Real Options Managing Risk in Strategic Alliances

You are a Brazilian bookstore that has floundered in the past few years. Although people are purchasing more books, you dont have the expertise needed to deal with changing market trends. You have identified a South African company that is doing very well creating kindle cafes where people browse for downloadable content at their store and enjoy a nice, relaxing reading atmosphere. You would like to partner with this company because they have been very successful in other countries. As a result, you have decided to contract with them to create a new type of bookstore, one that is half vintage bookstore and the other part is similar to the South African kindle cafes. Both of you invest a total of $10 M Real (The Real is Brazils national currency) (5M each) to create the first chain of stores in Rio and Manaus.

You are less ambitious than your South African Partners. They have already changed their plans three times, because the Ipad and other new technologies are changing the downloadable book market dramatically. They think there will be a strong outcome -- 30% net profits. You predict more modest growth, at 10% net profits. Thus, you have asked your partners for an assured 5% net profits (500,000 Real). During negotiations, you create a real option, where they offered you a 10% option fee (1M Real) to break your agreement in favor of 50/50 profit-sharing. All of these negotiations were based on the total cost of the project (10M Real).

1. Calculate the net profits for the Brazilian company and the South African company if the final profits result in 50% net profits (5M Real).
2. Calculate the net profits for both companies if you achieve 10% net profit (1M Real).