This one is throwing me for a loop. The book material does not really speak to this.

A)JTM Airlines, where you work, is looking at potentially buying more gates at their home airport.If it pays the airport $1M, JTM will hold exclusive rights to buy those gates for $17.5M (at the start) and $17.7M (one year later) at any time in the next 3 years.The option expires at the end of year 3.JTM's discount rate is 13%.What is the NPV of the gate purchases if it bought them today?Use the data in the template above.

B) After you run the numbers for part A, you know that the 3-year option has value so you decide to calculate it by:

1. present valuing the purchase price of the gatesseparatelyusing the risk-free rate.Once JTM decides to go ahead with the purchase, there is no risk to that expenditure

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 operation of the gates and are unrelated to the purchase price

3. using the Black-Scholes Option Pricing formula to come up with option's price assuming a 3-year maturity and a 10% price volatility for gate prices

4. you compare the price of the call option as calculated using the BSO formula with the NPV in the No Real Options scenario.With this, you can decide whether or not the $1M option is worth it or not.Is it?

JTM AirlinesRates:

Discount rate13.0%

Risk-free rate8.0%

Scenario: No Real Options

Cash from Operations

4.211.912.99.48.18.09.812.815.915.214.914.615.516.615.2

minus: Capital Expenditures17.517.75.34.13.51.30.10.3-0.18.1(0.1)0.20.1-

= Net Cash Flow (13.3)(5.8)7.65.34.66.79.712.515.915.16.814.715.316.515.2

Terminal Value 67.8

PV of NCF30.2

Scenario: Real OptionsOption Pricing:

PV of Cap. Ex. (Yrs. 1-2)

Cash from Operations 4.211.912.99.48.18.09.812.815.915.214.914.615.516.615.2

minus: Capital Expenditures 5.34.13.51.30.10.3-0.18.1(0.1)0.20.1-

= Net Cash Flow

Terminal Value 67.8

PV of NCF

PV of Cap. Ex. (Yrs. 1-2)

Maturity 3.0

PV of NCF

Risk free rate

Volatility 10%

BS calculations:

d1

N(d1)

d2

N(d2)

Price of call

Difference:

- Value of Option over PV

- % of PV