ACCA Strategic Professional · Advanced Financial Management · Application of option pricing theory in investment decisions
Corvin Ltd can undertake a follow-on expansion exactly three years from now. The expansion needs a further outlay of $40m at that time. The present value today of the expected expansion cash inflows is $45m. Which mapping of inputs to the option to expand, valued as a call option, is correct?
The present value of the expansion inflows, $45m, is the underlying asset price. The further outlay of $40m is the exercise price, and the time to expiry is the three years until the decision must be made, not the life of the project.
- AShare price = $45m; exercise price = $40m; time to expiry = 3 yearsCorrect
- BShare price = $40m; exercise price = $45m; time to expiry = 3 years
- CShare price = $5m; exercise price = $40m; time to expiry = 3 years
- DShare price = $45m; exercise price = $40m; time to expiry = the life of the expansion project
Explanation
For a real call option, the underlying asset price is the present value of the inflows from the opportunity ($45m). The exercise price is the further investment ($40m). The time to expiry is the period until the decision must be taken (3 years). Swapping the inputs or using the NPV of $5m as the asset price is wrong.
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