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analyst by Tropical Sweets Inc., a mid-sized California
company
that specializes in creating exotic candies from tropical fruits
such as mangoes, papayas, and
dates. firm's CEO, George Yamaguchi,
recently returned from an industry corporate executive conference
in San Francisco, and one of the sessions he attended addressed
real options. Because no one at Tropical
Continue to post
Sweets is familiar with
the basics of real options, Yamaguchi has asked you to prepare a
brief report that
the firm's executives can use to gain at least a
cursory understanding of the topic. 20 questions remaining
To begin, you gathered some outside materials on the

subject and used these materials to draft a list of
pertinent
questions that need to be answered. Now that the questions have
been drafted, you must
develop the answers.
Answer just these five questions Only! Complete and
accurate as possible!! ASP! My Textbook Solutions
f. Use a financial option pricing model to estimate the value of
the investment timing option.
g. Now suppose that the cost of the project is $75 million and
the project cannot be delayed. However, if
Tropical Sweets
implements the project then the firm will have a growth option: the
opportunity to
replicate the original project at the end of its
life. What is the total expected NPV of the two projects if both
are implemented?
h. Tropical Sweets will replicate the original project only if
demand is high. Using decision-tree analysis, Macroecon… Principles of... Algorithms
estimate the value of
the project with the growth option. 8th Edition 1st Edition
7th Edition
i. Use a financial option model to estimate the value of the
project with the growth option.
View all solutions
j. What happens to the value of the growth option if the
variance of the project's return is 14.2%? What if it
is 50%? How
might this explain the high valuations of many start-up high-tech
companies that have yet to
show positive earnings?
Required is Only this five questions Please! Correct and
as accurate as possible! ASP!
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f.
Use a financial option pricing model to estimate the value of the
investment timing option.
  Answer:
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The option
to wait resembles a financial call option-- we get to “buy” the
project for $70 million in
one year if value of project in one year
is greater than $70 million. This is like a call option with an
exercise
price of $70 million and an expiration date of one
year.
X = Exercise Price = Cost Of

Implement Project = $70 Million.
RRF = Risk-Free Rate =

6%.
T = Time To Maturity = 1 year.
P = Current Price Of Stock = Current

Value Of The Project’s Future Cash Flows.
σ 2 = Variance Of Stock
Return = Variance Of Project’s Rate Of Return.
We explain how to calculate P and

σ2 below.
Just as the price of a stock is the

present value of all the stock’s future cash flows, the “price” of
the real
option is the present value of all the project’s cash
flows that occur beyond the exercise date. Notice that
the exercise
cost of an option does not affect the stock price. Similarly, the
cost to implement the real
option does not affect the current value
of the underlying asset (which is the PV of the project’s cash
flows). It will be helpful in later steps if we break the
calculation into two parts. First, we find the value of all
cash
flows beyond the exercise date discounted back to the exercise
date. Then we find the expected
present value of those values.
Step 1: Find the value of all cash

date. Here
is the time line. The exercise date is year 1, so we
discount all future cash flows back to year 1.

0
1
2
3
4

High
$45
$45 $45

Average
$30
$30 $30

Low

$15
$15 $15
High: PV1 = $45/1.10 +

$45/1.102 + $45/1.103 = $111.91
Average: PV1 =

$30/1.10 + $30/1.102 + $30/1.103 = $74.61
Low: PV1 = $15/1.10 +

$15/1.102 + $15/1.103 = $37.30
The current expected present value,

P, is:
P = 0.3[$111.91/1.1] +
0.4[$74.61/1.1] + 0.3[$37.30/1.1] = $67.82.
For a stock option, σ2 is

the variance of the stock return, not the variance of the stock
price. Therefore, for a
real option we need the variance of the
project’s rate of return. There are three ways to estimate this
variance. First, we can use subjective judgment. Second, we can
calculate the project’s return in each
scenario and then calculate
the return’s variance. This is the direct approach. Third, we know
the projects
value at each scenario at the expiration date, and we
know the current value of the project. Thus, we can
find a variance
of project return that gives the range of project values that can
occur at expiration. This is
  the indirect
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Following is an explanation of each

