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(National Geographic (Little) Kids) #1
654 CHAPTER 17 Option Pricing with Applications to Real Options

Selected Additional References

For more information on the derivatives markets, see
Chance, Don M., An Introduction to Derivatives (Fort Worth,
TX: Dryden Press, 1995).
The original Black-Scholes article tested the OPM to see how well
predicted prices conformed to market values. For additional empir-
ical tests, see
Galai, Dan, “Tests of Market Efficiency of the Chicago
Board Options Exchange,” Journal of Business, April 1977,
167–197.
Gultekin, N. Bulent, Richard J. Rogalski, and Seha M.
Tinic, “Option Pricing Model Estimates: Some Empiri-
cal Results,” Financial Management, Spring 1982, 58–69.


MacBeth, James D., and Larry J. Merville, “An Empirical
Examination of the Black-Scholes Call Option Pricing
Model,” Journal of Finance, December 1979, 1173–1186.
Here are some references on real options:
Amram, Martha, and Nalin Kulatilaka, Real Options: Manag-
ing Strategic Investment in an Uncertain World (Boston,
MA: Harvard Business School Press, 1999).
Trigeorgis, Lenos,Real Options in Capital Investment: Models,
Strategies, and Applications(Westport, CT: Praeger, 1995).
Trigeorgis, Lenos, Real Options: Managerial Flexibility and
Strategy in Resource Allocation (Cambridge, MA: The MIT
Press, 1996).

ing department, you learn that there is a 30 percent chance of high demand, with future
cash flows of $45 million per year. There is a 40 percent chance of average demand, with
cash flows of $30 million per year. If demand is low (a 30 percent chance), cash flows will
be only $15 million per year. What is the expected NPV?
i. Now suppose this project has an investment timing option, since it can be delayed for a year.
The cost will still be $70 million at the end of the year, and the cash flows for the scenarios
will still last 3 years. However, Tropical Sweets will know the level of demand, and will im-
plement the project only if it adds value to the company. Perform a qualitative assessment of
the investment timing option’s value.
j. Use decision tree analysis to calculate the NPV of the project with the investment timing
option.
k. Use a financial option pricing model to estimate the value of the investment timing option.
l. Now suppose the cost of the project is $75 million and the project cannot be delayed. But if
Tropical Sweets implements the project, then Tropical Sweets will have a growth option. It
will have the opportunity to replicate the original project at the end of its life. What is the
total expected NPV of the two projects if both are implemented?
m. Tropical Sweets will replicate the original project only if demand is high. Using decision
tree analysis, estimate the value of the project with the growth option.
n. Use a financial option model to estimate the value of the project with the growth option.
o. What happens to the value of the growth option if the variance of the project’s return is 14.2
percent? What if it is 50 percent? How might this explain the high valuations of many dot-
com companies?

Option Pricing with Applications to Real Options 649
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