Mesa Inc has agreed to acquire 40% ownership stake in Velacro Mining for $225 million to help
Mesa Inc has agreed to acquire 40% ownership stake in Velacro Mining for $225 million to help finance the development of new mining operations. The mines are expected to have an economically useful life of 35 years. Mesa estimates that the present value of its share of the cash flows would be $210 million. Management of Mesa is considering backing out of the agreement to acquire the ownership stake. To induce Mesa Inc to make the investment, Velacro Mining has given Mesa a real option enabling it to sell its share to Velacro at any point during the next 5 years for $175 million. Mesa estimates the average variance in the present value of the future cash flows over a number of scenarios to be 20%. The appropriate risk free rate of return is 4%.
i) What is the type of option embedded in this project (delay, expansion, or abandonment option)?
ii) Is the embedded option a put or call option?
iii) In real options, what is cost of delay and how much (in percentage) is the cost of delay to Mesa?
iv) What is the NPV of the acquisition project without the option? Is the value of the embedded option sufficient to justify making the investment?