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ACCA Strategic Professional · Advanced Financial Management · Application of option pricing theory in investment decisions

Baltic Ltd has a project with a static NPV of -$1.5m. It holds an option to delay the investment by one year. Using Black-Scholes, the option is valued as a call with these results: N(d1)=0.65, N(d2)=0.50, PV of project cash inflows $20m, PV of the exercise price (investment outlay) $19.0m. What is the value of the delay option, and what is the expanded NPV of the project if the option is valued as N(d1) x Pa - N(d2) x PV(Pe)?

The option is worth $3.5m, from 0.65 x 20 minus 0.50 x 19. Adding this to the static NPV of -$1.5m gives an expanded NPV of $2.0m, so the project becomes worthwhile once the flexibility to delay is valued.

  1. AOption value $3.5m; expanded NPV $2.0mCorrect
  2. BOption value $3.5m; expanded NPV -$1.5m
  3. COption value $13.0m; expanded NPV $11.5m
  4. DOption value $2.0m; expanded NPV $0.5m

Explanation

Option value = 0.65 x 20 - 0.50 x 19 = 13.0 - 9.5 = 3.5m. Expanded NPV = -1.5 + 3.5 = $2.0m. Ignoring the static NPV gives 3.5m only, and omitting N(d2) gives 13.0m, both wrong.

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