FIN 6409 FIN6409 Week 5 Individual Work 1 (Everest University)

FIN 6409 FIN6409 Week 5 Individual Work 1 (Everest University)

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FIN 6409 Week 5 Individual Work 1 (Everest University)

 Chapter 14.   Real Options

Assume that you have just been hired as a financial analyst by Tropical Sweets Inc., a mid-sized California company that specializes in creating exotic candies from tropical fruits such as mangoes, papayas, and dates.  The firm's CEO, George Yamaguchi, recently returned from an industry corporate executive conference in San Francisco, and one of the sessions he attended was on real options.  Since no one at Tropical Sweets is familiar with the basics of real options, Yamaguchi has asked you to prepare a brief report that the firm's executives could use to gain at least a cursory understanding of the topics.

 a.   What are some types of real options?  

 b.  What are the five steps for analyzing a real option? 

c.  Tropical Sweets is considering a project that will cost $70 million and will generate expected cash flows of $30 per year for three years.  The cost of capital for this type of project is 10 percent and the risk-free rate is 6 percent. After discussions with the marketing department, you learn that there is a 30 percent chance of high demand, with future cash flows of $45 million per year.  There is a 40 percent chance of average demand, with cash flows of $30 million per year.  If demand is low (a 30 percent chance), cash flows will be only $15 per year. What is the expected NPV?

d.   Now suppose this project has an investment timing option, since it can be delayed for a year.  The cost will still be $70 million at the end of the year, and the cash flows for the scenarios will still last three years.  However, Tropical Sweets will know the level of demand, and will implement the project only if it adds value to the company.  Perform a qualitative assessment of the investment timing option’s value.

e.  Use decision tree analysis to calculate the NPV of the project with the investment timing option.

f.   Use a financial option pricing model to estimate the value of the investment timing option.

g.  Now suppose the cost of the project is $75 million and the project cannot be delayed.  But if Tropical Sweets implements the project, then Tropical Sweets will have a growth option.  It will have the opportunity to replicate the original project at the end of its life.  What is total expected NPV of the two projects if both are implemented?

h.  Tropical Sweets will replicate the original project only if demand is high.  Using decision tree analysis, estimate the value of the project with the growth option.

 i.  Use a financial option model to estimate the value of the growth option.

 

j.  What happens to the value of the growth option if the variance of the project’s return is 14.2 percent?  What if it is 50 percent?  How might this explain the high valuations of many dot.com companies?


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