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    Classwork 7

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    Classwork 7

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    mateoromansy
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    Classwork 7

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    mateoromansy

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    LSE Summer School

    Finance
    Classwork 7 – Real Options

    Question 7.1
    The management of Zincronium plc plans to produce 200,000 of zinc pounds next year provided that the
    economic conditions prove to be favourable. The extraction cost is estimated to be EURO 1.70 per
    pound. The management is forecasting two possible zinc prices next year, depending on the level of
    demand: either (a) EURO 1.10 per pound in the case that demand will be low, or (b) EURO 2 per pound
    if the high demand state of nature will be realised. At the moment, the year one zinc forward contract
    price is trading at EURO 1.30 with the one-year risk free interest rate at the 6% level. Calculate the value
    of this mine using the tracking portfolio approach.

    Question 7.2
    Spark Electricity plc is considering building a plant that is planned to cost £500 million and an estimated
    building period of 12 months. When the plant enters into operation after its completion it will produce a
    perpetual stream of cash flows. There are a number of factors leading to substantial uncertainty as to
    whether the plant should be given the go-ahead now or wait one year and then decide whether to build
    or not then.

    The cash flows expected to be generated by the project differ over these two options. In the case that
    the project is undertaken immediately, the plant will produce £50 million for sure in its first year of
    operation. However, subsequent annual cash flows will depend on the state of the economy: in the good
    state, the plant will generate £75 million each year, whereas in the bad state the total annual cash flows
    generated are forecasted to be £10 million.

    In the case that management decides to delay the project by one year, the first year initial cash flows of
    £50 million will be irretrievably lost. The perpetual cash flows will start two years from today and will be
    (a) either £75 million in the good state of nature, or (b) £10 million in the bad state of nature.

    The risk free interest rate is 6% per annum and investing £1 in the market portfolio is forecasted to
    generate either £1.40 in the good state, or £0.90 in the case that the bad state emerges. After computing
    the project's NPV, analyse whether or not the firm's management should build now or wait one year to
    take the decision.

    Question 7.3
    The total market value of the common stock of the Okefenokee Real Estate Company is $6 million, and
    the total value of its debt is $4 million. The treasurer estimates that the beta of the stock is currently 1.5
    and that the expected risk premium on the market is 10 percent. The Treasury bill rate is 8 percent.

    (a) What is the required return on Okefenokee stock?


    (b) What is the beta of the company's existing portfolio of assets?
    (c) Estimate the company's cost of capital.
    (d) Estimate the discount rate for an expansion of the company's present business.
    (e) Suppose the company wants to diversify into the manufacture of rose-coloured spectacles. The
    beta of unleveraged optical manufacturers is 1.2. Estimate the required return on Okefenokee's
    new venture.

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