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VALUATION OF A PUT OPTION

Forums › Ask ACCA Tutor Forums › Ask the Tutor ACCA AFM Exams › VALUATION OF A PUT OPTION

  • This topic has 1 reply, 2 voices, and was last updated 5 months ago by John Moffat.
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  • January 27, 2022 at 10:16 am #647586
    shaunak22
    • Topics: 195
    • Replies: 32
    • ☆☆☆

    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.a

    QUESTION

    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

    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 #647609
    John Moffat
    Keymaster
    • Topics: 57
    • Replies: 49595
    • ☆☆☆☆☆

    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.

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