Finance II

Problem Set 10
CLASS 9

Finance II – Fernando Santos Jorge – Spring 2022

 Mazda

Finance II – Fernando Santos Jorge – Spring 2022

 Mazda
Mazda has to choose between two production technologies for its Wankel engine outboard motor:
- Technology A uses computer-controlled machinery custom-designed to produce the complex shapes
required for Wankel engines in high volumes and at low cost. However, the equipment will be far too
specific to Mazda and hence cannot be resold.
- Technology B uses standard machine tools, whereby labor costs are much higher, but the machinery
could be resold one year from now if Mazda decides to do so.
The next year’s (𝑡 = 1) PV of future payoffs for each technology, conditional on demand, are given in
the table below:
PV of payoffs at 𝑡 = 1 (in $m)
Technology A Technology B
Buoyant 18.5 18
demand
Sluggish 8.5 8
demand

Assume that the present value of the project (at 𝑡 = 0) under technology A is $11.5m and that the
risk-free rate is 7%.
a) Ignoring the option to resell the machinery (i.e. assuming that the machinery cannot be resold for
anything more than zero at 𝑡 = 1), what is the present value of the project if technology B is used?
b) If Mazda knows it will be able to resell the machinery of technology B for $10m at 𝑡 = 1 if it wishes
to do so, calculate the value of the abandonment option.
Finance II – Fernando Santos Jorge – Spring 2022
 Mazda
a) Ignoring the option to resell the machinery (i.e. assuming that the machinery cannot be
resold for anything more than zero at 𝑡 = 1), what is the present value of the project if
technology B is used?

Technology B is equivalent to Technology A less a certain payment of $0.5m. Since the PV of

technology A is $11.5m, the present value of technology B (ignoring the abandonment value) is
equal to

$0.5𝑚
𝑃𝑉 𝐵 = 𝑃𝑉 𝐴 – = $11.03𝑚
1.07

PV of payoffs at 𝑡 = 1 (in $m)

Technology A Technology B
Buoyant 18.5 18
demand
Sluggish 8.5 8
demand

Finance II – Fernando Santos Jorge – Spring 2022

 PV of payoffs at 𝑡 = 1 (in $m)

Technology A Technology B Mazda

Buoyant 18.5 18
b) If Mazda knows it will be able to resell the machinery of technology B for $10m at 𝑡 = 1 if it wishes
demand
to do so, calculate the value of the abandonment Sluggish
option. 8.5 8
demand

Assume that, if you abandon Technology B, you receive the $10m salvage value but no operating cash
flows:
- if the demand is sluggish, you should exercise the put option and receive $10m (instead of
$8m),
- if the demand is buoyant, you should continue with the project and receive $18m.
Hence, at 𝑡 = 1, the put option will be worth $2m (= $10𝑚– $8𝑚) if demand is sluggish and is
worthless if demand is buoyant. We can value the put using the risk-neutral probabilities. Note that:
$"#$
- if the demand is buoyant, the gain in value is 63.2% (= − 1);
$"".&'$
$#$
- if the demand is sluggish, there is a value loss of 27.5% (= $"".&'$ − 1).
Denoting the probability of a rise in asset value by p, then
𝑝 ∗ 0.632 + 1 − 𝑝 ∗ −0.275 = 0.07
𝑝 = 0.38
Using the risk-neutral probabilities, the value of the option to abandon is worth
0.38 ∗ 0 + 0.62 ∗ 2
= $1.16𝑚
1.07
Finance II – Fernando Santos Jorge – Spring 2022
 Mazda
For the remainder of the exercise, let’s consider technology C, which has far more possible
states one year from now than technologies A and B. Ignoring that machinery of technology C
can be resold in one year’s time for $7m, the present value of the project under this technology
would also be $11.5m at 𝑡 = 0.
c) Mazda knows that the value of this technology could either increase by 25% or drop by
16.7% every three months. Using this information, construct a one-year binomial tree for
technology C.
$28.08
$22.46
$18.71
$17.97

$14.38 $14.97

$11.50 $11.97 $12.47

$9.58 $9.97

$7.98 $8.31

$6.65
$5.54

Finance II – Fernando Santos Jorge – Spring 2022

 Mazda
d) Assuming that technology C can be resold only at 𝑡 = 1, under what conditions would
Mazda abandon the project? What is the value of the abandonment option at 𝑡 = 0?

