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Hi, All.
In P3 CIMA study appetitude test 2. I came across the the following question.
To value real option, the Black Scholes option pricing model will incoporate five factors including (duration of the project/time until investment opportunities disappear) and the (shareholder’s required rate of return/risk free rate of interest).
The correct asnwers are
time until investment opportunities disappear and
the shareholder’s required rate of return.
My question is how come B-S model says anything related to Ke?
It’s easier to think about the rate of interest to start with.
A real option to postpone allows you to pay a small amount now to guarantee you the right to take up the option in the future. For example, you could buy an option to acquire a piece of land over the next 3 years for, say, $250,000. The land might cost $5m.
Therefore you can spend $250,000 now rather than spending $5m now to give you the right/opportunity to buy the land. That means you have $4.75M in the bank ($5m – 0.25m) that you would not have if you had to buy the land now to secure it. The higher the rate of interest, the more worthwhile is is to keep that money in the bank.
Essentially the same arguments apply for Ke. Not having to spend the money now means that you have more capital to spend on other projects.
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