Chapter 13: Real Options, Investment Strategy and Process Problem 1 Ptoject cost (Rs crore) PV of project's cash

flows (Rs crore) NPV (Rs crore) Cost of expansion (Rs crore) PV of cash flows of expansion (Rs crore) Time period (years) Standard deviation Risk-free rate
d1 = ln(S / E ) + r f + 2 / 2 t t

800 700 -100 2,000 2,100 3 32% 7.50%

E S0 t rf

0.7711

d2 = d t 1
N(d1) N(d2)
C = SN

0.2168 0.7797 0.5858

(d 1 )

Ee

rf t

N (d

701.72 601.72

Value of the project with option to expand (Rs crore): -100 + 701.72 Problem 2 Cost of development (Rs crore) PV of cash flows (Rs crore) NPV (Rs crore) Abandonment price (Rs crore) Time period (years) Standard deviation Risk-free rate Dividend yield: 1/30 ln(S / E ) + rf + 2 / 2 t d1 = t

1,200 1,000 -200 450 7 0.35 7.80% 0.0333

S0 E t rf y

1.9149 0.9889 0.9722 0.8387

d2 = d t 1
N(d1) N(d2)

The Black-Scholes call value will have to be adjusted for the assumed dividend yield. The adjustment will be made in the value of S0
C = Se
yt

N (d 1

Ee

rf t

N (d

551.31

Problem 3 Cost (Rs crore) Annual cash flows (Rs crore) Cost of capital PV of cash flows (Rs crore): 24/0.10 NPV (S crore): -185 + 24/0.10 Standard deviation Time period (years) Ris-free rate Using Balck-Schloes formula, we obtain: 185 24 10% 240 55 0.25 25 5%

d1 d2 N (d1 N (d2) Value of call Value of put Problem 4 Cost (Rs crore) Life (years) Annual cash flow (Rs crore) Cost of capital Risk-free rate Cash flow volatility (variance) Cash flow volatility (standard deviation) PV of cash flows (Rs crore) NPV (Rs crore) Suppose cash flows after one year (Rs crore) PV at the end of year 1 (Rs crore) Expected payoff after one year One-year return Suppose cash flows after one year (Rs crore) PV at the end of year 1 (Rs crore) One-year return Probability of high returns Probability of low returns Expected payoff (Rs crore) PV of expected payoff Problem 5 Patent life (years) Cost (Rs crore) PV (Rs crore) Volatility (standard deviation) Risk-free rate Expected cost of delay: y = 1/15 Using Balck-Schloes formula, we obtain: d1 d2 N (d1 N (d2) Value of call Value of put

1.4168 0.1668 0.92173 0.56623 131.58 15.35

50 15 7.5 15% 8% 0.0676 0.26 43.86 -6.14 9.45 63.55 4.10 44.9% 5.55 37.32 -14.9% 38.3% 61.7% 1.57 1.45

15 250 150 0.5 7% 0.0667 1.2467 -0.6898 0.89374 0.24515 27.87 60.17

E S0 rf y