Forums › ACCA Forums › ACCA AFM Advanced Financial Management Forums › Black-Scholes Option Pricing model – past exam question (june 2011)
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- February 13, 2016 at 8:41 am #300201
Hello, sir!
I’m trying to practice my skills with past exams questions and i got in trouble with the question below: black-scholes model is suggested to evaluate the option of delaying the decision but i don’t understand, why the Excercise price (Pe) equals 35M (Answers file downloaded from ACCA website). Other variables of the formulae and calculations are clear). I`d be very greatfull if you could help!
MesmerMagic Co (MMC) is considering whether to undertake the development of a new computer game based on an adventure film due to be released in 22 months. It is expected that the game will be available to buy two months after the film’s release, by which time it will be possible to judge the popularity of the film with a high degree of
certainty. However, at present, there is considerable uncertainty about whether the film, and therefore the game, is likely to be successful. Although MMC would pay for the exclusive rights to develop and sell the game now, the directors are of the opinion that they should delay the decision to produce and market the game until the film has
been released and the game is available for sale. MMC has forecast the following end of year cash flows for the four-year sales period of the game.
Year 1 2 3 4
Cash flows ($ million) 25 18 10 5
MMC will spend $7 million at the start of each of the next two years to develop the game, the gaming platform, and to pay for the exclusive rights to develop and sell the game. Following this, the company will require $35 million for production, distribution and marketing costs at the start of the four-year sales period of the game. It can be assumed that all the costs and revenues include inflation. The relevant cost of capital for this project is 11% and the risk free rate is 3·5%. MMC has estimated the likely volatility of the cash flows at a standard deviation of 30%.February 13, 2016 at 8:51 am #300254In future you must ask in the Ask the Tutor Forum if you want me to answer – this forum is for students to help each other.
The option applies to the spending of the $35M – they are going to spend $7 a year whether they delay or not.
So the option is the right to delay the $35M and therefore also delay the later cash flows.Pa, is always the value of whatever is being delayed (in the case the PV of the later cash flows) and Pe is always the amount that is needed to pay out (in this case $35M).
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