Risk Analysis, Real Options, and Capital Budgeting

MGMT 332 Corporate Finance I

Module 3: Risk Analysis, Real Options, and Capital Budgeting

Problem Set 3 – Risk Analysis, Real Options, and Capital Budgeting

1. Company Valuation Your manager has asked you to value JRA Inc., a potential acquisition. To make your life easier, your manager gave you some of the numbers in the Excel template file provided. Your manager wants the dollar price per share, so you must calculate the dollar value of the equity and then divide by the number of shares outstanding.

2. Real Options a. JTM Airlines, where you work, is looking at potentially buying more gates at their

home airport. If it pays the airport $1M, JTM will hold exclusive rights to buy those gates for $8M (at the start) and $9M (one year later) at any time in the next 3 years. The option expires at the end of year 3. JTM’s discount rate is 6.6% and the risk free rate is 2%. What is the NPV of the gate purchases if it bought them today? Use the data in the Excel template provided.

b. After you run the numbers for part A, you remember back to your ERAU corporate finance class’s coverage of real options. You know that the 3-year option has value, so you decide to calculate it by:

1. Present valuing the purchase price of the gates separately using the risk- free rate. Once JTM decides to go ahead with the purchase, there is no risk to that expenditure.

2. Present valuing the Net Cash Flow excluding those purchase prices. This calculation will include Cap. Ex. for years 3-15 as they are part of the normal operation of the gates and are unrelated to the purchase price.

3. Use the Black-Scholes Option Pricing formula to come up with option’s price assuming a 5-year maturity and a 55% price volatility for gate prices.

4. Compare the price of the call option as calculated using the BSO formula with the NPV in the No Real Options scenario. With this, you can decide whether or not the $1M option is worth it. Is it? What is the value of the option over not taking it? What is it net of the $1M cost?

3. Decision Tree JTM really liked your work on the option pricing of the gates, so they ask you to look at their 3-phase expansion at their home airport. The three phases are:

a. Upon purchase of the new gates, start a marketing program to promote JTM’s routes to the East Coast, West Coast, and the Caribbean. If all goes well and the market is receptive, they will go on to phase 2.

Continues on the next pagehttp://www.worldwide.erau.edu/

Page 2 of 2

b. Phase 2 has JTM invest in new routes to the three sets of destinations listed. If at any time, JTM finds that this is not going to work, they will pull the plug on phase 2 and scratch the project.

c. Phase 3 has JTM start the new routes to the destinations listed. If things don’t go well on any of the three destinations, they will pull the plug on phase 3 and scratch that destination out.

After much work with other departments, you generate enough data to calculate the NPV of the 3-phase expansion. Before you have a chance to save all your work, there is a power spike in the building, and you lose part of your work. You have to go back and complete it so you can present it to your manager. Please use the Excel template provided to complete problem 3.

  • Module 3: Risk Analysis, Real Options, and Capital Budgeting

Alex Otieno

Author Since: January 17, 2021