Chapter 13 PDF

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park.
ISBN: 0-13-611848-8
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Chapter 13 Real-Options Analysis

Financial Options
13.1
Define the option parameters for the call option.
S0
$80.38
$90
0.5
0.06
0.8
The value of the call option is $15.39 by Black-Scholes equation.

13.2
Define the option parameters for the put option.
S0
$136.08
$160
0.167
0.05
0.6
The value of the put option is $28.39 by Black-Scholes equation.

13.3
Long call and short call
Page | 1
Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

Long put and short put
13.4
Define the option parameters for this option.
S0
$52
0.75
0.05
0.6
To get a value of call option of $4 by Black-Scholes equation, the current

stock price should be $37.5 by Goal seek function in Excel.
13.5
u = e t = e0.3 0.75 = 1.2967
1
1
d= =
= 0.7712
u 1.2967
Risk neutral probability
q=
e r t d e0.050.75 0.7712
=
= 0.5081
ud
1.2967 0.7712
Page | 2

Tree valuation
100.88
Max(0, (100.88-60)) = $40.88
q
60
$9.81
77.80
$20.02
60
Max(0, (60-60)) = $0
1-q
46.27
$0.00
35.68
Max(0, (35.68-60)) = $0
European call option value = $9.81

13.6
u = e
= e0.3 1 = 1.3499 , d =
1
1
=
= 0.7408
u 1.3499

e r t d
e0.051 0.7408
q=
=
= 0.5097
ud
1.3499 0.7408
98.39
Max(0,45-98.39)
0
Do not exercise
Tree valuation
72.89
Max(0,45-72.89)
0
Do not exercise
53.99
40
Max(3.34,45-53.99)
3.34
Do not exercise
$8.79
53.99
Max(0,45-53.99)
0
Do not exercise
40
Max(7.17,45-40)
7.17
Do not exercise
29.63
Max(0,45-29.63)
15.37
Exercise
29.63
Max(14.24,45-29.63)
15.37
Do not exercise
21.95
Max(20.86,45-21.95)
23.05
Exercise
American option value = $8.79
16.26
Max(0,45-16.26)
28.74
Exercise
Page | 3

13.7
We may use the Goal Seek function in Excel to find the value of K by
inputting the known parameters into the Black-Scholes equation. Or we may
use a known result of put-call parity in financial option. The put-call parity
shows the relationship between the price of a European call option and the
price of a European put option when they have the same strike price and
maturity date.
r T
c+Ke f = p+S0
35.15+Ke0.06(1) =13.95+90
K=$73.05
If the equation above does not hold, there are arbitrage opportunities.
13.8
Portfolio
A long call with K = $40
A short put with K = $45
Two short calls with K = $35
Two stocks shorted at $40
Total
Premium
$3
$4
$5
Payoff at stock price $60

$17
$4
($40)
($40)
($59)
13.9
Intrinsic value = S0 K = $2
Time premium = option premium intrinsic value = $2
13.10
Invest $10,000 in the stocks
Stock Purchase
Price
Initial
Cost of
Stock 400
shares
Stock, Price
at Expiration
Value of Stock
at Expiration
Payoff
$25
$10,000
$27
$10,800
$800
$25
$10,000
$30
$12,000
$2,000
$25
$10,000
$40
$16,000
$6,000
Page | 4

Invest $10,000 in the call options

Option
Price
per
Contract
$4
Initial Cost of
Options (2500)
$4
$4
Profit Per
Option
at Expiration
Total Profit of
Options
Payoff
$0
$0
($10,000)
$3
$7,500
($2,500)
$13
$32,500
$22,500
$10,000
$10,000
$10,000
13.11
(a)
Discount rate per period
S0 =
K=
T=
r=
u=
d=
volatility =
q=
1-q =
w=
100
105
1.5
5%
1.354
0.739
35%
0.49
0.51
0.9632
183.35
135.41
36.74
100
17.23
78.35
100.00
73.85
0.00
0.00
54.54
17.23 = 0.9632*(0.49(36.74 )+ 0.51(0))

