Topic: Application of option pricing theory in investment decisions

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)