approach.
Subjective estimate:
The typical stock has σ2

of about 12%. Most projects will be somewhat riskier than the firm,
since the risk of
the firm reflects the diversification that comes
from having many projects. Subjectively scale the variance
of the
company’s stock return up or down to reflect the risk of the
project. The company in our example
has a stock with a variance of
10%, so we might expect the project to have a variance in the range
of 12%
to 19%.
Direct approach:
From our previous analysis, we know

the current value of the project and the value for each scenario at
the
time the option expires (year 1). Here is the time line:

Current
Value
Value At Expiration

Year
0
Year 1

High
$67.82
$111.91

Average
$67.82
$74.61

Low
$67.82
$37.30
The annual rate of return is:
High: Return = ($111.91/$67.82) – 1 =

65%.
High: Average = ($74.61/$67.82) – 1 =

10%.
High: Return = ($37.30/$67.82) – 1 =

-45%.
Expected Return = 0.3(0.65) +

0.4(0.10) + 0.3(-0.45)
= 10%.
s2 =
0.3(0.65-0.10)2 + 0.4(0.10-0.10)2 +
0.3(-0.45-0.10)2
=
0.182 = 18.2%.
The direct approach gives an estimate

of 18.2% for the variance of the project’s return.
The indirect approach:
Given a current stock price and an

anticipated range of possible stock prices at some point in the
future,
we can use our knowledge of the distribution of stock
returns (which is lognormal) to relate the variance of
the stock’s
rate of return to the range of possible outcomes for stock price.
To use this formula, we need
the coefficient of variation of stock
price at the time the option expires. To calculate the coefficient
of
variation, we need the expected stock price and the standard
deviation of the stock price (both of these
are measured at the
time the option expires). For the real option, we need the expected
value of the
project’s cash flows at the date the real option
expires, and the standard deviation of the project’s value at
  the
date
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We previously calculated the value of

the project at the time the option expires, and we can use this to
calculate the expected value and the standard deviation.

Value At Expiration

Year 1

High
$111.91

Average
$74.61

Low
$37.30
Expected Value
=.3($111.91)+.4($74.61)+.3($37.3)
= $74.61.
svalue
= [.3($111.91-$74.61)2 +
.4($74.61-$74.61)2
+
.3($37.30-$74.61)2]1/2

= $28.90.
Coefficient Of Variation = CV =
Expected Value / svalue
CV
= $74.61 / $28.90 = 0.39.
Here is a formula for the variance of

a stock’s return, if you know the coefficient of variation of the
expected stock price at some point in the future. The CV should be
for the entire project, including all
scenarios:
σ2 = LN[CV2 +
1]/T = LN[0.392 + 1]/1 = 14.2%.
Now, we proceed to use the OPM:
V =
$67.83[N(d1)] -
$70e-(0.06)(1)[N(d2)].

d1 =

= 0.2641.

d2 = d1 -
(0.142)0.5(1)0.5 = 0.2641 - 0.3768

= -0.1127.

N(d1) = N(0.2641) = 0.6041.

N(d2) = N(-0.1127) = 0.4551.
therefore,

  V = $67.83(0.6041)
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-
$70e-0.06(0.4551)
= $10.98.
g.
Now suppose the cost of the project is $75 million and the project
cannot be delayed. But if
Tropical Sweets implements the project,
then Tropical Sweets will have a growth option. It will have the
opportunity to replicate the original project at the end of its
life. What is the total expected NPV of the two
projects if both
are implemented?
Answer: Suppose the cost of the

project is $75 million instead of $70 million, and there is no
option to
wait.
NPV = PV of future

cash flows - cost

= $74.61 - $75 = -$0.39 million.

The project now looks like a loser. Using NPV analysis:

NPV = NPV Of Original Project + NPV Of Replication Project

= -$0.39 + -$0.39/(1+0.10)3

= -$0.39 + -$0.30 = -$0.69.

