Risk Analysis, Real Options, and Capital Budgeting
1. Real Options
A. JTM is looking to buy gates at their home airport. Its discount rate is 7%; the risk free rate is 2.5%. What is the NPV of the purchase if bought today? Use the data in the template and note that the terminal value is as of the end of year 6.
B. After you do part A, you remember back to the concept of real options, which means that JTM can make dynamic changes as time passes:
1. Present valuing the purchase price of the gates (that is, the years 1 and 2 Capital Expenditures) separately using the risk-free rate because once JTM decides to go with the purchase there is no risk.
2. Present valuing the Net Cash Flow excluding those Cap Ex. This calculation will include Cap. Ex. For years 3-6 as they are part of the normal operation of the gates and are unrelated to the purchase price. 3. Use the Black-Scholes Option Pricing formula to come up with option’s priceassuming a 1-year maturity and a 20% price volatility for gate prices.
4. Compare the price of the call option with the NPV in the No Real Options scenario. Is the option worth it?
2. Decision Tree
JTM really liked your work on the option pricing of the gates, so they ask you to look at their 3-phase expansion at their home airport. The three phases are:
a. Upon purchase of the new gates, start a marketing program to promote JTM’s routes to the East Coast, West Coast, and the Caribbean. If all goes well and the market is receptive, they will go on to phase 2.
b. Phase 2 has JTM invest in new routes to the destinations listed. If at any time, JTM finds that this is not going to work, they will pull the plug on everything.
c. Phase 3 has JTM start the new routes to the destinations listed. If things don’t go well on any of the three destinations, they will pull the plug on everything.
d. After much work with other departments, you generate enough data to calculate the NPV of the 3-phase expansion. Before you have a chance to save all your work, there is a power spike and you lose part of your work. You have to complete it for a presentation. Please use the Excel template provided to complete this
Finish the question with the excel file provide bellow