- January 27, 2022 at 10:16 am #647586shaunak22Participant
- Topics: 217
- Replies: 41
NOTE – I had asked a similar question previouly this one is different previous question was valuation of call option this i valuation of put option
Company X is a considering an investment in a joint venture to develop high quality office blocks
to be let out to blue chip corporate clients. This project has a 30-year life, and is expected to cost
Company X $90 million and to generate an NPV of $10 million for Company X.
The project manager has argued that this understates the true value of the project because the
NPV of $10 million ignores the option to sell Company X’s share in the project back to its partner
for $40 million at any time during the first ten years of the project.
The standard deviation is 45% p.a. and the risk-free rate is 5% p.a
identify the basic variables that are needed to complete the call option formula.
Pa = PV of cash inflow
Pe = cost of investment
ANSWER IN THE TEXT
Pa = 100m Assuming that this is in 10 years’ time, then 20 years of the project remain so Pa is estimated as 20/30 × 100 = $66.7m.
Pe = 40m
1) should’t the cost of investment (Pe) be 90 million since they have invested 90m ? why is it 40 m
2) should’t the PV of cash inflow (Pa) be 100 million since 90M+10M(NPV) ? how have they arrived at the figure 66.7M could you please explain in detailJanuary 27, 2022 at 5:04 pm #647609John MoffatKeymaster
- Topics: 57
- Replies: 51543
1. Because the option is to be able to sell the project at a price of $40M (that is what it would be exercised for).
2. The PV of the cash inflows now is $100M. The answer you are quoting is using the PV in 10 years time, but there is no reason that the PV should fall linearly as they have assumed. I do not know where you found this question but I cannot believe this would be asked in a real exam question.
- You must be logged in to reply to this topic.