Question 5

1. For each of the situations below, identify and describe the Real Option. Answer these specific questions: What constitutes the option cost, the exercise window, the trigger strategy? How could you estimate the value it gives you? (analytical answer only, no numerical analyses required, be short and precise)

1. Real Estate Development: You have been offered the opportunity to invest in the development of an apartment building in a year. Current expected value of the building is $25m. For the right to decide in a year, you have to pay $1m today, which will be adjusted against the required investment only if you choose to invest, otherwise forfeited. What kind of option is it, and how would you decide if the down payment is fair?

2. Research and development Project: A start-up company is offering you the opportunity to invest $5m today, with the opportunity to invest another $5m a year later, and a final $10m 2 years later. If you decide not to invest at any of the subsequent years, you can accept a payment if $2.5m and quit.

For this problem, assume the per period Risk free rate = R_f = 5%

Consider the investment opportunity for Franklin Capital, a phased project with the following decision points:

• Today, t = 0 Invest $100m immediately for permits and preparation
• At time = 1 Invest $500m to complete the design phase, or stop
• At time t = 2, or t = 3 Invest $1000m to expand by building the plant, or stop.

1. The PV of expected cash flows at t = 0 is $1000m. If the risk-adjusted discount rate is 15%, what is the NPV of the project? What is your decision about the project? Is this the correct approach? Explain
2. At each decision point, t = 0, 1, 2 3, carefully explain the opportunity as an option what type of option and what re its various parameters.
3. Calculate the option values at each decision point and explain the optimal action.

Event Tree: The expected PV of the project over the next 3 years is shown below: today Invest $100m 1 year Invest 500m 2 years invest $1000m or wait 3 years Invest 1000m Assume per period 1331 Risk-free Rate = 5% 1210 1089 1100 990 1000 891 900 810 729 Event Tree: The expected PV of the project over the next 3 years is shown below: today Invest $100m 1 year Invest 500m 2 years invest $1000m or wait 3 years Invest 1000m Assume per period 1331 Risk-free Rate = 5% 1210 1089 1100 990 1000 891 900 810 729