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- This topic has 1 reply, 2 voices, and was last updated 2 years ago by John Moffat.

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- January 27, 2022 at 10:16 am #647586
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

SCENARIO –

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.aQUESTION

identify the basic variables that are needed to complete the call option formula.

Pa = PV of cash inflow

Pe = cost of investmentANSWER 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

DOUBT

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 detail

January 27, 2022 at 5:04 pm #6476091. 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.

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