0.00
0= 0.9632(0.49(0) + 0.51(0))
Option value= $
17.23
Page | 5

(b)
S 0=
K=
T=
r=
u=
d=
volatility =
q=
1-q =
w=
100
100
1
5%
1.191
0.839
35%
0.49
0.51
0.9876
201.38
119.12
3.73
100
10.43
83.95
17.18
169.05
0.00
141.91
0.00
141.91
0.00
119.12
0.00
100.00
0.00
100.00
7.43
83.95
0.00
70.47
14.81
70.47
27.06
59.16
29.53
39.60
49.66
17.18= 0.9876(0.46(7.43) + 0.54(27.06))
50.34
Option value=
$ 10.43
MAX(0, 100 - 49.66)

= 50.34
Page | 6

(c)
S 0=
K=
T=
r=
u=
d=
volatility =
q=
1-q =
w=
100
100
1
5%
1.191
0.839
35%
0.49
0.51
0.9876
201.38
169.05
0.00
141.91
0.00
141.91
119.12
0.00
119.12
0.00
100
4.04
100.00
0.00
100.00
11.36
83.95
8.05
83.95
0.00
18.73
70.47
16.05
70.47
29.53
59.16
29.53
40.84
49.66
11.36 = 0.9876*(0.49(4.04 )+ 0.51(18.73))
MAX(18.73, 100 - 83.95)

= 18.73
Option value=
$ 11.36
50.34
MAX(39.20, 100 - 59.16)
= 40.84
MAX(0, 100 - 49.66)

= 50.34
13.12
(a)
Define the option parameters for this call option.
S0
$40
$40
1.167
0.06
0.4
The value of call option is $8.05 by Black-Scholes equation.
Page | 7

(b)
Define the option parameters for this put option.
S0
$50
$55
1.5
0.06
0.2
The value of put option is $5.02 by Black-Scholes equation.

(c)
Define the option parameters for this put option.
S0
$38
$40
0.25
0.06
0.6
The value of put option is $5.35 by Black-Scholes equation.

(d)
Define the option parameters for this call option.
S0
$100
$95
0.08
0.4
The value of call option is $38.27 by Black-Scholes equation.

13.13
The accumulated cost of the hedge at the end of year one is
($50,000 - $38,000)exp(0.06) = $12,742.
Let S be the market price:
If S < $1.25, the put option is in the money and the payoff is
$1,000,000(1.25 S) = $1,250,000 1,000,000S.
The sale of the coffee beans has a payoff of
1,000,000(S 1) - $12,742 + $1,250,000 1,000,000S = $237,258
Page | 8

From $1.25 to $1.40 neither option has a payoff and the profit is
1,000,000(S 1) - $12,742 = 1,000,000S -1,012,742
If S > $1.40, the call option is in the money and the payoff is
-$1,000,000(S 1.40) = $1,400,000 1,000,000S.
The profit is
1,000,000(S -1) - $12,742 +$1,400,000 1,000,000S = $387,258
Therefore, the range is $237,258 to $387,258.
Real-Options Analysis
13.14
Define the real option parameters for delaying option.
V0
$1.9 Million
$2 Million
0.08
0.4
The value of delaying is $0.32 Million by Black-Scholes equation. If the choice is

to defer or cancel, the value of delaying is $0.32M as calculated. If the choice is
to defer or upgrade now, then we have to subtract the conventional NPW and the
answer is $0.32M (-$0.1M) = $0.42M.
13.15
Define the real option parameters for license option.
V0
$30 Million
$40 Million
0.06
0.2
The value of license is $2.86 Million by Black-Scholes equation. Here we

assume that the option will be exercised in three years when exclusive mining
rights expire.
Page | 9

Growth Options
13.16
Define the real option parameters for this option.
V0
$1 Million
0.06
The best cutting policy:

It is most profitable when we cut the trees at year 2.
Keeping option open/waiting is better than cutting trees from year 0 to
year 1.
Option Value of the investment opportunity: $0.62M
0
1
1.6
2
1.5
0.4
0.4
unit: $M
Growth rate
Rent Cost
r
T=
dT
u=
d=
v=
q=
1-q =
0.06
2
1
1.25
0.8
0
0.58
0.42
3.75=2(1.25)(1.5)
2= 1(1.25)1.6
3.75
1
1.62
1
wait
Cutting
1.62=EXP(-0.06*1)*(2.6*0.58+1.52*0.42)-0.4: Wait
1: Cutting
2
2.60
2.00
wait
Cutting
1.28
1.52
1.28
wait
Cutting
3.75
2.40
2.40
Cutting
1.54
1.54
1.52=EXP(-0.06*1)*(2.4*0.58+1.54*0.42)-0.4: Wait
1.28: Cutting
Option value = $
Cutting
0.62
Page | 10
Cutting

