Two companies are developing a 50-50 joint venture with a net present value (NPV) of $25 million. The annual volatility (standard deviation) of the venture cash flows is 20%. The risk-free rate is 5%. One of the companies wants to buy the right from the other to its 50% share in one year for $15 million.

a)Using the real options approach to project evaluation and the Black-Scholes option-pricing model, calculate and interpret the call option price for the firm buying this right. (12 marks)

b)Comment briefly on some of the challenges that may be encountered using the real options approach to capital budgeting. (3 marks)