Chapter – Test

(60 minutes)

Pricing stock options

Problem 1 (2.5 points)
You have an option to buy a new plane in three years for $25 million. Your current
estimate of the value of the plane is $21 million. The annual volatility for the change in the
plane’s value is 25 percent, and the risk-free rate is 5 percent. What is the option to buy the
plane worth?

Problem 2 (2.5 points)

The current price of copper is 95 cents per pound. The annual volatility for copper prices is
20 percent, and the risk-free rate is 5 percent. In one year, you have the option (if you want
it) to spend $1.25 million to mine 8 million pounds of copper. The copper can be sold at
whatever the copper price is in one year. It costs 85 cents to extract a pound of copper
from the ground. What is the value of this situation to you?

Problem 3 (2.5 points)

You own the rights to a biotech drug. Your best estimate is that the current value of these
rights is $50 million. Assuming that the annual volatility of biotech companies is 90
percent and the risk-free rate is 5 percent, what is the value of an option to sell the rights to
the drug five years from now for $40 million?

Problem 4 (2.5 points)

Merck is debating whether to invest in a pioneer biotech project. The company estimates
that the worth of the project is $56 million. Investing in the pioneer project gives Merck
the option to own, if it wants to, a much bigger technology that will be available in four
years. If Merck does not participate in the pioneer project, it cannot own the bigger project.
The bigger project will require $1.5 billion in cash four years from now. Currently, Merck
estimates the net present value (NPV) of the cash flows from the bigger project to be $597
million. Assuming a risk-free rate of 10 percent and that the annual volatility for the bigger
project is 35 percent, what should Merck do?

Please submit the two following files:

1 The Answer Sheet in Word format with file name is your full name and student ID (e.g. Tran
Van An – 12345678). In the Answer Sheet, you just write your answer for each problem.

2 The Excel file that presents how you can solve the problems. Each problem (together with its
solution) is presented in one separate sheet (e.g. this test has 3 problems, so your Excel file
should have 3 sheets, sheet 1 for problem 1; sheet 2 for problem 2…). The Excel file also
should be named with the above rule.