Bodie2-IM-Ch17

CHAPTER17-RealOptionsEnd-of-ChapterProblems1.Tonyknowsthat,atanypointintimeoverthenextfiveyears,hecanclosedownhalfofhisproductionfacilitiesandliquidatetheproperty,buildingandequipmentforasumof$10million.However,thevalueoftheremainingoperationswouldbeadverselyimpactedandthedeclineinvaluewouldbe40percent.Describetheoptioninvolvedintermsoftheunderlyingriskyasset,theexerciseprice,thetimetomaturity,andthevolatility.Solution:Thisoptiontorescaleoperationsisaputoptiononfixedassetsofthefirmwitha$10payoff.Theoptionhasafive-yeartimetomaturityandtheexercisepriceisthe40percentlossinvalueoftheremainingoperationsplustheopportunitycostoftheexistingmarketvalueofthefixedassetsinquestion.2.Duringmanyperiodsofpasthistoryandinmanyjurisdictionstherehavebeenstatutesoutlawingusury,thechargingofexcessiveinterest.Considerthefollowingschemetobypasssuchprohibitions.Supposeyouwereamerchantandfounditnecessarytofinanceyourwarehousebutloansatapositiverateofinterestareillegal.Fromtheinvestoryouacceptcash,andinexchangepresentthedeedtothewarehouse.Youpromisetorepurchasethepropertyataspecifiedprice($P)intwoyearsandtheinvestoralsopromisestosellthewarehousetoyoufor$Ponthesamedate.Ifyouinitiallyneeded$500,000toacquirethewarehouse,andtheinvestorrequiresa20percentperyearreturnoninvestment,atwhatvalueshould$Phavebeenset?Whatoptionsareinvolvedinthisplanandwhatriskwouldtheinvestorbear?Solution:Iftheinvestorrequiresa20rateofreturnonhisinvestmentthenattheendoftwoyearsyouwouldowethefollowingpaymentoftheoriginalborrowingandinterest:500000120%+()2⋅720000.000=$720,000IfyouhaveaEuropeancalloptiononthewarehousewithaexpirationintwoyearsandanexerciseprice($P)of$720,000thenineffectyoucanexercisetheoptionandrepaytheloan.Ifyoudon'texercisetheoptiontheinvestor,whowrotethecalloption,willsimplykeepthedeedtothewarehouse.Ineffecttheoptionworksjustlikeamortgageloanwherethepropertyservesascollateralfortheloan.Theinvestorbearstheriskthatthepropertymayfallinvaluebyenoughthatyouwillbetemptedtoleavetheoptionunexercisedandhewillthereforekeepthewarehouseratherthancollectontheloanrepaymentvalue.Butthisisthesameriskhewouldhaverunwithamortgageloan.3.Commercialbanksmakeasignificantshareoftheirfee-basedincomefromestablishingprecommittedlinesofcredit.Inexchangeforafeeassessedagainstthelimitontheborrowingline,theyguaranteetolendatapredeterminedfixedorfloatingrate.Fromtheborrower'spointofview,whatoptionpositiondotheyhave,whatistheunderlyinguncertainty,andwhatistheexerciseprice?Solution:Theborrowerpaysafee,whichcanbethoughtofastheoptionpremium,foracalloptiononaloan.Exercisingtheoptiongivesthemapayoffequaltotheamounttheyborrowundertheagreement.Theexercisepriceisactuallythepresentvalueoftheloanrepaymentswhentheloanisinitiated.Thecalloptionisvaluableinthatitlocksinaninterestrateorinterestrateformulaontheloanthuseliminatingtheuncertaintyofwhatthefutureinterestrateorinterestratecalculationwillbe.Asinterestratesevolveovertimetheexercisepricemayfallbelowthevalueofthepayoff,theamountborrowed,makingitprofitabletoexercisetheoptionandtakedowntheloan.4.Withoneoutinthetopoftheninthandarunneronthird,ateamtrailingbyonerunconsidersthestrategyofexecutingasqueezeplay.Fromthemanager'sperspectiveisthesqueezeplayariskybetoranoption?Doesitmatterifwearetalkingaboutasafetysqueezeorasuicidesqueeze?Wikipediamayhelpyouanswerthequestionifyouarelessthanatrulydedicatedbaseballfan.Solution:Thekeydifferenceisthatthesafetysqueezegivestherunneranoptionpositionwhilethesuicidesqueezeisacommitmenttorunandthusariskybetonceinitiated.Howeverthelikelihoodofapositivepayoffisimprovedbygettingthejumpfromtheprecommitmentofthesuicidesqueeze.Chapter17-1Copyright©2009PearsonEducation,Inc.PublishingasPrenticeHall.FinancialEconomicsSolutionsManual5.RefertotheElectroUtilityexampleinthetextofthechapter.Whatisthebreak-evenrisklessinterestratefortheproject?Whatisthebreak-evenrisklevelfortheplant?Solution:TheanswertotheElectroUtilityexamplefromthetextisgivenas:Call6:=V100:=E106:=r6%:=T1:=σ20%:=CVE,r,σ,T,()8.045=Theprojectwouldhaveabreak-evenNPVofzeroisthevalueofthecalloptionwas$6millionratherthan$8.045million.Therisklessinterestratethatgivesthisvalueofthecalloptionis:rootCVE,r,σ,T,()6−r,()0.0119=1.19%isthebreak-evenrisklessrate..Theplantrisklevelthatgivesthisvalueofthecalloptionis:rootCVE,r,σ,T,()6−σ,()0.1485=14.85%isthebreak-evenlevelofplantrisk.6.Afilmstudio,NadirProductions,hastodecidewhethertomakeamovieoutofthebook”PlanetaryWars,”whichithasacquiredtherightsto.Thestudio’sexpertsestimatethattheproductioncostsforthefilmwillbe$30millionandthesubsequentcashflowsnetofdistributioncostsandtaxestobereceivedayearlaterareexpectedtobe$60millionwithaprobabilityof.5and$10millionwithaprobabilityof.5.Thestudiousesadiscountrateof20%indecidingwhethertoacceptsuchprojects.a.WhatistheNPVoftheproject?Shouldtheprojectbeaccepted?AtthispointanewMBAontheCFO‘sstaffsuggeststhattheyhavenottakenaccountoftheoptiontoproduceasequeltothemovie.Ifthemoviesucceedsattheboxoffice,thensurelytheywillwanttomake“PlanetaryWarsII”thefollowingyear.b.Drawadecisiontreefortheproject