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EXERCISE
- A company is investing in a project. The project requires an outlay of Rs 100 crore, and the present value of cash flows is
Rs 120 crore. This project is expected to lead to a second-generation project in 5 years that requires an investment of
another Rs 200 crore. The second generation would generate cash flows with a present value of Rs 170 crore, if developed
right now. The standard deviation of cash flows is 0.8. Assuming a risk free rate of 6 percent, estimate the value of option.
Would you undertake the project? - A company has a project that requires an outlay of Rs 100 crore. The present value of cash flows from the project is Rs 110
crore. The company has the option to sell the stake in the project to the other sponsor of the project for Rs 60 crore, anytime
in the next 8 years. The variance in project cash flows is 0.6. What is the value of the option to abandon? What is the true
NPV of the project? - Can equity be treated as an option held by shareholders? Why? Likewise, can debt be treated as an option held by creditors?
Why or how? - A company is in the process of acquiring another company.^5 The forecast of free cash flows are prepared on the basis of the
following assumptions:- Current sales are Rs 5 crore.
- Expected growth rate in sales is 6 percent, for the next 10 years.
- Cost of goods sold is 65 percent of the sales.
- Selling, general and administrative expenses are 15 percent of the sales.
- Depreciation is 4 percent of the sales.
- Capital investment to support sales is 8 percent of the sales.
- Tax rate is 35 percent.
- WACC for the company is 9.5 percent.
- The book value of the company’s debt is Rs 1 crore.
The target has an excellent distribution system that has value to the acquirer. The acquirer plans to set up a new plant if the
acquisition goes through. The new plant requires an initial investment of Rs 60 lac in year 0, and Rs 80 lac one year later.
(^5) Diane, Lander (Fall/Winter 2000). ‘Do Foregone Earnings Matter When Modeling and Valuing Real Options?: A Black–
Scholes Teaching Exercise’, Journal of Financial Practice and Education.