0.392 + 1]/3 = 4.7%.
Mini Case: 26 - 24
Now, we proceed to use the OPM:
V = $56.06[N(d1)] - $75e-(0.06)(3)[N(d2)].
ln( $56.06/$75 )  [( 0.06  0.047/2 )]( 3)

d1 =
0.5 0.5
(0.047 ) (3)
= -0.1085.
d2 = d1 - (0.047)0.5(3)0.5 = -.1085 - 0.3755

= -0.4840.
N(d1) = N(-0.1080) = 0.4568.
N(d2) = N(-0.4835) = 0.3142.

Therefore,
V = $56.06(0.4568) - $75e-(0.06)(3)(0.3142)
= $5.92.
Total Value = NPV Of Project 1 + Value Of Growth Option

=-$0.39 + $5.92
= $5.5 million
j. What happens to the value of the growth option if the variance of the project’s
return is 14.2 percent? What if it is 50 percent? How might this explain the
high valuations of many dot.com companies?
Answer: If risk, defined by σ2, goes up, then value of growth option goes up (see the file Ch26
mini case.xls for calculations):
σ2 = 4.7%, option value = $5.92
σ2 = 14.2%, option value = $12.10
σ2 = 50%, option value = $24.09
If the future profitability of dot.com companies is very volatile (i.e., there is the
potential for very high profits), then a company with a real option on those profits
might have a very high value for its growth option.
Mini Case: 26 - 25
Mini Case: 26 - 26

Chapter 14 Advanced Solutions

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 14 Advanced Solutions

Uploaded by

Copyright:

Available Formats

Chapter 26

Answers and Solutions: 26 - 1

NPV = $1.074 million.

Tax not imposed | | | |    |

Tax imposed: NPV @ Yr. 1 = (-20 + 15.45)/(1.13) = -4.027

Answers and Solutions: 26 - 2

NPV = $4.6795 million.

Low CF scenario: NPV = (-9 + 6.974)/(1.1)2 = -$1.674

Answers and Solutions: 26 - 3

NPV = -$19.0099 million. Don’t purchase.

The expected NPV of waiting 1 year is 0.5(-$27.1468) + 0.5($45.3430) = $9.0981

Answers and Solutions: 26 - 4

Using a financial calculator, input the following data: CF0 = -6,200,000;

Using a financial calculator, input the following data: CF0 = -6,200,000;

Answers and Solutions: 26 - 5

Answers and Solutions: 26 - 6

ENPV = 23,388 (0.40) – 11,322 (0.60) = $2,562

The NPV of the top row is 79,247 – 20,000 – 17,800 = 41,447.

The NPV of the bottom row is still -11,332, as it was in part a.

The expected NPV, E[NPV], is 41,447 (0.40) -11,332 (0.60) = $9,786.

Value of growth option = 9,786 – 2,562 = 7,224.

Answers and Solutions: 26 - 7

P = [0.5(15.45)+ 0.5(26.690] / 1.13 = $18.646.

d1 = ln[18.646/20] + [0.08 + .5(.0687)](1) = 0.1688

d2 = 0.1688 - (.0687)0.5 (1)0.5 = -0.0933

From Excel function NORMSDIST, or approximated from the table in Appendix A:

V = P[N(d1)] - Xe  rRF t [N(d2)]

Answers and Solutions: 26 - 8

P = [0.1(6.974)+ 0.9(13.313] / 1.102 = $10.479.

d1 = ln[10.479/9] + [0.06 + .5(.0111)](2) = 1.9010

d2 = 1.9010 - (.0111)0.5 (2)0.5 = 1.7520

From Excel function NORMSDIST, or approximated from the table in Appendix A:

V = P[N(d1)] - Xe  rRF t [N(d2)]

EPV of cash flows (as of time 0) = 35,858(0.40) + 7,172(0.60) = $18,646 = P.

Answers and Solutions: 26 - 9

Annual rate of return in good state = [43,388/18,646]1/2 -1 = 52.54%

Answers and Solutions: 26 - 10

Expected value at year 2: 43,388(0.4) + 8,678(0.6) = 22,562.

Then calculate the coefficient of variation:

σ2 = ln(CV2+1)/t = ln(0.75372+1)/2 = 0.2249

d1 = ln[18.646/20] + [0.06 + .5(0.2025)](2) = 0.3966

d2 = 0.3966 - (0.2025)0.5 (2)0.5 = -0.2398

From Excel function NORMSDIST, or approximated from the table in Appendix A:

V = P[N(d1)] - Xe  rRF t [N(d2)]

Answers and Solutions: 26 - 11

Answers and Solutions: 26 - 12

a. What are some types of real options?

Answer: 1. Investment timing options

b. What are five possible procedures for analyzing a real option?

Answer: 1. DCF analysis of expected cash flows, ignoring option.

Answer: Initial Cost = $70 Million

Alternatively, one could calculate the NPV of each scenario:

Find NPV of each scenario:

Find Expected NPV:

Answer: The project will be implemented only if demand is average or high.

High: NPV = -$70/1.06 + $45/1.102 + $45/1.103 +$45/1.104 = $35.70

Expected NPV = 0.3($35.70) + 0.4($1.79) + 0.3($0) = $11.42.

High: PV1 = $45/1.10 + $45/1.102 + $45/1.103 = $111.91

The current expected present value, P, is:

Current Value Value At Expiration

The annual rate of return is:

Expected Return = 0.3(0.65) + 0.4(0.10) + 0.3(-0.45)

2 = 0.3(0.65-0.10)2 + 0.4(0.10-0.10)2 + 0.3(-0.45-0.10)2

Expected Value =.3($111.91)+.4($74.61)+.3($37.3)