Exam 13: Real-Options Analysis

Value an American put option using a binomial lattice with the following attributes:

You are considering an investment in a tree farm. Trees grow each year by the following factors: The price of lumber follows a binomial lattice with 0. The interest rate (risk-free) is constant at 6%. It costs $2 million each year, payable at the beginning of the year, to lease the forest land. The initial value of the trees is $5 million (assuming they were harvested immediately). You can cut the trees at the end of any year and then not pay rent after that. With rent of $2 million per year, find the best cutting policy and the value of the investment opportunity.

A Korean auto-part supplier is evaluating an investment project to build a manufacturing plant close to Kia Automobile Assembly Plant near West Point, Georgia. The supplier can obtain a 1-year option to buy the required parcel of land near West Point area and if the land is purchased the price would be $1,500,000. The land option, if purchased, would expire 1-year from now. The supplier has two years to make a decision on whether to build the plant and start operations, once the land was purchased. The required capital investment would be $5,000,000. They estimate that the land, if purchased, could be sold for 110% of its purchase price anytime over next two years. What would the company be willing to pay for the combined value of the land option?

Value a European call option using a binomial lattice with the following attributes: • Current underlying asset value of 60 • Exercise price of 60 • Volatility of 30% • Risk-free rate of 5% • Time to expiration equal to 18 months • A two-time period lattice