Why might the cost of capital be higher in emerging markets than in domestic ones? The underlying asset value (Pa), (the PV of future project cash flows), The exercise price (Pe), (the amount paid / RECEIVED when the call/ PUT option is exercised), The risk-free (r), which is normally given or taken from the return offered by a short-dated government bill, The volatility (s), which is the project risk (measured by the standard deviation). Although Duck Co will not actually obtain any immediate cash flow from Swan Co’s offer, the real option computation below, indicates that the project is worth pursuing because the volatility may result in increases in future cash flows. Why might there be an advantage in being a minority investor in an emerging market as contrasted to majority ownership? Put Value = $3.45m. The general meaning of purchasing power parity is that the exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. The value computed can therefore be considered indicative rather than conclusive or correct. He should start selecting projects from the top of the list and continue selecting till the capital budget allows him. If Swan Co’s offer is not considered, then the project gives a marginal negative net present value, although the results of any sensitivity analysis need to be considered as well. A lot could happen to the cash flows given the high volatility rate, in that time. How can you use financial futures markets to hedge such risks as foreign exchange risk? It does not recognise that most investment appraisal decisions are flexible and give managers a choice of what actions to undertake. Real option analysis uses decision trees to model optimal actions in the future given the resolution of uncertainty 2. The method is to use the nominal discount rate to discount nominal cash flows and real discount rate to discount real cash flows. 2. Answer the below questions with at least five sentences each, >>>thoroughly and in your own words<<<. Although Duck Co will not actually obtain any immediate cash flow from Swan Co’s offer, the real option computation below, indicates that the project is worth pursuing because the volatility may result in increases in future cash flows. Discuss some examples of political risks facing firms that are investing in other parts of the world. Volatility (s) = 40%. NPV without any option to delay the decision. However, there are four years to go before a decision on whether or not to undertake the second project needs to be made. Exercise Price (Pe) $28m The variables to be used in the BSOP model for the second (follow-on) project are as follows: Asset Value (Pa) = $90m Risk free rate (r) = 4.5% In these situations the American-style option will have a value greater than the equivalent European-style option. Exercise price (Pe) = $35m Because traditional valuation tools such as NPV ignore the value of flexibility, real options are important in strategic and financial analysis. The risk free rate of return is 4%. Real options methodology takes into account the time available before a decision has to be made and the risks and uncertainties attached to a project. ? Download all ACCA course notes, track your progress, option to buy premium content and subscribe to eNewsletters and recaps. The NPV methodNPV FormulaA guide to the NPV formula in Excel when performing financial analysis. if an analyst is trying to establish value for a company located in an emerging market, he has to take into consideration the inflation in the emerging market. Why might inflation pose more problems in evaluating foreign firms than in evaluating a domestic business? Duck Co’s finance director is of the opinion that there are many uncertainties surrounding the project and has assessed that the cash flows can vary by a standard deviation of as much as 35% because of these uncertainties. Duck Co is considering a five-year project with an initial cost of $37,500,000 and has estimated the present values of the project’s cash flows as follows: Swan Co has approached Duck Co and offered to buy the entire project for $28m at the start of year three. And the beneficial asymmetry between the right and the obligation to invest under these conditions is what generates the option's value. The BSOP model requires further assumptions to be made involving the variables used in the model, the primary ones being: (a) The BSOP model assumes that the underlying project or asset is traded within a situation of perfect markets where information on the asset is available freely and is reflected in the asset value correctly. Typically, an emerging market is a growing economy and so has a high inflation rate. The time (t), which is the time, in years, that is left before the opportunity to exercise ends. Most options, real or financial, would, in reality, be American-style options. = $37,049,300 Volatility (s) = 50%, d1 = 0.401899 NPV without any option to delay the decision: Now let's suppose the company doesn't have to make the decision right now but can wait for two years... Variables to be used in the BSOP model Further, it assumes that the time to expiry can be estimated accurately The law of one price needs to be established by the analyst trying to establish value for the company located in an emerging market. In addition to this, candidates are expected to be able to explain (but not compute the value of) redeployment or switching options, where assets used in projects can be switched to other projects and activities. Exercise date (t) = Two years ? The likely volatility (standard deviation) of the cash flows is estimated to be 50%. It then worked through computations of three real options situations, using the BSOP model. What is a financial option? 1. Evaluate embedded real options within a project, classifying them into one of the real option archetypes. The variables to be used in the BSOP model for the second (follow-on) project are as follows: Asset Value (Pa) = $90m Since it is an offer to sell the project as an abandonment option, a put option value is calculated based on the finance director’s assessment of the standard deviation and using the Black-Scholes option pricing (BSOP) model, together with the put-call parity formula. The company has forecast the following end of year cash flows for the four-year project. The BSOP model is a simplification of the binomial model and it assumes that the real option is a European-style option, which can only be exercised on the date that the option expires. This is the first of two articles which considers how real options can be incorporated into investment appraisal decisions. The BSOP model assumes that the volatility or risk of the underlying asset can be determined accurately and readily. The second article will consider how managers can use real options to make strategic investment appraisal decisions. A company is considering bidding for the exclusive rights to undertake a project, which will initially cost $35m. A lot could happen to the cash flows given the high volatility rate, in that time. The second article considers a more complex scenario and examines how the results produced from using real options with NPV valuations can be used by managers when making strategic decisions. If a project has NPV = 0, should a manager accept the project? For example, in example three above, it is assumed that Swan Co will fulfil its commitment to purchase the project from Duck Co in two years’ time for $28m and there is therefore no risk of non-fulfilment of that commitment.

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