The only case in which one would want to abandon technology C at the end of the year is if the
project’s value is $5.54m (i.e. if the value declines in each of the four quarters). In this case, the
value of the abandonment option would be $1.46m (= $7𝑚– $5.54𝑚). Letting q equal the risk-
neutral probability of a rise in the value of technology C, q satisfies
$
𝑞 ∗ 0.25 + 1 − 𝑞 ∗ −0.167 = 1.07 − 1
𝑞 = 0.44

The risk-neutral probability of a fall in value in each of the four quarters is 0.098 (= (1– 0.44)! ).
Hence, the value of the abandonment option is $28.08
0.098 ∗ $1.46𝑚 $22.46
𝑃𝑢𝑡 = = $0.134𝑚 $18.71
1.07 $17.97

$14.38 $14.97

$11.50 $11.97 $12.47

$9.58 $9.97

$7.98 $8.31

$6.65
$5.54

Finance II – Fernando Santos Jorge – Spring 2022

 Waterman

Finance II – Fernando Santos Jorge – Spring 2022

 Waterman
You have acquired the option to buy the Waterman vineyard in the Douro Valley region for €2,200 one
year from now. The current value of the vineyard is €2,000 today, but the coming 12 months are
crucial for its future. In particular, in every one of the next four quarters, the value of the vineyard can
either increase by 15% or drop by 10%. The effective annual risk-free rate is 3%.

a) Assume that the vineyard will not produce any cash flows for the next twelve months. Build a one-
year binomial tree for Waterman with quarterly steps.

b) What is today’s present value of the option to buy at the end of the year the Waterman vineyard?

c) Suppose you have a vacant land and you are not sure whether you should build a gym or a
restaurant. Explain why it might make sense to wait a year to build either the gym or the
restaurant even if the NPV of both alternatives are positive today.

Finance II – Fernando Santos Jorge – Spring 2022

 Waterman
You have acquired the option to buy the Waterman vineyard in the Douro Valley region for €2,200 one
year from now. The current value of the vineyard is €2,000 today, but the coming 12 months are
crucial for its future. In particular, in every one of the next four quarters, the value of the vineyard can
either increase by 15% or drop by 10%. The effective annual risk-free rate is 3%.
a) Assume that the vineyard will not produce any cash flows for the next twelve months. Build a one-
year binomial tree for Waterman with quarterly steps.

€3498
€3042
€2738
€2645

€2300 $2381

€2000 €2070 €2142

€1800 €1863
f
€1620 €1677

€1458
€1312

Finance II – Fernando Santos Jorge – Spring 2022

 Waterman
b) What is today’s present value of the option to buy at the end of the year the Waterman
vineyard?

Note that it is worth exercising the option only at the two top nodes, where the payoffs from
exercising are €1,298 and €538 respectively. The risk-neutral probability of the top node
occurring is 𝑝! , while for the second one the r-n probability is 4 ∗ 𝑝" ∗ 1 − 𝑝 . The risk-neutral
probability of an upward movement is equal to
$
𝑝 ∗ 0.15 + 1 − 𝑝 ∗ (−0.1) = 1.03 − 1
𝑝 = 0.43

Using the risk-neutral probability p, the value of the option is

𝑝! ∗ €1,298 + 4 ∗ 𝑝" ∗ (1 − 𝑝) ∗ €538

= €137.47
€3498
1.03
€3042
€2738
€2645

€2300 $2381

€2000 €2070 €2142

€1800 €1863
f
€1620 €1677

€1458
Finance II – Fernando
€1312Santos Jorge – Spring 2022
 Waterman
c) Suppose you have a vacant land and you are not sure whether you should build a gym or a
restaurant. Explain why it might make sense to wait a year to build either the gym or the
restaurant even if the NPV of both alternatives are positive today.

If the NPV of both alternatives is positive, it might still pay off to wait one or two years and learn
a bit more about the local demand for gyms and restaurants (and figure out which of the two
options is more valuable!).

The option to wait is more valuable the higher the uncertainty and the higher the cost to
convert a restaurant into a gym and vice-versa.

Finance II – Fernando Santos Jorge – Spring 2022

 Finance II
Problem Set 10
CLASS 10

Finance II – Fernando Santos Jorge – Spring 2022

 Bolts and Wires

Finance II – Fernando Santos Jorge – Spring 2022

 Bolts and Wires
The R&D division of your firm, Bolts & Wires Ltd, has just synthesized a material that will
superconduct electricity at room temperature. You are considering producing this material
commercially.

It will take five years to find out whether the material is commercially viable, and you estimate
that the risk-neutral probability of success is 25%. The development of the technology will cost
$10m per year, paid at the beginning of each year. If the development is successful and you
decide to produce the material, the factory will be built immediately. It will cost $1bn to put in
place and will generate risk-free profits of $100m at the end of every year in perpetuity.

