Exercise 3 You are the CEO of an engineering company and the engineers working for the company are claiming that the company must begin producing turbo-encabulators in order to keep up with the market developments in the industry and to compete on an international level. To produce such turbo-encabulators, you need to build a new factory. After some extensive research, you are left with two designs for the factory; Design X and Design Y If Design X is chosen, construction on the factory must begin immediately. However, if you choose Design Y, you can decide when to start construction (there is no timeline). However. Design Y is more expen be equally efficient and productive. Cash-flows will only be generated by either design once investment has been undertaken. The fixed operating cost is the same for each design. sive to construct. Assume further that the designs, once built, will Suppose then that the demand for turbo-encabultors declines implying that the new factory is no longer needed. You may abandon the construction of either design at zero cost. Describe the above situation in terms of calls and puts by drawing analogies with Amer ican perpetual options. . Formulate the problem in terms of real options techniques similar to those we discussed in class. . Using your set-up, which is the more attractive design in terms of net present value? Will you invest in this design immediately? Why/Why not? . Derive, using your chosen set-up, expressions for the value matching and smooth pasting conditions for each design. . For Design X, find analytical expressions for the investment and abandonment thresholds. Are these expressions intuitive? Why/Why not? Exercise 3 You are the CEO of an engineering company and the engineers working for the company are claiming that the company must begin producing turbo-encabulators in order to keep up with the market developments in the industry and to compete on an international level. To produce such turbo-encabulators, you need to build a new factory. After some extensive research, you are left with two designs for the factory; Design X and Design Y If Design X is chosen, construction on the factory must begin immediately. However, if you choose Design Y, you can decide when to start construction (there is no timeline). However. Design Y is more expen be equally efficient and productive. Cash-flows will only be generated by either design once investment has been undertaken. The fixed operating cost is the same for each design. sive to construct. Assume further that the designs, once built, will Suppose then that the demand for turbo-encabultors declines implying that the new factory is no longer needed. You may abandon the construction of either design at zero cost. Describe the above situation in terms of calls and puts by drawing analogies with Amer ican perpetual options. . Formulate the problem in terms of real options techniques similar to those we discussed in class. . Using your set-up, which is the more attractive design in terms of net present value? Will you invest in this design immediately? Why/Why not? . Derive, using your chosen set-up, expressions for the value matching and smooth pasting conditions for each design. . For Design X, find analytical expressions for the investment and abandonment thresholds. Are these expressions intuitive? Why/Why not
