ACCA Strategic Professional · Advanced Financial Management · Application of option pricing theory in investment decisions
Dunmore Co values a real option on a new project using the equity share price volatility of a highly geared listed comparator in the same industry. Dunmore will finance the project with little debt. What is the likely effect on the option value?
The option value is likely overstated. A highly geared comparator's equity volatility includes financial risk, so it is higher than the volatility of the underlying business assets. Since option values rise with volatility, using it for a lightly financed project inflates the value.
- AThe option value will probably be overstated, because the comparator's equity volatility includes financial risk and exceeds the volatility of the underlying business assetsCorrect
- BThe option value will probably be understated, because gearing reduces equity volatility
- CThere will be no effect, because volatility is independent of capital structure
- DThe option value will be unaffected because only the risk-free rate depends on gearing
Explanation
Equity volatility in a geared firm combines business risk and financial risk, so it exceeds asset volatility. Using it for a lightly financed project overstates volatility. A higher volatility raises the value of a call option, so the option value is overstated. The claim that gearing reduces equity volatility is wrong.
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