Question #9
Chapter 22 Real Options Expansion options Look again at Table 22.2. How does the value in 1982 of the option to invest in the Mark II change if a. The investment required for the Mark II is $800 million (vs. $900 million)? b. The present value of the Mark II in 1982 is S500 million (vs. $467 million)? c. The standard deviation of the Mark II's present value is only 20% (vs. 35%)? 8. Timing options You own a parcel of vacant land. You can develop it now, or wait. a. What is the advantage of waiting? b. Why might you decide to develop the property immediately? 9. Timing options Look back at the Malted Herring option in Section 22-2. How did the com- pany's analysts estimate the present value of the project? It turns out that they assumed that the probability of low demand was about 45%. They then estimated the expected payoff as (.45 x 176) + (-55 x 275) = 230. Discounting at the company's 15% cost of capital gave a pres- ent value for the project of 230/1.15 = 200. a. How would this present value change if the probability of low demand was 55%? How would it change if the project's cost of capital was higher than the company cost of capital at, say, 20%? b. Now estimate how these changes in assumptions would affect the value of the option to delay. 10. Abandonment options A start-up company is moving into its first offices and needs desks. chairs, filing cabinets, and other furniture. It can buy the furniture for $25,000 or rent it for $1,500 per month. The founders are of course confident in their new venture, but nevertheless they rent. Why? What's the option? 11. Abandonment options Flip back to Tables 6.2 and 6.3, where we assumed an economic life! of seven years for IM&C's guano plant. What's wrong with that assumption? How would you werk of million); if you de how the project is We can use the bino westors are risk nem is risk-neutral world cash flow of $25 25 + 250/200 - 1 $16 million and a year-es or -12%. In a risk TULE HII you pul ve first year's cash flow ($16 million or delay, you miss out on this cash flow, but you will have more information roject is likely to work out. binomial method to value this option. The first step is to pretend that neutral and to calculate the probabilities of high and low demand in vorld. If demand is high in the first year, the malted herring plant has of $25 million and a year-end value of $250 million. The total return is If demand is low, the plant has a cash flow of a year-end value of $160 million. Total return is (16+160)/200 - 1= -12, risk-neutral world, the expected return would be equal to the interest rate. 2507200 - l = .375, or 37.5%. If demand , 430 million. The total return is which we assume is 5%: Now 200 (NPV = 200 - 180 = 20) (?) FIGURE 22.2 Possible cash flows and end-of-period values for the malted herring project are shown in black. The project costs $180 million, either now or later. The red figures in parentheses show payoffs from the option to wait and to invest later if the project is positive NPV at year 1. Waiting means loss of the first year's cash flows. The problem is to figure out the current value of the option. Cash flow =16 Cash flow = 25 Year 1 160 250 (250 - 180 = 70) We have been a bit te meaning is clear. But mely postpones productio een a bit vague about forecasted project cash flows. If competitors can enter and take away cash that you could have earned, ng is clear. But what about the decision to say, develop an oil well? Here delay doesn't waste barrels of oil in the ground; it pones production and the associated cash flow. The cost of waiting is the decline in today's present value of revenues from inses more slowly than the cost of capital
