Problemas de Opciones Reales Con Solución

ECONOMIC DECISION ANALYSIS
HANDOUTS
ISyE 4803R Summer 2010
Table of Contents
Syllabus 3-6
A. Cash Flow Analysis 7-40
B. Dynamic Cash Flow Analysis 41-66
C. Financial Options Analysis 67-104
D. Real Options Analysis 105-156
E. Market Survey Analysis 157-184
F. Utility Analysis 185-192
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ECONOMIC DECISION ANALYSIS
ISyE 4803R Summer 10
Professor: Steve Hackman

Office: Room
Phone:
Email: shackman@isye.gatech.edu
Office Hours: Before/After class or by appointment
1. Course Description and Objectives
Students learn core concepts and techniques for economic decision analysis of complex problems
that involve dimensions of time, uncertainty, economics, strategy and constraints, as well as basic
terminology, concepts and issues relevant to financial engineering and management.
2. Course Materials
There is no text. Course handouts will be provided on my website. Download the Hava program
from my website. Portions of the course material have been adapted from the following texts:
• Investment Science by D. Luenberger. Prentice-Hall. 1998.
• Real Options by T. Copeland and V. Antikarov. Texere. 2003.
• Engineering Economy and the Decision-Making Process by J. Hartman. 2007.
3. Course Organization
Class time will be used to motivate, explain, and illustrate concepts and techniques. On occasion
you will be asked to solve problems in class. Bring a calculator. It is your responsibility for
bringing materials to class posted on my website. It is your responsibility to catch up if you must
miss class. (No private lectures.) Some material in the handouts may not be covered in class.
4. Grading
Your grade will be based on two exams (40% each) and one group project (20%). Exam I:
Thursday, July 29. Exam II: Thursday, August 5. No regrading. In case of an emergency, you
must receive my prior permission to miss an exam. In such a case, at my discretion either: (i) the
exam will be rescheduled, or (ii) an alternative exam will be scheduled, or (iii) you will receive
an incomplete.
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5. Homework
Some problems are straightforward; others quite challenging. You are encouraged to work
together and consult with me. Use the Hava files provided to you to create and solve example
problems to learn the material.
6. Projected Topical Outline
A. Cash Flow Analysis.

Interest rates and economic equivalence. Interest formulas. Fixed-rate mortgages.
Equipment selection. After tax cash flow analysis.
B. Dynamic Cash Flow Analysis.

Production timing problems. Replacement analysis.
C. Financial Options Analysis.

Pricing via replication and state-price approaches. Vanilla and exotic options.
Dynamic portfolio optimization. Asset price dynamics.
D. Real Options Analysis.

Delay, expansion/contraction, compound, installment examples. Decision tree
analysis. Pro forma simulation case study.
E. Market Survey Analysis.

Revising assessments via Bayesian updating. Contingent decision-making.
F. Utility Analysis.
Expected utility criterion. Certainty equivalence. Stochastic dominance.
G. Strategic Decision Analysis.

Auctions. Cournot competition. Decision Psychology.
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Economic Decision Analysis Examples
Portfolio Investment
For each dollar invested (positive or negative) the following table records the total returns of
several investment opportunities. How would you allocate your wealth?
Scenario Probability I II III IV

“Up” 0.60 1.02 1.15 1.35 1.55
“Down” 0.40 1.02 0.90 0.70 0.50
Real Estate Investment
A company owns a parcel of land on which it can build either an 8-unit or a 16-unit
condominium. The current real-estate price for a one-unit condominium is $200 thousand. Next
year the price will rise to either $260 thousand, if the market moves favorably, or decline to $150
thousand, if the market moves unfavorably. The chance the market moves favorably is 60%. The
construction cost (both now and next year) is $140 thousand per unit for an 8-unit building or
$180 thousand for a 16-unit building. Assume construction is instantaneous. Rent covers
operating expenses, so no free cash flow is generated. Risk-free rate is 2.5%. What is the value
of the land?
Multistage Capital Investment
A biotech project involves a pioneer venture stage to first prove the new technology in order to
establish its viability for future commercial development of spin-off products. The pioneer
venture typically involves high initial costs and insufficient projected cash inflows. If the
technology proves successful, subsequent product commercialization can be many times the size
of the pioneer venture. Suppose a pioneer venture requires an initial investment outlay of I0 =
$100 million, and expected cash inflows over two years of C1 = $54 million and C2 = $36 million.
The follow-on product commercialization will become available at the end of year two, and its
expected cash flows are 10 times the size of the pioneer venture. That is, I2 = $1,000 million, and
the expected cash inflows over the subsequent two years are C3 = $540 million and C4 = $360
million. The cost of capital is 20% and the risk-free rate is 2.5%. Should the company invest in
the pioneer venture? follow-on commercialization? this biotech project?
Natural Resource Investment
A company has the option to acquire a ten-year lease to extract gold from a gold mine. There is a
fixed, known capacity of gold reserves. Operating costs reflect inherent nonlinearities in mining,
namely, decreasing returns-to-scale and increasing costs as reserves are depleted. Should the
lease be acquired?
Capacity Expansion
A company is considering expanding its retail store to accommodate recent and projected
business growth. The first option (“expand large”) expands the store by leasing additional floor
space and then remodeling the entire store. The second option (“expand small”) expands the
store by redoing the layout and making a small addition, this is less costly. Which option is best?
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CASH FLOW ANALYSIS
HANDOUTS
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FIXED RATE MORTGAGE REFINANCING SPREADSHEET EXAMPLE
a. A company takes out a 5-yr fixed rate for 10,000 at a loan interest rate of 10%. Payments made
annually. Marginal tax rate is 40%.
0 1 2 3 4 5
Loan Balance 10000 8362.03 6560.26 4578.32 2398.18 0.00
Interest payment 1000.00 836.20 656.03 457.83 239.82
Principal payment 1637.97 1801.77 1981.94 2180.14 2398.15
Total payment** 2637.97 2637.97 2637.97 2637.97 2637.97
Tax shield 400.00 334.48 262.41 183.13 95.93
After tax cash flow 10000 -2237.97 -2303.49 -2375.56 -2454.84 -2541.99
**Total payment = 10000[ .10 ÷ {1 – (1 + 0.10)-5} ] = 2637.97.
NPV@10% = 10000-[2238/(1.10)+2303/(1.10)2+2376/(1.10)3+2455/(1.10)4+2542/(1.10)5] = 1021.88.

