Chapter 12

Real Options
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
12-1

a.

20

-20

NPV = $1.074 million.

b. Wait 1 year:

Tax imposed
50% Prob.
Tax not imposed
50% Prob.

0 13%
r=
|

0
|

1
|

-20
|

-20

2
|

2.2
|

3.8

3
|

2.2
3.8

21
|

2.2
|

3.8

PV @
Yr. 1
15.45
26.69

Tax imposed: NPV @ Yr. 1 = (-20 + 15.45)/(1.13) = -4.027

Tax not imposed: NPV @ Yr 1 = (-20 + 26.69)/ (1.13) = 5.920
Expected NPV = .5(-4.027) + .5(5.920) = 0.947
Note though, that if the tax is imposed, the NPV of the project is negative and therefore
would not be undertaken. The value of this option of waiting one year is evaluated as
0.5($0) + (0.5)($ 5.920) = $2.96 million.
Since the NPV of waiting one year is greater than going ahead and proceeding with the
project today, it makes sense to wait.

Mini Case: 12- 1

12-3

a.

0 13% 1

20

-300

40

40

40

NPV = -$19.0099 million. Dont purchase.

b. Wait 1 year:
0
r = 13%
|

50% Prob. 0
|

50% Prob. 0

1
|

-300
|

-300

2
|

30
|

50

3
|

30
|

50

4
|

30
50

21

NPV @
Yr. 0

30 -$78.9889
|

50

45.3430

If the cash flows are only $30 million per year, the NPV of the project is negative.
However, weve not considered the fact that the company could then be sold for $280
million. The decision tree would then look like this:
0r = 13%
|

50% Prob. 0
|

50% Prob. 0

1
|

-300
|

-300

2
|

30
|

50

30 + 280
|

50

0
50

21
|

0
|

50

NPV @
Yr. 0
-$27.1468
45.3430

The expected NPV of waiting 1 year is 0.5(-$27.1468) + 0.5($45.3430) = $9.0981

million.
Given the option to sell, it makes sense to wait 1 year before deciding whether to
make the acquisition.

12-5

P = PV of all expected future cash flows if project is delayed. From Problem 15-3 we
know that PV @ Year 1 of Tax Imposed scenario is $15.45 and PV @ Year 1 of Tax Not
Imposed Scenario is $26.69. So the PV is:
P = [0.5(15.45)+ 0.5(26.690] / 1.13 = $18.646.
X = $20.
t = 1.
rRF = 0.08.
2 = 0.0687.
d1 = ln[18.646/20] + [0.08 + .5(.0687)](1) = 0.1688
(.0687)0.5 (1)0.5
d2 = 0.1688 - (.0687)0.5 (1)0.5 = -0.0933

Mini Case: 12 - 2

From Excel function NORMSDIST, or approximated from Table 13E-1 in Extension to

Chapter 13:
N(d1) = 0.5670
N(d2) = 0.4628
Using the Black-Scholes Option Pricing Model, you calculate the options value as:
V = P[N(d1)] - Xe rRF t [N(d2)]
= $18.646(0.5670) - $20e(-0.08)(1)(0.4628)
= $10.572 - $8.544
= $2.028 million.

SOLUTION TO SPREADSHEET PROBLEMS

12-7

The detailed solution for the problem is available both on the instructors resource CDROM (in the file Solution for FM11 Ch 12 P7 Build a Model.xls) and on the instructors
side of the textbooks web site, http://brigham.swcollege.com.

Mini Case: 12- 3