In: Finance
Zuti has a capital investment project that could start
immediately. The project will require a machine costing $2.4
million. The total discounted value now of the cash inflows from
the project will be either $2.6 million or $1.9 million with equal
probability. The risk-free rate is 3%.
Instead of starting immediately the project could be delayed until
one year from now to gain more market information. Its total
discounted cash inflows at that time will be known as either $2.6
million, or $1.9 million, with certainty.
(i) What is the present value of the option to delay?
(ii) The supplier of the machine has offered to deliver it (if
required) in one year’s time at a price of only $2 million, if Zuti
pays a non-refundable deposit now. What is the maximum the firm
should pay as a deposit now? What type of real option does this
represent for Zuti? Identify the specific components of the option
contract.
As per the given information , the real option given to Zuti is an option to delay (which is a type of call option) and the value of this option can be derived using the Black-Scholes Option Pricing Model, as below -
where,
wherein,
Pa = underlying asset value, which is the present value of future cash flows arising from the project [here, since there are two possible cash inflows at equal probability, Pa = $2.6M*50%+$1.9M*50% = $2.25M]
Pe = exercise price, which is the amount paid when the call option is exercised [here, cost of asset, Pe = $2.40M]
r = risk-free rate [here, 3%]
s = volatility of cash flows, which is the risk attached to the project or underlying asset, measured by the standard deviation [here, 50%, since there is equal probability]
t = time in years, that is left before the opportunity to exercise ends [here, 1 year]
N(d) = area under the normal curve upto d
e = 2.71828, the exponential constant
ln = the natural logarithm
Pee(-rt) = the PV of the exercise price calculated by using the continuous discounting factors.
Thus, we first compute the values for N(d1) and N(d2) as below -
d1 = [ln($2,250,000/$2,400,000)+(0.30+0.50*(0.50)2)*1]/(0.50*1)] = [ln(0.9375)+0.425]/0.50 = [-0.0280+0.425]/0.50 = 0.794 = 0.79
d2 = 0.794- (0.50*1) = 0.294 = 0.29
N(d1) = 0.50+0.2852 = 0.7852 ; N(d2) = 0.50+0.1141 = 0.6141
Then, value of call option can be computed as
Value of call option = [$2,250,000*0.7852]-[$2,400,000*0.6141*2.7183(-0.03*1)] = $1,766,700 - $1,473,840*0.9705 = $1,766,700 - $1,430,362 = $336,338
In the case where supplier of the machine has offered to deliver it in one year’s time at a price of only $2 million, the Pe changes to $ 2 million and the same is substitued in the above formula and computations are made as below -
We first compute the values for N(d1) and N(d2) as below -
d1 = [ln($2,000,000/$2,400,000)+(0.30+0.50*(0.50)2)*1]/(0.50*1)] = [ln(0.8333)+0.425]/0.50 = [-0.0792+0.425]/0.50 = 0.6916 = 0.69
d2 = 0.6916- (0.50*1) = 0.1916 = 0.19
N(d1) = 0.50+0.2549 = 0.7549 ; N(d2) = 0.50+0.0753 = 0.5753
Then, value of call option can be computed as
Value of call option = [$2,000,000*0.7549]-[$2,400,000*0.5753*2.7183(-0.03*1)] = $1,509,800 - $1,380,720*0.9705 = $1,509,800 - $1,339,989 = $169,811
Thus, Zuti should pay a maximum security deposit of $169,811.