Option Value

Hi John,

As you mention in your answer ….to post the questions on this forum so I m posting my question again.. I have listen to your lecture on Real option and realized that probably I need to calculate the PV of the future receipts which will be calculated by discounting the demand of 120,000 units multiply and inflating the contribution price of 16 by 2%( PLEASE Correct me If I m wrong here)…. This will give me the value of Pa of around 7309000.. and Pe would be 6000,000 and then calculate the value of put option (all I’ m asking please is can you guide me if my approach is correct or not..)

This question was passed on by my colleague who doesn’t have the solution for it.

I m copying the question below..

S co have invent a product that can be developed over next 12 months. Annual demand of this product is 120,000 units at a contribution of $16 and has a life of 5 years once fully developed. It is envisaged that price inflation will be 2% but the standard deviation of contribution per unit will be 30%

Once fully developed company will need to spend$600000 on retooling one of its factories in order to undertake production though given volatility to prices in this market, it is by no means certain that S will chose to enter into production if prices have fallen dramatically

RFR =5% and Ke=12%

The question is asking to calculate the max development cost that S should be prepared t o pay today to create an option to develop the project stating any necessary assumption?

I know that assumptions part is about differnt types of option i-e Option to expand, to delay, option to withdraw or to redeploy however I m a bit clueless of how should I calculate the Development cost? Do I use the Black sholes model and if I m using this the Current price I will use is 16 and exercise price will be what then? do I need to inflate the 16 for next five years? or do I use exercise price as $6000,000 and discount it at current cost of capital to get the current price and then use black sholes model.

please just your little wisdom will help me to approach this question correctly..

Regards,
Noureen