Corporate Finance - Assignment Two

Introduction

Options are a financial instrument with which one can reduce risk. Financial options are used by companies for this purpose and come in many forms, for example com- modity, currency or interest rate options.

Options are also embedded in real investment decisions, for example in the form that a company gains the possibility (or option) to make a very profitable future invest- ment (B), but only under the condition that the original investment (A) is made. This possibility increases uncertainty about the future, and has a value to the purchaser of the asset (A) at the time of purchase. Option pricing attempts to value this. This offers an alternative form of investment appraisal to the traditional Discounted Cash Flow (DCF) methods such as Net Present Value (NPV), that do not and can not account for and place a value on this uncertainty.

There are two major methods of valuing options. One is the binomial method and the other is the Black & Scholes Formula. The options valued here all use the Binomial Model assuming European Options.

2

Calculating a Development Option (Call)

To value the land in question the binomial option pricing method is used to deter- mine the value of having the option to develop the land after purchase. The specific method used in this case is the Hedging Method.

Today’s price = = 95.000 So

Land Value goes up = Land Value goes down = Exercice Price = Exercice Date = Risk free interest rate = Calls value if Su = Calls value if Sd = = 0

So is 95.000 because this is the net effect of taking the current asking price at 175.000 minus the current achievable resale value of 80.000.i.e. the current net actual value of the land.

Su is 300.000 because this is the expected value of the land as a building plot and as such depicts the best possible outcome for Moore (best case scenario).

Sd, 80.000, is the expected value of the land after purchase should it not become a building plot and remain agricultural (worst case scenario).

ExPr of 90.000 is the amount that must be paid at t1 (equal to the exercise date - ExDt), one year after the initial outlay of So at to, to be in the position to develop the land and gain the 300.000 (Su).

Rf is given.

Cu is the value gained if Su becomes true.

Oppositely Cd occurs if Sd becomes true and is therefore 0. The 80.000 that will be received on sale is not shown here because it has been accounted for under So.

3

After defining the above parameters it is required to calc ulate the option delta or

hedging Ratio as follows:

000 . 210 0 000 . 210

Cd Cu − −

This tells us that to produce a risk free position it is necessary to sell 1,047619 op-

tions for each security held.

Therefore the risk free outcome is:

Sd – (option delta Í Cd) = 80.000 – (1,047619 Í 0) = 80.000

The most you would pay for this future value today would not be 80.000 as sug-

gested, but the value discounted at the risk free rate:

000 . 80

This is then deducted from the price of the asset: 95.000 - 76.190,48 = 18.809,5

To find the value of both one call on the asset and the maximum acceptable value for

the development option:

The value of purchasing the land is therefore the value of the development option or

call (17.955) plus the value of the agricultural land (80.000):

17.955 + 80.000 = 97.955

Considering that the present value of the land is 95.000 it appears that this invest-

ment is worthwhile and should be undertaken, as the predicted value including the

option is higher than the current value.

4