13.17
Define the real option parameters for deferral option.
V0
I1
I2
$60,000
$38,588
$60,638
0.06
0.2
The value of postponing the construction decision for two years: $349,743
0
I1 =
I2 =
volatility
r
T=
dT =
u=
d=
q=
1-q =
60,000
349,743
2
38,588
60,638
0.2
0.06
2
2
1.33
0.75
0.65
0.35
38,588=35,000(1.05)(1.05)
60,638=55,000(1.05)(1.05)
410,263=MAX(79,614-38,588,0)*10
569,289=MAX(79,614-60,638,0)*30
79,614
410,263 10 stores mall open
45,218
0 30 stores mall open
349,743=EXP(-0.06*2)*(569, 289*0.65+ 66,308*0.35)
Page | 11

Switching Options
13.18
The NPW of project B:
PW (12%) B = $2 + $1( P / A,12%,10) = $3.65M
Define the real option parameters for switching option.
V0
$4 Million
$3.65 Million
0.06
0.5
The value of switching is $0.85 Million by Black-Scholes equation for put

option.
Therefore, the total value is:
SNPW = Value of project A + Option to switch to project B
SNPW = $4 + $0.85 = $4.85M
R&D Options
13.19
Assuming MARR = 12%, the cash flow diagram transforms to:
$73.42
0
$14.18
R&D Expenses
10
Manufacturing and Distribution

$80
Define the real option parameters for R&D option.
Page | 12

V0
$46.66 Million
$80 Million
0.06
0.5
The value of option today is $13.70 Million by Black-Scholes equation

for a call option.
Therefore, the total value is:
Option value = SNPW - Cost for R&D
= $13.7 $14.18 = $0.48M < 0
The firm should not embark on the project as the required R&D
expenditure already exceeds by $0.48M.
Abandonment Options
13.20
Standard NPW approach
0.35 0.35 0.35 0.35
0.35
...
0
$3
$0.35
= $0.08M
0.12
1
e0.06 d
= 1.6487, d = = 0.6065, and q =
= 0.4369
u
ud
PW (12%) = $3 +
u = e0.5
Abandon Option value through the binomial tree - Option parameters

V0
$2.92 Million
I
$2.2 Million
T
5
r
0.06
0.5
Page | 13

- Option valuations
Time
0
2.92
1
4.81
1.77
2
7.94
2.92
1.07
3
13.09
4.81
1.77
0.65
4
21.58
7.94
2.92
1.07
0.40
0.50
0.23
0.77
0.06
0.42
1.13
0.00
0.12
0.69
1.55
0.00
0.00
0.23
1.13
1.80
Monetary Value
Option value
5
35.57
13.09
4.81
1.77
0.65
0.24
0.00
0.00
0.00
0.43
1.55
1.96
* It is optimal to exercise early at the shaded positions.

Option premium = $0.50 (-0.08) = $0.58M
Scale-Down Options
13.21
Scale down option parameters
V0
$10 Million
I
$4 Million
T
3
r
0.06
0.3
Decision tree for a scale-down option through one-year time increment.

o
o
o
u = e t = e0.3 1 = 1.35
1
1
d= =
= 0.74
u 1.35
e r t d e0.061 0.74
q=
=
= 0.53
ud
1.35 0.74
Page | 14

K=
volatility
r
u=
d=
q=
4
0.3
0.06
1.35
0.74
0.53
1.35
10
11.7671
=max(18.22*0.8+4,EXP(-0.06)*(24.6*0.53+14.8*(1-0.53))) =18.8
13.50
14.7989
scale down
0.74
7.41
9.9265
scale down
24.60
max(24.6*0.8+4,24.6)
1.35
24.60
=24.6
18.22
Do not scale down
1.35
18.8003
0.74
Do not scale down
13.50
max(13.5*0.8+4,13.5)
0.74
1.35
14.80
=14.8
10
scale down
1.35
12.0000
0.74
scale down
7.41
0.74
1.35
9.93
5.49
scale down
8.3905
0.74
scale down
4.07
7.25
scale down
From the result of the tree we can get the SNPW:

