WK 4-Finance

# WK 4-Finance - Answer the following questions: 1. Use Excel...

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Answer the following questions: 1. Use Excel and the following template to build an option calculator for a call. (30 points) You should further verify model validity even if the initial work conforms to the example shown. To do so, you should be using examples discussed in "A9. Use Option Concept to Analyze Merger and Diversification" or "A10. Use Option Concept to Analyze Capital Budgeting Decision" in Week Four. If your model works in all three cases, then it should be good to go. If not, you should go back and debug. 2. Assume that Patty Putt Company is considering taking a 20-year project which requires an initial investment of $50 million to develop a new line of golf clubs with Tommy Tee Inc. The present value of expected cash flows is$49 million. Based on the conventional method, Patty Putt would not undertake the project because the NPV is negative. However, Patty Putt Company has the option to abandon this project anytime by selling its interests in the operations to Tommy Tee Inc. in the next 5 years for \$25 million. If the estimated volatility (σ 2 ) of this project’s cash flow is 0.09 and the risk free rate is 3%, what would be the abandonment option value? How will it affect Patty Putt’s decision? (50 points) An abandonment option is a put option. The Black-Scholes Pricing formulas for call and put option are as follows: C 0 = S × N( d 1 ) – Ee -RT × N( d 2 ) P 0 = Ee -RT × N(– d 2 ) – S × N(– d 1 ), where

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Note: Put option value can also be inferred from call price and the put-call parity. See Practice Exercises - Part II Problem 2 for an example. For projects with a finite life, we must adapt the B-S valuation formula to capture the rate at which project value declines over time; the project’s value declines over time because there will be fewer cash flows left as the project gets closer to maturity. A simplistic assumption is to maintain a constant rate of decline ( k ) proportional to the life of the project such that k = 1/ n where n is the life of the project. The Merton (1973) option pricing model with continuous dividends is applicable in cases where k > 0. The pricing formulas are as follows: C 0 = S × e -kT N( d 1 ) – Ee -RT × N( d 2 ), where P 0 = Ee -RT × N(– d 2 ) – S × e -kT N(– d 1 ), where Here is example A-9 referenced above in the question: Use Option Concept to Analyze Merger and Diversification Diversification is a frequently mentioned reason for mergers. But can diversification be the only
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## WK 4-Finance - Answer the following questions: 1. Use Excel...

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