Still looks like a loser, but you will only implement project 2 if
demand is high. We might have
chosen to discount the cost of the
replication project at the risk-free rate, and this would have made
the
NPV even lower.
h.
Tropical Sweets will replicate the original project only if demand
is high. Using decision tree
analysis, estimate the value of the
project with the growth option.
Answer: The future cash flows of

the optimal decisions are shown below. The cash flow in year 3 for
the
high demand scenario is the cash flow from the original project
and the cost of the replication project.

0
1
2
3
4
5
6

High
-$75
$45
$45 $45
-$70
$45
$45
$45

Average
-$75
$30
$30
$30
$0
$0
$0

Low
-$75
$15
$15
$15
$0
$0
$0
To find the NPV, we discount the

risky cash flows at the 10 percent cost of capital, and the
non-risky cost to
replicate (i.e., the $75 million) at the
risk-free rate.
NPV high = -$75 + $45/1.10 +

$45/1.102 + $45/1.103 +
$45/1.104

+ $45/1.105 + $45/1.106 -
$75/1.063

= $58.02
NPV average = -$75 + $30/1.10 +

$30/1.102 + $30/1.103 = -$0.39
NPV average = -$75 + $15/1.10 +

$15/1.102 + $15/1.103 = -$37.70
  Expected
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NPV = 0.3($58.02) +
0.4(-$0.39) + 0.3(-$37.70) = $5.94.
Thus, the option to replicate adds

enough value that the project now has a positive NPV.
i.
Use a financial option model to estimate the value of the growth
option.
Answer: X = Exercise Price =

Cost Of Implement Project = $75 million.
rRF = Risk-Free Rate =

6%.
t = Time To Maturity = 3 years.
P =
Current Price Of Stock = Current Value Of The Project’s Future Cash
Flows.
σ2 = Variance Of Stock
Return = Variance Of Project’s Rate Of Return.
We explain how to calculate P and

σ2 below.
Step 1: Find the value of all cash

date. Here
is the time line. The exercise date is year 1, so we
discount all future cash flows back to year 3.

0
1
2
3
4
5
6

High
$45
$45
$45

Average
$30
$30
$30

Low

$15
$15
$15
High: PV3 = $45/1.10 +

$45/1.102 + $45/1.103 = $111.91
Average: PV3 =

$30/1.10 + $30/1.102 + $30/1.103 = $74.61
Low: PV3 = $15/1.10 +

$15/1.102 + $15/1.103 = $37.30
The current expected present value,

P, is:
P = 0.3[$111.91/1.13] +
0.4[$74.61/1.13] + 0.3[$37.30/1.13] =
$56.05.
Direct approach for estimating

σ2:
From our previous analysis, we know

the current value of the project and the value for each scenario at
the
time the option expires (year 3). Here is the time line:

Current
Value
Value At Expiration

Year
0
Year 3

High
$56.02
$111.91

Average
$56.02
$74.61

Low
$56.02
$37.30
  The annual
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rate of return is:
High: Return =
($111.91/$56.02)(1/3) – 1 = 25.9%.
High: Average =
($74.61/$56.02)(1/3) – 1 = 10%.
High: Return =
($37.30/$56.02)(1/3) – 1 = -12.7%.
Expected Return = 0.3(0.259) +

0.4(0.10) + 0.3(-0.127)
= 8.0%.
s2 =
0.3(0..259-0.08)2 + 0.4(0.10-0.08)2 +
0.3(-0.127-0.08)2
=
0.182 = 2.3%.
This is lower than the variance found

for the previous option because the dispersion of cash flows for
the
replication project is the same as for the original, even
though the replication occurs much later. Therefore,
the rate of
return for the replication is less volatile. We do sensitivity
analysis later.
The indirect approach:
First, find the coefficient of

variation for the value of the project at the time the option
expires (year 3).
We previously calculated the value of

the project at the time the option expires, and we can use this to
calculate the expected value and the standard deviation.

