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Please describe the real option inherent in each of the following cases and provide some real-life hypothetical cases. Also, explain in each case if the option seller is involved and who that seller might be.

a. Moda di Milano postpones a major investment. The expansion has positive NPV on a discounted cash- �ow basis, but top management wants to get a better �x on product demand before proceeding.

b. Western Telecom commits to production of digital switching equipment specially designed for the European market. The project has a negative NPV, but it is justi�ed on strategic grounds by the need for a strong market position in the rapidly growing, and potentially very pro�table, market.

c. Western Telecom vetoes a fully integrated, automated production line for the new digital switches. It relies on standard, less-expensive equipment. The automated production line is more efficient overall, according to a discounted cash-�ow calculation.

d. Mount Fuji Airways buys a jumbo jet with special equipment that allows the plane to be switched quickly from freight to passenger use or vice versa.

Kamini Mandloi answered this 2,186 answers

Ans.

a. In this case the Moda di Milano postpones a major investment because while the management is able to forecast positive NPV from the project they are not con�dent on the demand prospects. IN this case the option is to delay the project. SO we see characteristics of the option here. In this case the option seller is the party who would have been paid to commence the project. This is a notional contract.

b. In this case Western Telecom commits to production of digital switching equipment specially designed for the European market. The project has a negative NPV now but it will have positive NPV in the future. This gives the characteristics of the call option.. In this the company anticipates very strong and potentially very pro�table, market.so the future value of the cash �ow will be very high. In this case it is like call option and Western Telecom is the option buyer for the call option and the company which has seld the project to Wester Teelcom is the option seller so that they can have the upside from the investment in the project.

c. Western Telecom vetoes a fully integrated, automated production line for the new digital switches. It relies on standard, less-expensive equipment. The automated production line is more efficient overall, according to a discounted cash-�ow calculation. In this case the company has traded off the automated production line with more efficient overall to standard less expensive equipment . Which looks like company has taken short option. In this case there is no really option seller becaue it’s a notional options contract and the trade off is between the automated equipment vs the manual equipment.

d. Mount Fuji Airways buys a jumbo jet with special equipment that allows the plane to be switched quickly from freight to passenger use or vice versa IN this case the option the company has bought is the �exibility to convert from freight to passenger use or vice versa so there are characteristics of the option s. here again company has bought the call option and paid the one time price for the future bene�ts and company has not further obligation. IN this case the

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