Chapter 22, Problem 5PS

Real options Describe each of the following situations in the language of options:

1. a. Drilling rights to undeveloped heavy crude oil in Northern Alberta. Development and production of the oil is a negative-NPV endeavor. (Assume a break-even oil price is C$90 per barrel, versus a spot price of C$80.) However, the decision to develop can be put off for up to five years. Development costs are expected to increase by 5% per year.
2. b. A restaurant is producing net cash flows, after all out-of-pocket expenses, of $700,000 per year. There is no upward or downward trend in the cash flows, but they fluctuate as a random walk, with an annual standard deviation of 15%. The real estate occupied by the restaurant is owned, not leased, and could be sold for $5 million. Ignore taxes.
3. c. A variation on part (b): Assume the restaurant faces known fixed costs of $300,000 per year, incurred as long as the restaurant is operating. Thus,

   $\begin{array}{c}\text{Net cash flow}=\text{revenue less variable costs}-\text{fixed costs}\\ \$700,000=1,000,000-300,000\end{array}$

   The annual standard deviation of the forecast error of revenue less variable costs is 10.5%. The interest rate is 10%. Ignore taxes.

4. d. A paper mill can be shut down in periods of low demand and restarted if demand improves sufficiently. The costs of closing and reopening the mill are fixed.
5. e. A real estate developer uses a parcel of urban land as a parking lot, although construction of either a hotel or an apartment building on the land would be a positive-NPV investment.
6. f. Air France negotiates a purchase option for 10 Boeing 787s. Air France must confirm the order by 2021. Otherwise Boeing will be free to sell the aircraft to other airlines.