Describe each of the following situations in the language of options:

(a) Drilling rights to undeveloped heavy crude oil in Northern Alberta. Development and production of the oil is a negative-NPV endeavor. (The break-even oil price is C$32 per barrel, versus a spot price of C$20.) However, the decision to develop can be put off for up to five years. Development costs are expected to increase by 5 percent per year.

(b) A restaurant is producing net cash flows, after all out-of-pocket expenses, of $700,000 per year. There is no upward or downward trend in the cash flows, but they fluctuate, with an annual standard deviation of 15 percent. The real estate occupied by the restaurant is owned, not leased, and could be sold for $5 million. Ignore taxes.

(c) A variation on part (b): Assume the restaurant faces known fixed costs of $300,000 per year, incurred as long as the restaurant is operating. Thus

Net cash flow = revenue less variable costs – fixed costs

$700,000 = 1,000,000 – 300,000

The annual standard deviation of the forecast error of revenue less variable costs is 10.5 percent. The interest rate is 10 percent. Ignore taxes.

(d) A paper mill can be shut down in periods of low demand and restarted if demand improves sufficiently. The costs of closing and reopening the mill are fixed.

(e) A real-estate developer uses a parcel of urban land as a parking lot, although construction of either a hotel or an apartment building on the land would be a positive-NPV investment.

(f) Air France negotiates a purchase option for the first 10 Sonic Cruisers produced by Boeing. Air France must confirm its order in 2005. Otherwise, Boeing will be free to sell the aircraft to other airlines.