SNPW = NPV + Option value = $11.77M
Option value = $11.77M - $10M = $1.77M
Expansion-Contraction Options
13.22
(a) Binomial lattice tree
u = e t = e0.15 1 = 1.1618
1
1
= 0.8607
d= =
u 1.1618
Tree with incremental period one year
134.99
116.18
100
100
86.07
74.08
Page | 15

(b) Option valuation

q=
e0.051 0.8607
ert d
=
= 0.6329 , 1 q = 0.3671
ud
1.1618 0.8607
134.99
Max(134.990.9+25,134.991.3-20,134.99)
155.48
Expand
116.8
Max(116.80.9+25,116.81.3-20,133.76)
133.76
Keep option open
100
Max(1000.9+25,1001.3-20,100)
115
Contract
100
116.31
86.07
Max(86.070.9+25,86.071.3-20,101.24)
102.46
Contract
74.08
Max(74.080.9+25,74.081.3-20,74.08)
91.67
Contract
Option value = SNPW NPV = $116.31 - $100 = $16.31M
Compound Options
13.23
Compound option parameters
V0
I1
I2
$32.43
$10
$30
T1
T2
r
0.06
0.5
Decision tree for a scale-down option through one-year time increment.

- u = e t = e0.5 1 = 1.6487
1
1
-d= =
= 0.6065
u 1.6487
e r t d
e0.061 0.6065
- q=
=
= 0.4369
ud
1.6487 0.6065
Page | 16

145.34
Max(145.34 - 30, 0)
115.34
Invest $30
88.15
59.90
Keep option open
53.47
Max(53.47 - 30, 0)
23.47
Invest $30
53.47
Max(29.77 - 10, 0)
19.77
Invest $10
32.43
9.66
Keep option open
32.43
8.13
Max(19.67 - 30, 0)
0
Do not invest
19.67
Max(3.97 - 10, 0)
0
Do not invest
19.67
11.93
0
Do not invest
7.24
Max(7.24 -30, 0)
0
Do not invest
First Option
Second Option
SNPW is $8.13 and this exceeds the initial cost $5. Initiate the phase I.
Page | 17

13.24
Option parameters
V0
I1
I2
$19.5M
$3M
$12M
T
3
r
0.05
Phase 1
1
0
I=
0.25
Phase 2
2
3,000,000
12,000,000
12,000,000
29,281,500=MAX(41,281,500-12,000,000, 0)
2,700,000: Abandon (Selling price of the land)
volatility=
r
T=
dT
u=
d=
v=
q=
1-q=
0.25
0.05
3.00
1.00
1.28
0.78
0.00
0.54
0.46
20,735,312=EXP(-0.05*1)*(29,281, 500*0.54+13,038,496*0.46)
20,150,065=MAX(32,150,065-12,000,000, 0)
41,281,500
25,038,496
14,180,447
22,038,496
2,700,000
15,186,615
5,382,658
12,186,615
2,700,000
19,500,000
16,646,312
Keep Option
Invest 3M
Abandon
Keep Option
Invest 3M
Abandon
5,382,658=EXP(-0.05*1)*(8,085,247*0.54+2,817,955*0. 46)
12,186,615=MAX(15,186,615-3, 000,000, 0)
Option value=
32,150,065
20,735,312
20,150,065
2,700,000
19,500,000
8,085,247
7,500,000
2,700,000
11,827,348
2,817,955
2,700,000
Keep Option
Invest 12M
Abandon
Keep Option
Invest 12M
Abandon
Keep Option
Invest 12M
Abandon
29,281,500 Invest 12M

2,700,000 Abandon
25,038,496
13,038,496 Invest 12M
2,700,000 Abandon
15,186,615
3,186,615 Invest 12M
2,700,000 Abandon
9,211,148
Invest 12M
2,700,000 Abandon
16,646,312
Page | 18

Short Case Studies

ST 13.1
(a) American put option value
Option parameters
V0
$150
u = e
K
$100
t
= e0.3 1 = 1.3499 , d =

q=
t
1 year
T
2
r
0.05
0.3
1
1
=
= 0.7408
u 1.3499
e r t d
e0.051 0.7408
=
= 0.5097 , 1 q = 0.4903
ud
1.3499 0.7408
0
K=
volatility
r =
u=
d=
q=
100
0.3
0.05
1.35
0.74
0.51
1.35
1.35
150
3.84
202.48
0.00
0.74
0.74
1.35
111.12
8.24
273.32
0.00
150.00
0.00
0.74
82.32
17.68
American put option value = $3.84
Page | 19

