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Dear Sir,
I have a problem attacking theoretical questions. Please guide me on the answer approach to question (b) and (c) of this question. I do not understand the answer in the revision kit.
(b) On the basis of your valuation of the option to delay, estimate the overall value of the project, giving a concise rationale for the valuation method you have used.
(c) Describe the limitations of the valuation method you used in (a) above and describe how you would value the option if the government were to make the announcement at ANY time over the next two years.
Please guide me. Thanks
For (b) I assume you are happy with the first part of the answer in that if the option did not exist then the value of the project would simply be the NPV. Because there is the option to delay then this makes the project more valuable.
The rationale of using Black-Scholes is the an option to delay is just like a call option in shares. You have the right to pay a fixed amount on a future date, but you don’t have to exercise that right – if the value has gone up then you will and if the value goes down then you won’t.
(There is lots more you could say about the logic behind Black Scholes (which is covered in the free lecture on option pricing) but for the number of marks for this part, the examiner did not expect any more)For (c) the limitations are really how we would find out the values of all the variables in the Black-Scholes formula. You need to think about then one by one (again the lecture explains what they all are) and decide how easy they would be to find in real life. The two really big problems will be finding the standard deviation (volatility) and finding the risk-free interest rate (in real life nothing is completely risk-free).
The other thing (which is what the second part of the question is after) is that the Black-Scholes formula only works for European style options (options that are exercisable on a fixed future date). If it was exercisable at any time up until a fixed date (i.e. and American style option) then the Black Scholes formula doesn’t work. (As the examiner mentions we would have to use binomial pricing. However this is not in the syllabus and so you would not need to mention it and you could never be expected to do it 🙂 )Thanks Sir. My motivation is increasing due to your encouragement. Fear is gradually is loosing its grib on me at a faster rate. God bless you Sir.
Dear sir
Per question pe =24 and it will be exercise in the future (within 2years).
I think it should be discounted to PV in order to caculate cost of project. Therefore Pa should be 24/1.1^2 +4.
(Same as example Pandy Inc in BPP textbook P196
– they discounted cost of investment at Y5 to Y0).
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