Module 6

Module 6, Chapter 23, Options and, Chapter 10, Project Analysis

All  page numbers are references to Fundamentals of Corporate Finance, 7th  edition by Brealey, Myers, and Marcus (McGraw-Hill, 2012)

This module discusses advanced capital budgeting methods.  In Chapter 23, we learn about options.  In Chapter 10, we learn methods to adjust for project risk.  Covered in both chapters, and the primary reason we study these chapters, is the topic of Real Options.  Real Options are the ability to change your mind after you have accepted a capital budgeting project.  This ability to change our mind often has great value.   The result is the that we change our accept/ reject rule.  Our new rule is accept a project only if the Strategic Net Present Value is positive.  In words, Strategic NPV = Passive NPV + Present value of options arising from  the active management of the firm’s  investment opportunities. Mathematically, Strategic Net Present Value = Passive NPV + Value of Real Options - Cost of Real Options.

For most of you, this material is new and requires a different way of looking at problems.   I do not think one can absorb this material without time and focus. You can do this module in either order.  If you are not familiar with options, I suggest you complete Chapter 23 before Chapter 10.  Mathwise, these are the two most difficult quizzes of the semester.

From Chapter 23

Need to Absorb - Definitions and terms related to options, such as put, call, long, short, in-the-money, at-the-money, out-of-the-money, strike, exercise price, real option, etc.  Be able to compute the value of a call option or put option using a 1-period binomial option pricing model.  You must be able to compute the value of assets, calls, puts, and bonds using the put-call parity formula.  Be aware of the inputs into valuing options as listed with  the Black-Scholes Options Pricing Model.  When given information on real options, be able to identify the type of option, who is long, who is short, the underlying asset, the exercise price, and sometimes the premium.

Need to Read -  Read the Chapter.  Read my handout.  Be prepared to do some Internet searches where if you need additional information.

Need to Do - You should download my handout on real options. A useful handout on Real Options.  Make 100 on the Chapter 23 Quiz.  Questions and Problems that you should be able to answer ; 1-8, 10-18, and 21-25.  Some of the problems take many steps to solve.  Note, many of the problems may require extended periods of quiet contemplation. You will probably need my videos in addition to the textbook to understand this material.  If my materials and the textbook are not sufficient, the Chicago Board Options Exchange (CBOE) has some basic tutorials on financial options

1.  Read the Chapter Summary on Page 314, then read the Chapter introduction on page 296-302. Watch the Chapter Overview  video and the Chapter Lecture video.  The Chapter Lecture video is an extended discussion of the concepts in the chapter, most will benefit from viewing the video. The Powerpoints for all of this chapter's videos are located here.

2. After viewing the Chapter Lecture video, be able to answer end of chapter Questions 1, 2, and 4-6.

3. Re-Read pages 296-302.  Watch the video on Options Terms and Concepts and Payoff Diagrams . The Powerpoints for all of this chapter's videos are located here, starting at about slide 22.

4. After viewing the Options Terms video, be able to answer end of chapter Questions 3, 5, 6, 10, 11, and 12.   

5. Read pages 302-309.  Watch the video on Black Scholes Pricing Model variables and valuation using a 1-Period Binomial Option Pricing Model. The Powerpoints for all of this chapter's videos are located here, starting at about slide 40.

6. After viewing the Chapter Lecture video, be able to answer end of chapter Questions 13, 7, 8, and 9. 

7. Re-Read pages 302-309.  Watch the video on Put-Call Parity. The Powerpoints for all of this chapter's videos are located here, starting at about slide 52.

8. After viewing the video, be able to answer Self-Test 23.3. 

9. Read the rest of Chapter 23.  Watch the video on Recognizing Real and Hidden Options. The Powerpoints for all of this chapter's videos are located here, starting at about slide 62.

10. After viewing the Chapter 23 videos, be able to answer the remaining end of chapter questions and problems.    

11. If you need additional instruction, here are audio solutions to the most common types of Option Valuation type questions;

a. Suppose you believe that Du Pont's stock price is going to decline from its current level of $84.39 sometime during the next 5 months. For $396.18 you could buy a 5-month put option giving you the right to sell 100 shares at a price of $82 per share. If you bought a 100-share contract for $396.18 and Du Pont's stock price actually changed to $86.79, your net profit (or loss) after exercising the option would be ______?

b. Suppose you believe that Du Pont's stock price is going to decline from its current level of $84.46 sometime during the next 5 months. For $517.89 you could buy a 5-month put option giving you the right to sell 100 shares at a price of $85 per share. If you bought a 100-share contract for $517.89 and Du Pont's stock price actually changed to $75.30, your net profit (or loss) after exercising the option would be ______?  

c. Suppose you believe that Bennett Environmental's stock price is going to increase from its current level of $31.09 sometime during the next 7 months. For $535.00 you could buy a 7-month call option giving you the right to buy 100 shares at a price of $28 per share. If you bought a 100-share contract for $535.00 and Bennett's stock price actually changed to $32.62, your net profit (or loss) after exercising the option would be ______?

d. The current price of a stock is $62.60 and the annual effective risk-free rate is 3.8 percent. A call option with an exercise price of $55 and one year until expiration has a current value of $13.23. What is the value of a put option written on the stock with the same exercise price and expiration date as the call option?

e. The current price of a stock is $54.98 and the annual risk-free rate is 4.3 percent. A put option with an exercise price of $55 and one year until expiration has a current value of $3.61. What is the value of a call option written on the stock with the same exercise price and expiration date as the put option?