Assume that the current five-year risk-free interest rate is 10% per year and that the yield on a
perpetual risk-free bond will be either 12%, 10%, 8%, or 5% in five years (the risk-neutral
probability of each possible rate is the same).
0 1 2 4 5 6 7

Successful
What is the value the project today? 25%
-1,000 100 100

75%
-10 -10 -10 -10
Unsuccessful

0 0 0

Finance II – Fernando Santos Jorge – Spring 2022

 Bolts and Wires
Decision Tree 0 1 2 4 5 6 7

Successful
-1,000 100 100
25%
75%
-10 -10 -10 -10
Unsuccessful

0 0 0

If the development is successful, the NPV (at 𝑡 = 5) of producing the wire is:
€100𝑚
𝑁𝑃𝑉# = − €1,000𝑚
𝑟
It’s easy to see that this is negative for 𝑟 > 10% and hence the wire will only be produced if
the rates are 5% or 8%. In these cases
𝑁𝑃𝑉#,%&'.'# = €1,000𝑚
𝑁𝑃𝑉#,%&'.') = €250𝑚
In case the development is successful, the expected value of the growth opportunity at 𝑡 = 5 is
𝔼 𝑉# = 0.25 ∗ €250𝑚 + 0.25 ∗ €1,000𝑚 = €312.5𝑚
Given that the probability of success is 25%, the NPV of the opportunity is equal to

€10𝑚 1 0.25 ∗ €312.5𝑚

𝑁𝑃𝑉 = −€10𝑚 − ∗ 1− + = €6.82𝑚
0.1 1.1! 1.1#
Finance II – Fernando Santos Jorge – Spring 2022
 Montblanc

Finance II – Fernando Santos Jorge – Spring 2022

 Montblanc
Suppose that one year has passed since you have acquired the option to purchase the
Waterman vineyard and that you are one hour away from the expiration of your option. You are
about to let the option expire as the value of the Waterman vineyard stands only at €2,142, but
you are suddenly presented with new information involving the adjacent Montblanc vineyard.

In particular, the owner of the Waterman vineyard will have the opportunity to expand their
activities by acquiring the Montblanc vineyard at a price of €2,000 in two years’ time (at 𝑡 = 3).
Your current best estimate of the PV at 𝑡 = 3 of the cash flows stemming from the acquisition of
the Montblanc vineyard is just €1,800, but this figure is considerably volatile (𝜎 = 40% annually
and the variation is continuous). The systematic component of this cash flow volatility is such
that the appropriate discount rate for these cash flows is 12%; however, note that the
acquisition price will not vary with market conditions.

a) What is the value of the option to expand into the Montblanc vineyard?

b) Does this information affect your decision to acquire the Waterman vineyard?

Finance II – Fernando Santos Jorge – Spring 2022

 Montblanc
a) What is the value of the option to expand into the Montblanc vineyard?
Since the change in the value of the Montblanc vineyard is continuous, we need to apply the Black-
Scholes formula to figure out the value of the expansion option. Using the Black-Scholes notation, the
present value of the vineyard’s payoff is
€1,800
𝑆= = €1,434.95
1.12(
while that of the exercise price (note the different discount rate due to the invariance of the strike
price to market movements) is
€2,000
𝑃𝑉 𝐾 = = €1,885.92
1.03(
Combining these with the rest of the data, we can compute 𝑑" and 𝑑( as follows
€1,434.95
ln 0.4 ∗ 2
€1,885.92
𝑑" = + = −0.2
0.4 ∗ 2 2
𝑑( = 𝑑" − 0.4 ∗ 2 = −0.765
Applying these value to the Black-Scholes formula returns a value of the call option equal to
𝐶 = 𝑆 ∗ 𝑁 𝑑" − 𝑃𝑉 𝐾 ∗ 𝑁 𝑑( = €185.36
Note that although the numbers do not look very attractive today, the option to expand will only be
exercised at the highest states of the world two years from now. The volatility of the vineyard’s value
is high enough to generate a current value of €185.36 for the call option.

Finance II – Fernando Santos Jorge – Spring 2022

 Montblanc
b) Does this information affect your decision to acquire the Waterman vineyard?

In light of the expansion option, the value of the Waterman vineyard increases from €2,142 to
€2,327.36 and it is now beneficial to exercise the option to acquire it for a price of €2,200.

Finance II – Fernando Santos Jorge – Spring 2022