The Acid Rain: The Southern Company (A) case mentions that if the firm chooses to install the scrubbers, it has the option to delay start of the installation. Suppose they were considering waiting until the end of 1994 to begin installation (i.e., CapEx would take place in 1994-1996 and benefits begin in 1997). This would allow them to know the price of sulfur emission allowances (i.e., the key uncertainty would resolve) before committing to the investment. For this question only, assume the allowances will be worth $350 with a 50% chance or $150 with a 50% chance in 1995 (continue to assume 10% growth after 1995 in either case). Set up a real options approach to evaluate the scrubbers investment with a right to delay the installation for two years by answering the following questions:

2. What is the underlying asset of the real option?
4. How long is the maturity of this real option?
6. What is the current expected value of the underlying asset (S)?
8. What is the strike price (E)? What is the intrinsic value of the option? (Hint: The "intrinsic value of a call option" represents the value of the option if you have to decide on option exercise TODAY.)
10. What are the option payoffs at maturity in each of the two scenarios (i.e., high allowance cost vs. low allowance cost)?
12. What is the value of the scrubber investment project with the option to delay? (Assuming standard deviation is 30% and Rf=5%.)

Answer rating: 100% (QA)

To solve this problem we will use a real options approach to evaluate the scrubber investment project with the option to delay the installation for tw... View the full answer