Question Tag: Option pricing

Search 500 + past questions and counting.
  • Filter by Professional Bodies

  • Filter by Subject

  • Filter by Series

  • Filter by Topics

  • Filter by Levels

FM – Nov 2022 – L3 – Q4 – Investment Appraisal Techniques

Evaluate the decision to invest in an innovative beverage using real options and the Black-Scholes model.

Tayo Kayode (TK) is a highly successful beverage company listed on the Nigerian stock market. Its products are particularly attractive to the younger generation.

Eko Laboratory (EL) has developed an innovative synthetic, alcoholic beverage – the Younky.

It is believed that the product, if manufactured commercially, will be popular among the youths.

TK has been offered a license to produce the Younky on the condition that it commences production within the next twelve months. In the last board meeting, the Marketing Director, Kehinde Kay, presented the following preliminary evaluation of the project.

Kehinde recommended that the project should thus be rejected.

However, the Finance Director (FD), Ben Okon, argued that conventional NPV analysis undervalues projects with high uncertainty as the value of embedded real options is often ignored. He suggested that the possibility of delaying the project for up to twelve months effectively gives TK a call option on development and that if market forecasts improve over the next year, then the company can benefit. To get the ‘right answer,’ he concluded, option values must be incorporated.

The current long-term government bond yield is 5%. The expected standard deviation of future cash flows is estimated to be 35%.

Required:

a. Comment on the views of the Marketing and Finance Directors. (5 Marks)
b. Using the Black-Scholes option pricing model for a European call option, estimate the value of the option to commercially develop and market the Younky. Provide a recommendation as to whether or not TK should manufacture the Younky. (10 Marks)
c. Comment on modeling the possibility of delay as a European call option. (5 Marks)

(Total 20 Marks)

Login or create a free account to see answers

Find Related Questions by Tags, levels, etc.

Report an error

You're reporting an error for "FM – Nov 2022 – L3 – Q4 – Investment Appraisal Techniques"

AFM – May 2017 – L3 – Q1b – Application of option pricing theory in investment decisions

Explanation of variables for real option valuation and use of Black Scholes model to estimate value of the option to delay.

BigDaddy Ltd, a drug development company, has gained drug production permission for the manufacturing of a drug for Ebola, which will be developed over a three-year period. The resulting drug sales less costs have an expected net present value of GH¢4 million at a cost of capital of 10% per annum. BigDaddy Ltd has an option to acquire the ownership of the drug at an agreed price of GH¢24 million, which must be exercised within the next two years. Immediate preparatory and research would be risky, as the project has a volatility attaching to its net present value of 25%.

One source of risk is the potential for absolute control over Ebola by people taking good care of themselves. Within the next two years, the World Health Organization will make a pronouncement on whether the disease will be eradicated or not. The risk-free rate of interest is 5% per annum.

Required:
i) What are the variables that determine the value of a real option for BigDaddy Ltd? (5 marks)
ii) Estimate the value of the option to delay the start of the project for two years using the Black-Scholes option pricing model and comment upon your findings. Assume that the World Health Organization will make its announcement about the potential eradication of Ebola at the end of the two-year period. (10 marks)

 

Login or create a free account to see answers

Find Related Questions by Tags, levels, etc.

Report an error

You're reporting an error for "AFM – May 2017 – L3 – Q1b – Application of option pricing theory in investment decisions"

FM – Nov 2022 – L3 – Q4 – Investment Appraisal Techniques

Evaluate the decision to invest in an innovative beverage using real options and the Black-Scholes model.

Tayo Kayode (TK) is a highly successful beverage company listed on the Nigerian stock market. Its products are particularly attractive to the younger generation.

Eko Laboratory (EL) has developed an innovative synthetic, alcoholic beverage – the Younky.

It is believed that the product, if manufactured commercially, will be popular among the youths.

TK has been offered a license to produce the Younky on the condition that it commences production within the next twelve months. In the last board meeting, the Marketing Director, Kehinde Kay, presented the following preliminary evaluation of the project.

Kehinde recommended that the project should thus be rejected.

However, the Finance Director (FD), Ben Okon, argued that conventional NPV analysis undervalues projects with high uncertainty as the value of embedded real options is often ignored. He suggested that the possibility of delaying the project for up to twelve months effectively gives TK a call option on development and that if market forecasts improve over the next year, then the company can benefit. To get the ‘right answer,’ he concluded, option values must be incorporated.

The current long-term government bond yield is 5%. The expected standard deviation of future cash flows is estimated to be 35%.

Required:

a. Comment on the views of the Marketing and Finance Directors. (5 Marks)
b. Using the Black-Scholes option pricing model for a European call option, estimate the value of the option to commercially develop and market the Younky. Provide a recommendation as to whether or not TK should manufacture the Younky. (10 Marks)
c. Comment on modeling the possibility of delay as a European call option. (5 Marks)

(Total 20 Marks)

Login or create a free account to see answers

Find Related Questions by Tags, levels, etc.

Report an error

You're reporting an error for "FM – Nov 2022 – L3 – Q4 – Investment Appraisal Techniques"

AFM – May 2017 – L3 – Q1b – Application of option pricing theory in investment decisions

Explanation of variables for real option valuation and use of Black Scholes model to estimate value of the option to delay.

BigDaddy Ltd, a drug development company, has gained drug production permission for the manufacturing of a drug for Ebola, which will be developed over a three-year period. The resulting drug sales less costs have an expected net present value of GH¢4 million at a cost of capital of 10% per annum. BigDaddy Ltd has an option to acquire the ownership of the drug at an agreed price of GH¢24 million, which must be exercised within the next two years. Immediate preparatory and research would be risky, as the project has a volatility attaching to its net present value of 25%.

One source of risk is the potential for absolute control over Ebola by people taking good care of themselves. Within the next two years, the World Health Organization will make a pronouncement on whether the disease will be eradicated or not. The risk-free rate of interest is 5% per annum.

Required:
i) What are the variables that determine the value of a real option for BigDaddy Ltd? (5 marks)
ii) Estimate the value of the option to delay the start of the project for two years using the Black-Scholes option pricing model and comment upon your findings. Assume that the World Health Organization will make its announcement about the potential eradication of Ebola at the end of the two-year period. (10 marks)

 

Login or create a free account to see answers

Find Related Questions by Tags, levels, etc.

Report an error

You're reporting an error for "AFM – May 2017 – L3 – Q1b – Application of option pricing theory in investment decisions"

error: Content is protected !!
Oops!

This feature is only available in selected plans.

Click on the login button below to login if you’re already subscribed to a plan or click on the upgrade button below to upgrade your current plan.

If you’re not subscribed to a plan, click on the button below to choose a plan