= 400/(1.10)+334/(1.10)2+262/(1.10)3+183/(1.10)4+96/(1.10)5.
b. Same situation as (a) except that the loan interest rate is 8%.
0 1 2 3 4 5
Loan Balance 10000 8295.44 6454.52 4466.32 2319.07 0.00
Interest payment 800.00 663.64 516.36 357.31 185.53
Principal payment 1704.56 1840.92 1988.20 2147.25 2319.03
Total payment** 2504.56 2504.56 2504.56 2504.56 2504.56
Tax shield 320.00 265.46 206.54 142.92 74.21
After tax cash flow 10000 -2184.56 -2239.10 -2298.02 -2361.64 -2430.35
**Total payment = 10000[ .08 ÷ {1 – (1 + 0.08)-5} ] = 2504.56.
NPV@8% = 10000-[2185/(1.08)+2239/(1.08)2+2298/(1.08)3+2362/(1.08)4+2430/(1.08)5] = 843.41.

= 320/(1.08)+265/(1.08)2+207/(1.08)3+143/(1.08)4+74/(1.08)5.
c. Company refinances loan in (a) at new loan interest rate of 8%. 5 years remaining.
0 1 2 3 4 5
After tax cash flow 0 53.41 64.39 77.54 93.20 111.64
NPV@8% = [53/(1.08) + 64/(1.08)2 + 78/(1.08)3 + 93/(1.08)4 + 112/(1.08)5] = 310.70.
d. Same situation as (c) except that company will payoff loan in 3 years.
0 1 2 3
After tax cash flow 0 53.41 64.39 77.54+(4578.32-4466.32)=189.54
NPV@8% = [53/(1.08) + 65/(1.08)2 + 190/(1.08)3] = 255.12.
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SIMPLE EQUIPMENT SELECTION ANALYSIS
I. A company must acquire a piece of equipment. It is considering the following two options:
a. Initial cost = 1,000. Annual cost = 300. Salvage value = 100. 10-year lifetime.
b. Initial cost = 1,300. Annual cost = 270. Salvage value = 200. 15-year lifetime.
Discount rate = 12%. Ignore taxes and depreciation.
ANALYSIS:
I. COMPUTE PRESENT VALUE:
The present value cost of option (a) is:
1000 + 300{ [ 1 – (1.12)-10 ] ÷ 0.12} - 100(1.12)-10 = 2662.87.
The present value cost of option (b) is:
1300 + 270{ [ 1 – (1.12)-15 ] ÷ 0.12} - 200(1.12)-15 = 3024.99.
2. COMPUTE ANNUAL EQUIVALENT:
The Annual Equivalent (or Worth) of option (a) is:
2662.87 { 0.12 ÷ [ 1 – (1.12)-10 ] } = 471.28,
and its “lifetime cost” is:
471.28 ÷ 0.12 = 3927.33.
The Annual Equivalent (or Worth) of option (b) is:
3024.99 { 0.12 ÷ [ 1 – (1.12)-15 ] } = 444.14,
and its “lifetime cost” is:
444.14 ÷ 0.12 = 3701.18.
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II. A manufacturer requires a chemical finishing process for a product produced under contract for 4
years. Three options are available. Initial cost of process device A = 100,000. It has an annual cost =
60,000 and a salvage value = 40,000 after 4 years. Initial cost of process device B = 150,000. It has an
annual cost = 50,000 and a salvage value = 30,000 after 6 years. It is also possible to subcontract at
100,000 per year (option S). Appropriate cost of capital is 10%. Marginal tax rate = 40%. Process
devices are classified as 5-year property. Other profitable ongoing operations are sufficient to cover any
losses on sale of equipment.
ANALYSIS
Process devices A and B are depreciating at assumed constant rates of 15,000 and 20,000 per year,
respectively. Using Straight Line (SL) depreciation (with half-year convention):
Process Device A 0 1 2 3 4
Operations cost (60,000) (60,000) (60,000) (60,000)
Depreciation (7,500) (15,000) (15,000) (7,500)
Total cost (67,500) (75,000) (75,000) (67,500)
Tax benefit 27,000 30,000 30,000 27,000
After-tax cost (40,500) (45,000) (45,000) (40,500)
Depreciation 7,500 15,000 15,000 7,500
Investment -100,000 0 0 0 *46,000
After-tax cash flow -100,000 -33,000 -30,000 -30,000 13,000
Process Device B 0 1 2 3 4
Operations cost (50,000) (50,000) (50,000) (50,000)
Depreciation (10,000) (20,000) (20,000) (10,000)
Total cost (60,000) (70,000) (70,000) (60,000)
Tax benefit 24,000 28,000 28,000 24,000
After-tax cost (36,000) (42,000) (42,000) (36,000)
Depreciation 10,000 20,000 20,000 10,000
Investment -150,000 0 0 0 **78,000
* 46,000 = 40,000 – 0.4(40,000 – 55,000). SV – τ(SV – BV).

