Real Options Problem Set

Problem 1
Assume that the value of an underlying risky asset without flexibility is $1,000, its up movement
each time period is u = 1.06184 and that its down movement is d =1/u = 0.94176, and that there
are four time periods per year. Assume that the project pays no dividends. The continuous risk
free rate rf is 5 per cent per year (equivalent discrete quarterly risk-free rate is 1.258%). The
maturity date of the option is six months (two time periods).
a. If we can abandon the project by selling it for $900 at any point in time, what is the value
of the option to abandon the project?
b. Suppose there is an option to contract the sale of operations (and therefore its value) by
50 per cent by selling assets (plant and equipment) worth $450 after taxes. What is the
value of the option to shrink the project?
c. Suppose there is an option to expand the scale of operations of the project, at an expense
of $100, for a benefit that increases the value of operations by 10 percent. What is the
value of the option to expand the project?
d. Consider the possibility of a project that allows any of the three simple options to be
exercise at each decision node.

Problem 2
The cash flow of a project right now is $100. At the end of year 1 it is likely to go up by 20
percent to $120 or down by 16.67 percent to $83.3, with similar percentage changes in year 2. At
the end of the second year, the company has two mutually exclusive alternatives. In one branch of
the decision tree it can spend $700 to lock in its annual level of cash flows forever. In a mutually
exclusive branch it can spend an additional $120 to test market a new version of the product
(thereby forgoing a year of cash flows) to find out, as of year 4, that, with 50-50 probability, the
perpetual cash flows will be either 50 percent higher, or 33 1/3% lower. Then in year 4 the
company can at a cost of $700 lock in perpetual cash flows or it can abandon the project.
Additionally the cost of capital is 10 percent, risk-free rate is 5 percent, and the initial outlay
required to commence the project is $400.
Problem 3
Suppose that we have a firm whose current value is $1,000 and that (given multiplicative
stochastic process) its value could go up by 12.75 percent or down 11.30 percent a standard
deviation of 12 percent per annum. The risk-free rate is 8 percent. The equity of the firm is
subordinated to debt that has a face value of $800 maturing in 3 years and that pays no coupon.
(a) What is the value of an American option written on the equity if the exercise price is
$400 and it matures in 3 years.
(b) Now there are two options in sequence. The first has an exercise price of $400, the
investment required to move to the next phase at the end of year 1 when the option
expires. It allows us to decide whether to abandon the project or continue by making an
additional investment. The second has an exercise price of $800 and expires at the end of
year3.