(7.8) 2.0 18.1 2.0% 3 2.9 4 3.9 5 4.8 2.5 2.3 6 5.8 2.8 2.0 2.3 15% 6.7 3.0 3.7 8.4 - 0.9 1.6 3.0 Module 3 Problem Set 1 JTM Airlines Risk Analysis, Real Options, and Capital Budgeting 2 Rates: 3 Discount rate 5.5% Real Options 4 Risk-free rate 2.0% A. JTM Airlines is looking at buying more gates at their home airport. JTM's discount rate is 5.5% and the risk free rate is 2.0%. What is the NPV of the gate purchases if it bought Scenario: No Real Options them today? Use the data in the Excel template provided. 6 Start 1 B. After you run the numbers for part A, you remember back to the concept of real 7 Cash from Operations 1.0 2.0 options, which means that JTM can make investment decisions as time passes: 8 minus: Capital Expenditures 5.0 6.0 1. Present valuing the purchase price of the gates (that is, the years 1 and 2 9 = Net Cash Flow (4.0) (4.1) Capital Expenditures) separately using the risk-free rate. Once JTM decides to 10 Terminal Value go ahead with the purchase, there is no risk to that expenditure. 11 PV of NCF 9.4 2. Present valuing the Net Cash Flow excluding those purchase prices. This calculation will include Cap. Ex. for years 3-15 as they are part of the normal 12 Scenario: Real Options operation of the gates and are unrelated to the purchase price. 13 Start 1 2 3. Use the Black-Scholes Option Pricing formula to come up with option's price 14 Cash from Operations 1.0 2.0 assuming a 2-year maturity and a 15% price volatility for gate prices. 15 minus: Capital Expenditures 1.0 4. Compare the price of the call option with the NPV in the No Real Options 16 = Net Cash Flow (1.0) 1.0 2.0 scenario. Is the option worth it? 17 Terminal Value Decision Tree 18 PV of NCF 18.1 JTM really liked your work on the option pricing of the gates, so they ask you to look at their 3- 19 PV of Cap. Ex. (Yrs. 1-2) (7.8) phase expansion at their home airport. The three phases are: 20 21 A. Upon purchase of the new gates, start a marketing program to promote JTM's routes to 22 the East Coast, West Coast, and the Caribbean. If all goes well and the market is Option Pricing: PV of Cap. Ex. (Yrs. 1-2) Maturity PV of NCF Risk free rate Volatility BS calculations: dl N(dl) d2 Nd2) Price of call Difference: - Value of Option over PV % of PV 2.21 0.99 2.00 0.98 3 2.9 2.0 4 3.9 2.3 1.6 5 4.8 2.5 2.3 6 5.8 2.8 3.0 7 6.7 3.0 3.7 8.4 0.9 Answer part B. 4 in the box (7.8) 2.0 18.1 2.0% 3 2.9 4 3.9 5 4.8 2.5 2.3 6 5.8 2.8 2.0 2.3 15% 6.7 3.0 3.7 8.4 - 0.9 1.6 3.0 Module 3 Problem Set 1 JTM Airlines Risk Analysis, Real Options, and Capital Budgeting 2 Rates: 3 Discount rate 5.5% Real Options 4 Risk-free rate 2.0% A. JTM Airlines is looking at buying more gates at their home airport. JTM's discount rate is 5.5% and the risk free rate is 2.0%. What is the NPV of the gate purchases if it bought Scenario: No Real Options them today? Use the data in the Excel template provided. 6 Start 1 B. After you run the numbers for part A, you remember back to the concept of real 7 Cash from Operations 1.0 2.0 options, which means that JTM can make investment decisions as time passes: 8 minus: Capital Expenditures 5.0 6.0 1. Present valuing the purchase price of the gates (that is, the years 1 and 2 9 = Net Cash Flow (4.0) (4.1) Capital Expenditures) separately using the risk-free rate. Once JTM decides to 10 Terminal Value go ahead with the purchase, there is no risk to that expenditure. 11 PV of NCF 9.4 2. Present valuing the Net Cash Flow excluding those purchase prices. This calculation will include Cap. Ex. for years 3-15 as they are part of the normal 12 Scenario: Real Options operation of the gates and are unrelated to the purchase price. 13 Start 1 2 3. Use the Black-Scholes Option Pricing formula to come up with option's price 14 Cash from Operations 1.0 2.0 assuming a 2-year maturity and a 15% price volatility for gate prices. 15 minus: Capital Expenditures 1.0 4. Compare the price of the call option with the NPV in the No Real Options 16 = Net Cash Flow (1.0) 1.0 2.0 scenario. Is the option worth it? 17 Terminal Value Decision Tree 18 PV of NCF 18.1 JTM really liked your work on the option pricing of the gates, so they ask you to look at their 3- 19 PV of Cap. Ex. (Yrs. 1-2) (7.8) phase expansion at their home airport. The three phases are: 20 21 A. Upon purchase of the new gates, start a marketing program to promote JTM's routes to 22 the East Coast, West Coast, and the Caribbean. If all goes well and the market is Option Pricing: PV of Cap. Ex. (Yrs. 1-2) Maturity PV of NCF Risk free rate Volatility BS calculations: dl N(dl) d2 Nd2) Price of call Difference: - Value of Option over PV % of PV 2.21 0.99 2.00 0.98 3 2.9 2.0 4 3.9 2.3 1.6 5 4.8 2.5 2.3 6 5.8 2.8 3.0 7 6.7 3.0 3.7 8.4 0.9 Answer part B. 4 in the box