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Hello,
In appendix iii) in the answers to question 1, the black-scholes model is used to price the option of being able to develop a follow on product “within 2 years”.
So in the black-scholes equation T=2, and Pa is provided assuming positive cash flows begin in year 3.
But I’m a bit confused because if the option is to start “within” 2 years, then can’t T be less than 2? And if the company chose to start development in year 1, then positive cash flows would start in year 2 which would mean Pa would be greater because there is less discounting? Or am I missing a reason why the follow on product can’t be developed until year 2?
Thanks,
Stu
What you say is correct.
However strictly the BS formulae only apply when there is a fixed date for exercising the option (a European option) and so we do not really have a choice but to assume it is exercised in 2 years time.
(Mind you, it would be a good point to mention in writing – it might get you a bonus mark :-)) )
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