(b) Expansion Option value

Option parameters
t
T
2
1 year
1
1
u = e t = e0.35 1 = 1.42 , d = =
= 0.70
u 1.42
er t d
q=
= 0.51, 1 q = 0.49
ud
K
V0
$400
volatility
r=
u=
d=
q=
1.42
400
593.17
567.63
658.20
902.16
0.70
0.35
805.50
1361.00
0.70
1.42
281.88
201.00
353.89
0.35
0.07
1.42
0.70
0.51
1.42
r
0.07
400.00
550.00
0.70
198.63
198.63
Total option value = $593.18

Real option premium = $598.13 - $400 = $198.13
Page | 20

ST 13.2
(a) Since $4 M is lower than the option price, it is a good investment for Merck
Co.
To give a range for the option value, first using one period lattice.
V0
K
$36M
$72M
($301.2M) ($601.2M)
t
3 years
T
3
r
0.06
0.5
u = e t = e0.5 3 = 2.3774
1
1
d= =
= 0.4206
u 2.3774
q=
e r t d
e0.063 0.4206
=
= 0.3969 , 1 q = 0.6031
ud
2.3774 0.4206
One period lattice and option price: 4.50M

85.59
Max(85.59 - 72, 0)
13.59
Buy the stock
36
4.50
15.14
Max(15.14 - 72, 0)
0
Do not buy the stock
Through the B-S model, the option price should be $6.54M.
Page | 21

Note: We can think that the price from the one step binomial tree is the lower bound
and B-S being the upper bound. So the option price is definitely higher than
the suggested price.
(b) With the agreement, Merck has a chance to buy Genetics with a lower price
than the prevailing market price when the project is successful. Otherwise
they just lose $4M. To make this concept simple, a basic example is
demonstrated below:
Profit/loss analysis
Success
Fail
Buy stock
Gain $37.59M
Loss $32.86M
Aforesaid agreement
Gain $9.59M
Loss $4M
The Buy stock option has a higher risk than the option.
Page | 22

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Contemporary Engineering Economics, Fifth Edition, by Chan S. Park.

Chapter 13 Real-Options Analysis

The value of the call option is $15.39 by Black-Scholes equation.

The value of the put option is $28.39 by Black-Scholes equation.

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

Long put and short put

To get a value of call option of $4 by Black-Scholes equation, the current

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

European call option value = $9.81

Risk neutral probability

American option value = $8.79

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

Payoff at stock price $60

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

Invest $10,000 in the call options

Discount rate per period

17.23 = 0.9632*(0.49(36.74 )+ 0.51(0))

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

Discount rate per period

17.18= 0.9876(0.46(7.43) + 0.54(27.06))

MAX(0, 100 - 49.66)

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

Discount rate per period

11.36 = 0.9876*(0.49(4.04 )+ 0.51(18.73))

MAX(18.73, 100 - 83.95)

MAX(0, 100 - 49.66)

The value of call option is $8.05 by Black-Scholes equation.

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

The value of put option is $5.02 by Black-Scholes equation.

The value of put option is $5.35 by Black-Scholes equation.

The value of call option is $38.27 by Black-Scholes equation.

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

Therefore, the range is $237,258 to $387,258.

The value of delaying is $0.32 Million by Black-Scholes equation. If the choice is

The value of license is $2.86 Million by Black-Scholes equation. Here we

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

The best cutting policy:

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

349,743=EXP(-0.06*2)*(569, 289*0.65+ 66,308*0.35)

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

The value of switching is $0.85 Million by Black-Scholes equation for put

SNPW = $4 + $0.85 = $4.85M

Manufacturing and Distribution

Define the real option parameters for R&D option.

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

The value of option today is $13.70 Million by Black-Scholes equation

0.35 0.35 0.35 0.35

Abandon Option value through the binomial tree - Option parameters

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

* It is optimal to exercise early at the shaded positions.

Decision tree for a scale-down option through one-year time increment.

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

From the result of the tree we can get the SNPW:

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

(b) Option valuation

Option value = SNPW NPV = $116.31 - $100 = $16.31M

Decision tree for a scale-down option through one-year time increment.

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

29,281,500 Invest 12M

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

Short Case Studies

Risk neutral probability

349,743=EXP(-0.062)(569, 2890.65+ 66,3080.35)