12.   Be able to answer the suggested End of Chapter questions and problems.   Be prepared for a moderately long quiz.  Mathwise, this is a difficult quiz.

From Chapter 10

Need to Absorb - There are three important areas in this chapter; decision trees, sensitivity/ scenario analysis, and real options.  I am placing some emphasis on decision trees and break-even analysis.  I think real options are a very important topic, so I tend to have an in-depth coverage in both available material and difficulty of the quiz.  Exam and Quiz Questions would be similar to end of chapter questions. My guess is that the Final Exam problems for this chapter are likely to be based on end of chapter problems like problems 3, 4, 6-8, and 21-24).  Decision trees, are a form of weighted average, that represents a method of viewing sequential decisions. Sensitivity/ Scenario analysis examines how sensitive a project's NPV is to changes in the underlying assumptions.  You should learn to to spot and describe real options such as the option to expand, the option to abandon, and the timing (a.k.a., wait and learn) option.

Need to Read - Reading the Chapter should be sufficient to understand this chapter's materials.

Need to Do - Remember your Capital Budgeting Methods and Cash Flows from BA 530.  If you cannot remember your Capital Budgeting Methods, here is a link to lectures (uses another textbook, but has PowerPoints) on that topic.  If you cannot remember Capital Budgeting Cash Flows, here is a link to lectures (uses another textbook, but has PowerPoints) on that topic.  If you have not done so already, you should download my handout on real options, A useful handout on Real Options.    Make 100 on the quiz.  Be able to answer end-of-chapter Questions and Problems 1-14, and 19-26. 

1.  Read the Chapter Summary on Page 154-155, then read the Chapter introduction on page 135-136. Watch the Chapter Overview Lecture  video.  The video is both the Absorb, Read, Do and an extended discussion of the concepts in the chapter. The Powerpoints for all of this chapter's videos are located here.

2. After viewing the Chapter Lecture video, be able to answer end of chapter Questions 1-3.

3. Read pages 126-144.  Watch the video on Investment Process, Sensitivity, Scenario, and Simulation Analysis . The Powerpoints for all of this chapter's videos are located here, starting at about slide 8.

4. Be able to answer end of chapter Questions 4-8. 

5. Read the rest of the Chapter.  Watch the video on Break-even Analysis and Real Options . The Powerpoints for all of this chapter's videos are located here, starting at about slide 20.

6. Be able to the remaining suggested end of chapter questions, with a focus on 9, 10, 12, 15, 19, 20, 23 and 25.   

7. Below are a couple of audio solutions.

a. If a firm's DOL is 4.0 with an operating profit of $2,000,000 and depreciation of $500,000, what are its fixed costs?  The Audio link is here.

b. A firm with $600,000 fixed costs and $200,000 depreciation is expected to produce $225,000 in operating profits. What is its DOL? The Audio link is here.

c. Modern Artifacts can produce keepsakes that will be sold for $80 each. Nondepreciation fixed costs are $1,000 per year and variable costs are $60 per unit. If the project requires an initial investment of $3,000 and is expected to last for 5 years and the firm pays no taxes, what are the accounting break-even levels of sales? The initial investment will be depreciated straight-line over 5 years to a final value of zero, and the discount rate is 10%. The Audio link is here.

d. Modern Artifacts can produce keepsakes that will be sold for $80 each. Nondepreciation fixed costs are $1,000 per year and variable costs are $60 per unit. If the project requires an initial investment of $3,000 and is expected to last for 5 years and the firm pays no taxes, what are the economic break-even levels of sales? The initial investment will be depreciated straight-line over 5 years to a final value of zero, and the discount rate is 10%. The Audio link is here.

e. Hit or Miss Sports is introducing a new product this year. If its see-at-night soccer balls are a hit, the firm expects to be able to sell 50,000 units a year at a price of $60 each. If the new product is a bust, only 30,000 units can be sold at a price of $55. The variable cost of each ball is $30, and fixed costs are zero. The cost of the manufacturing equipment is $6 million, and the project life is estimated at 10 years. The firm will use straight-line depreciation over the 10-year life of the project. The firm's tax rate is 35% and the discount rate is 12%.  a. If each outcome is equally likely, what is expected NPV? Will the firm accept the project?  b. Suppose now that the firm can abandon the project and sell off the manufacturing equipment for $5.4 million if demand for the balls turns out to be weak. The firm will make the decision to continue or abandon after the first year of sales. Does the option to abandon change the firm's decision to accept the project? The Audio link is here.

f. Hit or Miss Sports is introducing a new product this year. If its see-at-night soccer balls are a hit, the firm expects to be able to sell 50,000 units a year at a price of $60 each. If the new product is a bust, only 30,000 units can be sold at a price of $55. The variable cost of each ball is $30, and fixed costs are zero. The cost of the manufacturing equipment is $6 million, and the project life is estimated at 10 years. The firm will use straight-line depreciation over the 10-year life of the project. The firm's tax rate is 35% and the discount rate is 12%.  a. If each outcome is equally likely, what is expected NPV? Will the firm accept the project?  b. Now suppose that Hit or Miss Sports from the previous problem can expand production if the project is successful. By paying its workers overtime, it can increase production by 25,000 units; the variable cost of each ball will be higher, however, equal to $35 per unit. By how much does this option to expand production increase the NPV of the project?  The Audio link is here.

8. Take the Chapter 10 Quiz.

Revised November 24, 2014.

Web Design