a. What are some types of real options?
b. What are five possible procedures 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 million per year for 3 years. The cost of capital for this type of project is 10% and the risk-free rate is 6%. After discussions with the marketing department, you learn that there is a 30% chance of high demand, with future cash flows of $45 million per year. There is a 40% chance of average demand, with cash flows of $30 million per year. If demand is low (a 30% chance), cash flows will be only $15 million 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 3 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 that 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 the 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 project with the growth option.
j. What happens to the value of the growth option if the variance of the project's return is 14.2%? What if it is 50%? How might this explain the high valuations of many dot.com companies?
You have just been hired as a financial analyst by Tropical Sweets Inc., a mid-sized Ontario 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 Vancouver, and one of the sessions he attended was on real options. Because 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 can use to gain at least a cursory understanding of the topics.
To begin, you gathered some outside materials the subject and used these materials to draft a list of pertinent questions that need to be answered. In fact, one possible approach to the paper is to use a question-and-answer format. Now that the questions have been drafted, you have to develop the answers.