Scribd
Upload
10 views

Problem Set 5 Solution-2 Copie

Uploaded by

Carol Varela
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
10 views

Problem Set 5 Solution-2 Copie

Uploaded by

Carol Varela
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 5

Problem Set 5

Advanced Corporate Finance


Due date: November 24
Submit via e-mail to TA

Problem 1

You are considering a new investment opportunity that lasts two years. The project characteristics
are given in Table 1. In addition to this information, you know that you can double the capacity of
the project after one year by investing another $150m only if the economy is good (in node B). If
you do so, the cash flows in year two will double. The risk free rate is 1.5%. Determine the value
of the option to expand.

Part 1: NPV without option


Value at B = (0.53*220+0.47*160)/1.015 = 188.97
Value at C = (0.35*160+0.65*105)/1.015 = 122.41
Value at A = (0.5*188.97+0.5*122.41)/1.015 = 153.39
NPVstatic = Value at A – Investment cost = 153.39 – 150 = 3.39

Part 2: NPV with option


Value at B = -150 + (0.53*440+0.47*320)/1.015 = 227.93
Value at C = (0.35*160+0.65*105)/1.015 = 122.41
Value at A = (0.5*227.93+0.5*122.41)/1.015 = 172.58
NPVoption = Value at A – Investment cost = 172.58 – 150 = 22.58
Part 3: Value of the option
Option_expand = NPVoption – NPVstatic = 22.58 – (3.39) = 19.19

Problem 2

You have the opportunity to invest I = $115 (in millions) in a gold project which (gross) value will
move according to gold prices. In each period, you estimate that gold prices can either move up
by 20% or down by 16.67%. In a year from now (year 1), the project will have an expected value
(from subsequent cash flows) of $120 (million) if the gold price moves up or $83.33 (million) if it
moves down. The risk-free interest rate is 1.5%. We are currently in year 0. You have this project
for two years (from year 0 to year 2).

a) What is the static NPV of the project?

p = (1 + r - d)/(u - d) = 0.4955

evolution of the underlying asset


144
120
100 99.996
83.33
69.439

NPV = (0.4955 * 120 + （1-0.4955） * 83.33)/1.015 – 115 = -15

b) Suppose that you will have the possibility to postpone the investment decision but if you
do so the capital expenditure increases by 5% every year. What is the optimal investment
strategy? What is the value of the project?

Cuu = max(144 – 115*1.05*1.05,0) = 17.21 with probability 0.2455


Cud = max(99.996 – 115*1.05*1.05,0) = 0 with probability 0.49996
Cdd = max( 69.439 – 115*1.05*1.05,0) = 0 with probability 0.2545

Cu = max((0.4955*17.21 + (1-0.4955)*0)/1.015,120-115*1.05) = 8.40 with probability


0.4955
Cd = max((0.4955*0 + (1-0.4955)*0)/1.015,83.33-115*1.05) = 0 with
probability 0.5045
C0 = (0. 4955*8.40 + 0.5*0)/1.015 = 4.10

c) Where does the change in value between a) and b) come from?

The change in value 4.1-(-15)=19.1 comes from the option to delay investment. By waiting
you get valuable information concerning the profitability of the project and you adapt your
strategy to this information, i.e. you only invest in the up-state.

Problem 3

Your company can undertake an investment project today, next year, or the second year. The cost
of the investment is $150. The expected discounted value of all cash flows generated by this project
is estimated at $140. This value can increase by 35% or decrease by 25.93%. Based on historical
data you estimate the probability of the project to go up to be 42%. The cost of capital is 10%. The
risk-free rate is 2%.

a) Draw the binomial tree depicting the value of the project. What is the NPV of the project
if you invest at t = 0?
1 + 0.02 − 0.7407
𝑝= = 0.4584
1.35 − 0.7407

underlying dynamics
255.15
189*1.4-50
140.00 139.99
103.70*1.4-50
76.81

NPV = 140-150 = -10


b) Compute the value of the option to defer investment, OD

At t = 2
CFuu = max(255.15-150,0)=105.15
CFud = max(139.99-150,0)=0
CFdd = max(76.81-150,0)=0

At t = 1
CFu = max(189-150,( 0.4584*105.15+(1-0.4584)*0)/1.02) = 47.26
CFd = max(103.698-150, (0.4584*0+(1-0.4584)*0)/1.02) = 0

At t = 0
CF = max(140-150, (0. 4584*47.26+(1-0.4584)*0)/1.02) = 21.24

OD = CF – NPV = 21.24 – ( - 10) = 31.24

c) Assume that you invest at t=0. At t=1, you have the opportunity to scale up your
investment. You can scale up by 40% by incurring an additional cost of $50. What is the
value of the option to scale up, OE?

At t = 1
CFu = max(189,189*1.4-50) = 214.6
CFd = max(103.70, 103.70*1.4-50) = 103.70

At t = 0
CF = (0. 4584*214.6+(1-0.4586)* 103.70)/1.02 – 150 = 1.5

OE = CF – NPV = 1.5 – (- 10) = 11.5

d) Assume that you invest at t=0. At t=1, you have the opportunity to scale down your
investment. You can scale down by 50% by selling a part of the project. You estimate the
resale value to be $70. What is the value of the option to scale down, OC?

At t = 1
CFu = max(189, 189*0.5+70) = 189
CFd = max(103.70, 103.70*0.5+70) = 121.85
At t = 0
CF = (0. 4584*189+(1-0. 4584)* 121.85)/1.02 – 150 = -0.36

OC = CF – NPV = -0.36 - ( -10) = 9.64

e) Consider now that the firm has the option to defer investment (until t=1 or t=2) and the
option to expand the scale of operations at t=1 (note that you cannot expand at t=2). What
is the joint value of all options, OJ?

At t = 2
CFuu = 105.15
CFud = 0.00
CFdd = 0.00

At t = 1
CFu = max[max[189-150,189*1.4-50-150],(0.4584*105.15+0.5416*0)/1.02)] = 64.6.
CFd = max[max[103.69-150,103.69*1.4-50-150],(0. 4584*0+0. 5416*0)/1.02)] = 0

At = 0
CF = max[140-150,(0. 4584*64.6+0. 5416*0)/1.02)] = 29.03
OJ = CF – NPV = 29.03 – (-10) = 39.03

f) Is the sum of the option to defer in part b) and the option to expand in part c) higher or
lower than the value of the options computed jointly in part e)? Explain why the difference
in value occurs.

It is higher. Indeed, when you have the two options together, at t=1 it is best to expand. In
this situation, you lose the option value of waiting till t=2. One says that the option value
is eroded.

You might also like