i watched this video but i am confused with the last part. Without the option if the project is carried out, NPV will be -$451,000 for the 5 years. If project sold at end of second year, the project is worth $3,444,000. Can you explain why NPV of the project with put option is the addition of both the values above? The NPV of -$451,000 includes the cashflows of the last three years.

The question says “Recently Bulud Co offered Chmura Co the option to sell the entire project to Bulud Co for $28 million at the start of year three. Chmura Co will make the decision of whether or not to sell the project at the end of year two.”

Why do not need to calculate the PV of $28 million when doing b(ii)?

$28M is the exercise price. As I explain in my lectures on option pricing, in the formula what we multiply Pe by is there effectively to do the discounting.

one silly question, i am always confused regarding the value of option, is 3.20m we are suppose to pay to buy the put option?
and is it the same reason why we add it to the negative NPV to find the net value of project?

amazing lecture, thanks a ton for taking such an effort for making things easy and manageable, its really helping me.

Very helpful! Just one silly question. If they didn’t give you the risk adjusted cost of capital and you had to work it out, would you then consider the inflation? I presume in this question we assume the 12% they tell us covers that?

in b(ii) while calculating option pricing, how is the time to expiry is 2 years and not 3 years? is “t” not the years the project life is left? or is it life of project that has elapsed?

The question says “Recently Bulud Co offered Chmura Co the option to sell the entire project to Bulud Co for $28 million at the start of year three. Chmura Co will make the decision of whether or not to sell the project at the end of year two.”

The start of year 3 and the end of year 2, is 2 years from now 🙂

Wow! thank you, lecture made the exam a walk in the park. I think on Friday i will show this exam the level of professionalism you use to tackle the questions. wow.

Thanks, you really made it easy to understand. I understand why we deduct capital allowances before we tax the cash flows but I am not quite clear on why we had to add it back to the post tax cash flows.

mathurya says

Hi,

i watched this video but i am confused with the last part. Without the option if the project is carried out, NPV will be -$451,000 for the 5 years. If project sold at end of second year, the project is worth $3,444,000. Can you explain why NPV of the project with put option is the addition of both the values above? The NPV of -$451,000 includes the cashflows of the last three years.

Thanks in advance.

aliansari14 says

Thank you so much , this really means alot ,it helped me out on the bits of confusion I had while attempting the question before watching this.

danny969 says

Hello John

I have a question regarding the calculation of d1.

These are my results

ln(30614/28000) = 0.089

[0.04 + (0.5*s^2)] = 0.101

0.35*2^(1/2) = 0.494

Thus d1 = [(0.089 + 0.101)*2]/0.494 = 0.769

The answer according to this lecture as well as several other sources = 0.589

Can you tell me where I’m going wrong?

John Moffat says

Your last line should read:

(0.089 + (0.101*2)) / 0.494 = 0.589

danny969 says

Got it. Thank you ?

John Moffat says

You are welcome 🙂

teresa1014 says

Hi Mr. Moffat,

The question says “Recently Bulud Co offered Chmura Co the option to sell the entire project to Bulud Co for $28 million at the start of year three. Chmura Co will make the decision of whether or not to sell the project at the end of year two.”

Why do not need to calculate the PV of $28 million when doing b(ii)?

Thank you very much. It’s a great lecture!!

John Moffat says

$28M is the exercise price. As I explain in my lectures on option pricing, in the formula what we multiply Pe by is there effectively to do the discounting.

rohanmehta says

one silly question, i am always confused regarding the value of option, is 3.20m we are suppose to pay to buy the put option?

and is it the same reason why we add it to the negative NPV to find the net value of project?

amazing lecture, thanks a ton for taking such an effort for making things easy and manageable, its really helping me.

John Moffat says

It is not that we actually pay for the option, but it is how much extra the option makes the project worth to us.

(And thank you for your comment 🙂 )

acxdc says

Very helpful! Just one silly question. If they didn’t give you the risk adjusted cost of capital and you had to work it out, would you then consider the inflation? I presume in this question we assume the 12% they tell us covers that?

John Moffat says

Thank you for your comment 🙂

jimruta says

Thank You So Much. Easily and professionally explained. Looking forward to passing

juanalonso says

great lecture…many thanks!

John Moffat says

Thank you for the comment.

umair85 says

Hi Mr Moffet,

in b(ii) while calculating option pricing, how is the time to expiry is 2 years and not 3 years? is “t” not the years the project life is left? or is it life of project that has elapsed?

Thanks in advance.

John Moffat says

The question says “Recently Bulud Co offered Chmura Co the option to sell the entire project to Bulud Co for $28 million at the start of year three. Chmura Co will make the decision of whether or not to sell the project at the end of year two.”

The start of year 3 and the end of year 2, is 2 years from now 🙂

tinashe says

Wow! thank you, lecture made the exam a walk in the park. I think on Friday i will show this exam the level of professionalism you use to tackle the questions. wow.

John Moffat says

Thank you for the comment, and good luck on Friday.

demashi says

You make it all so easy. However, I dont understand why we have to add back the capital allowances to the after tax cash flows.

demashi says

Thanks, you really made it easy to understand. I understand why we deduct capital allowances before we tax the cash flows but I am not quite clear on why we had to add it back to the post tax cash flows.