Explanation After the wait of one year, the project will be bought if its value is greater than $70 million. This option is like ‘call option’ that has the exercise price of $70 million and expiry date of 1 year. Current prices of stock is the ‘current value of the future cash flows of the project’; and variance of stock return is the ‘variance of the project’s rate of return ’. The present value of future cash flows of all the stock is the price of stock. The present value of the cash flows after the exercise date is the price of the real option. Stock price is not affected by the exercise cost. Current value of the underlying asset is not affected by the cost to implement the real option. If the later parts are break into two parts then the calculation will be easier. The value of the cash flows beyond the exercise date is calculated first and then the expected present values are calculated of those cash flows. Calculation of cash flows beyond the exercise date is as follows: 0 1 2 ($) 3 ($) 4 ($) High 45 45 45 Average 30 30 30 Low 15 15 15 Table (1) Formula to calculate NPV in case of high demand is as follows: NPV = $ 45 ( 1 + 10 % ) + $ 45 ( 1 + 10 % ) 2 + $ 45 ( 1 + 10 % ) 3 = $ 111.91 Formula to calculate NPV in case of Average demand is as follows: NPV = $ 30 ( 1 + 10 % ) + $ 30 ( 1 + 10 % ) 2 + $ 30 ( 1 + 10 % ) 3 = $ 74

Estimate: The value of the investment timing option using ‘financial option pricing model’.

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You have recently become Head of Finance at Bhawan & Company, a company which provides catering services to the public sector. Your previous employer was Asama & Company where, as finance manager, you had the opportunity to work on areas relating to financial accounting,procurement, contracts, and bids. One of Company Bhawan & Company’s major contracts is with Asama & Company. The contract is now up for renewal, and Company Bhawan & Company is preparing a competitive bid for this contract. You have been asked to lead the team responsiblefor bidding for this contract. You also suspect that your knowledge and experience of Asama & Company were good reasons for appointing you to the position at Bhawan & Company. You do not want to let your new employer down. The loss of such a major contract would have asignificant effect on the financial performance of Bhawan & Company and its performance-related bonus scheme for management. What is threat associated with…

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Estimate: The value of the investment timing option using ‘financial option pricing model’.

Solution Summary: The author explains the value of the investment timing option using 'financial option pricing model'.

Estimate: The value of the investment timing option using ‘financial option pricing model’.

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Chapter 26 Solutions