Chapter 22, Problem 6P

You are a financial analyst at Global Conglomerate and are considering entering the shoe business. You believe that you have a very narrow window for entering this market. Because of Christmas demand, the time is right today and you believe that exactly a year from now would also be a good opportunity. Other than these two windows, you do not think another opportunity will exist to break into this business. It will cost you $35 million to enter the market. Because other shoe manufacturers exist and are public companies, you can construct a perfectly comparable company. Hence, you have decided to use the Black-Scholes formula to decide when and if you should enter the shoe business. Your analysis implies that the current value of an operating shoe company is $40 million and it has a beta of 1. However, the flow of customers is uncertain, so the value of the company is volatile-your analysis indicates that the volatility is 25% per year. Fifteen percent of the value of the company is attributable to the value of the free cash flows (cash available to you to spend how you wish) expected in the first year. If the one-year risk-free rate of interest is 4%:

1. a. Should Global enter this business and, if so, when?
2. b. How will the decision change if the current value of a shoe company is $36 million instead of $40 million?
3. c. Plot the value of your investment opportunity as a function of the current value of a shoe company.
4. d. Plot the beta of the investment opportunity as a function of the current value of a shoe company.