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hi sir,
im still not clear as to what constitutes the pa and pe in the black scholes formula.
i understood previously that pe is the exercise price or the money that is going out but in this mmc question, it failed to take into account the two 7 millions.
the pa if im right is the money coming in so that constitutes the cash inflows only.
all in all, i want to understand it as pa total cash coming in, pe total cash going out.
please rectify me where possible
The 7M in each of the next two years will be paid whatever happens. The option is whether on not to spend the 35M in order to produce and develop the game.
So as far as this option is concerned, Pe is the 35M and Pa is the PV of the inflows that will result if they do go ahead and spend the 35M.
(The point is that without the option, on the forecast cash flows it is not worth going ahead. However, the cash flows from time 3 might end up being higher (and maybe making it all worthwhile) or might end up being lower (in which case they could avoid paying the 35M and only suffer the two 7M’s). The fact that they will have that option is worth something and makes the overall value of the project with the option higher and worth doing.)
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