Question Tag: Real options

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  • 30 Marks

FM – May 2018 – L3 – SA – Q1 – Investment Appraisal Techniques

Evaluate the NPV of Plateau Plc.'s project, assess sensitivity, discuss political risk, and explore real options for the project.

Plateau Plc. (PT) is a Nigerian company that manufactures and sells innovative products. Following favourable market research that cost N4,000,000, PT has developed a new product. It plans to set up a production facility in Kano, although its board had contemplated setting up the facility in an overseas country. The project will have a life of four years.

The selling price of the new product will be N5,900 per unit, with sales in the first year to December 31, 2019, expected to be 120,000 units, increasing by 5% per annum thereafter. Relevant direct labour and material costs are expected to be N3,400 per unit, and incremental fixed production costs are expected to be N60 million per annum. The selling price and costs are stated in December 31, 2018 prices and are expected to increase at a rate of 3% per annum. Research and development costs to December 31 will amount to N25 million.

Investment in working capital will be N30 million on December 31, 2018, and this will increase in line with sales volumes and inflation. Working capital will be fully recoverable on December 31, 2022.

The company will need to rent a factory during the life of the project. Annual rent of N20 million will be payable in advance on December 31 each year and will not increase over the life of the project.

Plant and machinery will cost N1 billion on December 31, 2018. The plant and machinery are expected to have a resale value of N300 million (at December 31, 2022, prices) at the end of the project. The plant and machinery will attract 20% (reducing balance) capital allowances in the year of expenditure and in every subsequent year of ownership by the company, except in the final year when there will be a balancing allowance or charge.

Assume a corporate tax rate of 20% per annum in the foreseeable future and that tax flows arise in the same year as the cash flows which gave rise to them.

The directors are concerned by rumours in the industry of research by a rival company into a much cheaper alternative product. However, the rumours suggest that this research will take another year to complete, and if successful, it will take a further year before the alternative product comes on the market.

An appropriate weighted average cost of capital for the project is 10% per annum.

Required:

a. Calculate, using money cash flows, the NPV of the project on December 31, 2018, and advise the company whether to proceed with the project or not.
(15 Marks)

b. Calculate and interpret the sensitivity of the project to a change in:

  • (i) The annual rent of the factory (2 Marks)
  • (ii) The weighted average cost of capital (4 Marks)

c. If the board of PT decided to set up the manufacturing facility overseas, advise the board on how political risk could change the value of the project and how it might limit its effects. (4 Marks)

d. Discuss briefly FOUR real options available to PT in relation to the new project. (5 Marks)

(Total 30 Marks)

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  • 20 Marks

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)

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  • 15 Marks

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)

 

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  • 30 Marks

FM – May 2018 – L3 – SA – Q1 – Investment Appraisal Techniques

Evaluate the NPV of Plateau Plc.'s project, assess sensitivity, discuss political risk, and explore real options for the project.

Plateau Plc. (PT) is a Nigerian company that manufactures and sells innovative products. Following favourable market research that cost N4,000,000, PT has developed a new product. It plans to set up a production facility in Kano, although its board had contemplated setting up the facility in an overseas country. The project will have a life of four years.

The selling price of the new product will be N5,900 per unit, with sales in the first year to December 31, 2019, expected to be 120,000 units, increasing by 5% per annum thereafter. Relevant direct labour and material costs are expected to be N3,400 per unit, and incremental fixed production costs are expected to be N60 million per annum. The selling price and costs are stated in December 31, 2018 prices and are expected to increase at a rate of 3% per annum. Research and development costs to December 31 will amount to N25 million.

Investment in working capital will be N30 million on December 31, 2018, and this will increase in line with sales volumes and inflation. Working capital will be fully recoverable on December 31, 2022.

The company will need to rent a factory during the life of the project. Annual rent of N20 million will be payable in advance on December 31 each year and will not increase over the life of the project.

Plant and machinery will cost N1 billion on December 31, 2018. The plant and machinery are expected to have a resale value of N300 million (at December 31, 2022, prices) at the end of the project. The plant and machinery will attract 20% (reducing balance) capital allowances in the year of expenditure and in every subsequent year of ownership by the company, except in the final year when there will be a balancing allowance or charge.

Assume a corporate tax rate of 20% per annum in the foreseeable future and that tax flows arise in the same year as the cash flows which gave rise to them.

The directors are concerned by rumours in the industry of research by a rival company into a much cheaper alternative product. However, the rumours suggest that this research will take another year to complete, and if successful, it will take a further year before the alternative product comes on the market.

An appropriate weighted average cost of capital for the project is 10% per annum.

Required:

a. Calculate, using money cash flows, the NPV of the project on December 31, 2018, and advise the company whether to proceed with the project or not.
(15 Marks)

b. Calculate and interpret the sensitivity of the project to a change in:

  • (i) The annual rent of the factory (2 Marks)
  • (ii) The weighted average cost of capital (4 Marks)

c. If the board of PT decided to set up the manufacturing facility overseas, advise the board on how political risk could change the value of the project and how it might limit its effects. (4 Marks)

d. Discuss briefly FOUR real options available to PT in relation to the new project. (5 Marks)

(Total 30 Marks)

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  • 20 Marks

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)

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  • 15 Marks

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)

 

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