Value At Expiration

Year 3

High
$111.91

Average
$74.61

Low
$37.30
Expected Value
=.3($111.91)+.4($74.61)+.3($37.3)
= $74.61.
svalue
= [.3($111.91-$74.61)2 +
.4($74.61-$74.61)2
+
.3($37.30-$74.61)2]1/2

= $28.90.
Coefficient Of Variation = CV =
Expected Value / svalue
CV
= $74.61 / $28.90 = 0.39.
To find the variance of the project’s

rate or return, we use the formula below:
σ2 = LN[CV2 +
1]/T = LN[0.392 + 1]/3 = 4.7%.
  Now, we proceed to use the OPM: My courses
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V = $56.06[N(d1)] -
$75e-(0.06)(3)[N(d2)].

d1 =

= -0.1085.

d2 = d1 -
(0.047)0.5(3)0.5 = -.1085 - 0.3755

= -0.4840.

N(d1) = N(-0.1080) = 0.4568.

N(d2) = N(-0.4835) = 0.3142.
Therefore,
V = $56.06(0.4568) - $75e-(0.06)(3)(0.3142)

= $5.92.
Total Value = NPV Of Project 1 +

Value Of Growth Option

=-$0.39 + $5.92

= $5.5 million
j.
What happens to the value of the growth option if the variance of
the project’s return is 14.2
percent? What if it is 50 percent? How
might this explain the high valuations of many dot.com
companies?
Answer: If risk,
defined by σ2, goes up, then value of growth option goes
up (see the file ch 12 mini
case.xls for
calculations):
σ2 = 4.7%, option value =

$5.92
σ2 = 14.2%, option value =

$12.10
σ2 = 50%, option value =

$24.09
If the future profitability of dot.com companies is very

volatile (i.e., there is the potential for very high
profits), then
a company with a real option on those profits might have a very
high value for its growth
option
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Q: Assume you have just been hired as a financial analyst by

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MINI CASE: Enter question

To begin, you gathered some outside materials on the

Anonymous answered this

X = Exercise Price = Cost Of

RRF = Risk-Free Rate =

T = Time To Maturity = 1 year.

P = Current Price Of Stock = Current

We explain how to calculate P and

Just as the price of a stock is the

Step 1: Find the value of all cash

High: PV1 = $45/1.10 +

Average: PV1 =

Low: PV1 = $15/1.10 +

The current expected present value,

For a stock option, σ2 is

Following is an explanation of each

The typical stock has σ2

From our previous analysis, we know

The annual rate of return is:

High: Return = ($111.91/$67.82) – 1 =

High: Average = ($74.61/$67.82) – 1 =

High: Return = ($37.30/$67.82) – 1 =

Expected Return = 0.3(0.65) +

The direct approach gives an estimate

The indirect approach:

Given a current stock price and an

We previously calculated the value of

Here is a formula for the variance of

Now, we proceed to use the OPM:

Answer: Suppose the cost of the

NPV = PV of future

Answer: The future cash flows of

To find the NPV, we discount the

NPV high = -$75 + $45/1.10 +

NPV average = -$75 + $30/1.10 +

NPV average = -$75 + $15/1.10 +

Thus, the option to replicate adds

Answer: X = Exercise Price =

rRF = Risk-Free Rate =

t = Time To Maturity = 3 years.

We explain how to calculate P and

Step 1: Find the value of all cash

High: PV3 = $45/1.10 +

Average: PV3 =

Low: PV3 = $15/1.10 +

The current expected present value,

Direct approach for estimating

From our previous analysis, we know

Expected Return = 0.3(0.259) +

This is lower than the variance found

The indirect approach:

First, find the coefficient of

We previously calculated the value of

To find the variance of the project’s

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Total Value = NPV Of Project 1 +

σ2 = 4.7%, option value =

σ2 = 14.2%, option value =

σ2 = 50%, option value =

If the future profitability of dot.com companies is very