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PQ6_A - Value of Call(Natural Resource Reserve = \$37.36...

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FINA 537 Equity Valuation – Real Option (Answer) Assignments for practice (No need to submit) 1. a. PV(B)=PV(A)-PV(certain \$0.5 million)=11.5-0.5/1.07=\$11.03 million b. The abandon option payoff is 0 for buoyant demand and 2 (\$10-\$8) for sluggish payoff. Calculate the option value using risk neutral probability u=18/11.03 d=8/11.03 r=0.07; p=(1+r-d)/(u-d)=0.38 Option value= (0.38*0+(1-0.38)*2)/1.07=\$1.16 Technology B(\$11.03+\$1.16=\$12.19m) is better than Technology A (\$11.5m) 2. Current Value of Developed Reserve = 10* (\$20 - \$6) = \$140 Exercise Price = Cost of Developing Reserve = \$120 t = 20 years; r = 7%; σ = 20% y = 4% (the cost of delay is dividend yield)

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Unformatted text preview: Value of Call (Natural Resource Reserve) = \$37.36 million 3. u 1.1 p 0.75 d 0.9 1-p 0.25 Year 0 Year 1 Year 2 Year 3 33.275 30.25 12.2750 27.5 10.25 27.225 25 8.452381 24.75 6.225 6.896866 22.5 4.75 22.275 3.609694 20.25 1.275 0.910714 18.225 The maximum price you want to pay is 6.897. Drill in year t 9.25 6.5 4 3.75 1.50 -.75 J&B should wait until year 3 and will drill if the value is more than \$21 million (at the first three notes). (You don’t have to calculate the numbers as shown above. Since it’s never optimal to exercise an American option earlier for a non-dividend paying stock, J&B should wait until year 3.)...
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PQ6_A - Value of Call(Natural Resource Reserve = \$37.36...

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