Question 1: Please show all relevant computations.
NuPetrol is an international conglomerate with a petroleum division and is currently competing in an auction to win the right to drill for crude oil on a large piece of land in one year. The current market price of crude oil is $60 per barrel, and the land is believed to contain 400,000 barrels of oil. If found, the oil would cost $45 million to extract. U.S. Treasury bills that mature in one year yield a continuously compounded interest rate of 3 percent. The standard deviation of the returns on the price of crude oil is 50 percent. Use the Black-Scholes-Merton model to calculate the maximum bid that the company would be willing to make at the auction.
Suppose instead that the available oil reserve follows a lognormal distribution with a mean of 400,000 barrels and standard deviation of 80,000 barrels. The extraction cost also follows a lognormal distribution with a mean of $45 million and standard deviation of $10 million. What is, on average, the maximum bid that the company would be willing to make? Use the Black-Scholes-Merton model. Please show your Monte Carlo simulation results.
Question 2: Please show all relevant computations.
WebflixTV has just introduced video-on-demand services in two major metropolitan areas in the United States. While not totally disappointing, the initial market response has been lukewarm. Using a risk-adjusted discount rate of 8%, the DCF value of the project today is estimated to be $80 million. The annual standard deviation of logarithmic returns of the future cash flows from similar projects is 30%. The company decides to explore the option to expand based on its belief that its services will have great potential in eight other metropolitan areas. If the company pursues this opportunity, it will need to spend $200 million, but its operating value is expected to increase threefold. What is the value of the option to expand over the next four years? The continuously compounded annual risk-free rate of return over the same time period is 5%. Please use the Binomial Option Pricing approach.
Question 3: Please show all relevant computations.
Genedrug Co is a drug company with several initiatives in its R&D pipeline. Its scientists have developed several patented product ideas, one of which has become a lead candidate for a development effort due to its potential market demand. The total estimated cost to launch the product, including its development, is $95 million, in present value terms. It takes five years to fully develop this product. During this development phase, there is no cash flow associated with this product. The finance and marketing groups of the company have estimated the following cash flows from the product after it has been fully developed (figures in million dollars):
Year 6 7 8 9 10
Cash flow 33.88 60.64 65.53 70.17 85.72
The finance group considers 15% to be the appropriate discount rate for this project. Despite its market potential, this product faces stiff competition from other major projects in the company's pipeline. The Vice President of the division decides to explore a strategic abandonment option. At any time during the next five years of development, Genedrug can either continue with the development effort or sell off its intellectual property for $65 million to a strategic partner, who has shown great interest in this technology. The annual standard deviation of logarithmic returns of the future cash flows is estimated to be 35%, and the continuously-compounded annual risk-free rate of return over the next five years is 5%. Using the Binomial Option Pricing approach, what is the value of the abandonment option? Also, identify the timing of the firm's abandonment strategy, namely, when would be optimal for Genedrug to abandon this project?