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Dear sir,
In the question 4b of june 11,The question mentions about development of game.
The question mentions that 12m will be spend immediately to develop the game. Following this further 35m will be required for production, distribution and marketing costs at the start of the project.In solution there is a use of black Scholes model (call option) and they have taken Pe = 35 only.
The $12 million initial cost will be incurred whether the option to delay is exercised
or not. Therefore, since it is common to both scenarios, it can be ignored in the
calculations for the moment.As per your instruction and study text books, I found that Pe is the capital investment required for call option.
I am confused that why they have not included this 12m i.e., 12+35 = 47.
Will it be OK if I include this 12m as well in my calculation?No it will not be OK.
The option is as to whether or not to spend the additional $35m. Exercising this option will cost them $35m.
Thank you for answering my query.
However, they have not mentioned anywhere in the question that this 35m is price of the option or will be incurred if the project is delayed. Also, while I was checking the solution to the question, they have mentioned in the brackets like:
NPV if the project is undertaken immediately;
Net Present Value = $47.73 million – $35 million = $12.73 million
(or $0.73 million after taking account of the initial $12 million investment).Similarly when the option was utilized
the option value = = 28.63 – 14.95 = $13.68 million (positive value)They also mentions again about this 12m like:
By taking account of the option to delay the project, the value of the project
increases to $13.68 million (or $1.68 million after bringing in the unavoidable
$12 million initial investment).I need to know about the statements mentioned in the brackets.
Including 35m only would have been the case if it was related to delay. However they have not specified that this 35m will only be incurred if there is delay.Thanks for your help.
Now I am very puzzled because I am looking at the original exam question and there is no mention of an initial $12M investment.
What they are delaying is the decision to produce and market the game (not the development of the game).
I am wondering if you are looking at the question in a Revision Kit and that they have amended the question. All I have is the original exam question and answer.
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