ACCA Strategic Professional · Advanced Financial Management · Valuation for acquisitions and mergers
Orlin plc is considering acquiring a small biotech firm. Owning it would give Orlin the right, but not the obligation, to invest in a larger production facility in three years if clinical trials succeed. Using option analogies, which statement about valuing this opportunity is correct?
The opportunity resembles a call option, with the future investment cost as the exercise price. Its value rises as the volatility of the underlying project value rises, because upside is unlimited while downside is limited to the cost of acquiring the option. So it does have value.
- AIt resembles a call option, and its value rises as the volatility of the underlying project's value risesCorrect
- BIt resembles a put option, and its value falls as volatility rises
- CIt resembles a call option, and its value falls as volatility rises
- DIt has no option value because the investment is not yet committed
Explanation
The right to make a later investment is an option to expand, which is a call option on the project's value, with the investment cost as the exercise price. Higher volatility increases the upside while losses are limited to the premium, so value rises. Saying there is no option value ignores the flexibility.
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