** 78,000 = 70,000 – 0.4(70,000 – 90,000).
PV @ 10% of after-tax cash flow for A = -168,454. AE for 4 years = -53,142.

PV @ 10% of after-tax cash flow for B = -172,830. AE for 4 years = -54,523.
PV @ 10% of after-tax cash flow for S = -190,192. AE for 4 years = -60,000.
Process device A is the best option.
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Process devices A and B are depreciating at assumed constant rates of 15,000 and 20,000 per year,
respectively. Using MACRS depreciation (with half-year convention):
Process Device A 0 1 2 3 4
Operations cost (60,000) (60,000) (60,000) (60,000)
Depreciation (20,000) (32,000) (19,200) (5,760)
Total cost (80,000) (92,000) (79,200) (65,760)
Tax benefit 32,000 36,800 31,680 26,304
After-tax cost (48,000) (55,200) (47,520) (39,456)
Depreciation 20,000 32,000 19,200 5,760
Investment -100,000 0 0 0 *33,216
Process Device B 0 1 2 3 4
Operations cost (50,000) (50,000) (50,000) (50,000)
Depreciation (30,000) (48,000) (28,800) (8,640)
Total cost (80,000) (98,000) (78,800) (58,640)
Tax benefit 32,000 39,200 31,520 23,456
After-tax cost (48,000) (58,800) (47,280) (35,184)
Depreciation 30,000 48,000 28,800 8,640
Investment -150,000 0 0 0 **55,824
* 33,216 = 40,000 – 0.4(40,000 – 23,040). SV – τ(SV – BV).

** 55,824 = 70,000 – 0.4(70,000 – 34,560).
PV @ 10% of after-tax cash flow for A = -159,758. AE for 4 years = -50,399.

PV @ 10% of after-tax cash flow for B = -168,806. AE for 4 years = -53,253.
PV @ 10% of after-tax cash flow for S = -190,192. AE for 4 years = -60,000.
Process device A is the best option.
SENSITIVITY ANALYSIS: What is the salvage value of B after 4 years that would cause the
manufacturer to be indifferent in choosing between it and A?
• Let δSV denote the change in salvage value of B for which we would be indifferent between it and A.
• The new salvage value = 70 + δSV.
• The change to after-tax cash flows for B will simply be (1-τ)δSV = 0.60δSV.
• The present value of this change @ 10% = 0.60δSV (1.1)-4.
• This must equal (-159,758) - (-168,806) = 9,048.
• Thus, δSV = 22,079 so that the “break-even” salvage value = 92,079.
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Depreciation
A. Tax Effect of Depreciation
1. For the current year a company has income of R and cost of C for a net income before tax of
R-C for the year. The company’s marginal tax rate is τ. The company’s after-tax cash flow for
the year is therefore (1- τ)[R – C].
Example 1. Say R = 3,000 and C = 1,000 with τ = 40%. Then the company’s after-tax cash
flow for the year is (1 – 0.40)[3,000 – 1,000] = 1,200. Note that this may be equivalently
expressed as (0.60)[3,000] – (0.60)[1,000] = 1,800 – 600 = 1,200. That is, the company receives
a net of 60 cents for each dollar of revenue it takes in but it only costs the company 60 cents for
dollar of expense. On the expense side note that
-(1- τ)[C] = -C + τC = -1000 + (0.40)(1000),
and so the net effect of being able to deduct expenses it that the company “receives” a “tax
benefit” of τC = 400, i.e., it “wrote a check” for 1,000 during the year and receives back 400 due
to the expense write-off.
2. Let’s assume the revenue R is sufficiently high to offset the expenses. In what follows we
shall ignore the after-tax cash flow due to revenue, since it is a “constant” as far as the analysis of
the after-tax cash flow due to cost.
Now let’s suppose for the current year a company spends I = 1000 on capital investment for
equipment. The equipment is classified as 5-year property and straight-line depreciation is used.
If the company were able to write-off this capital investment as an expense, then the after-tax
cash flow would be –600, exactly as in Example 1.
However, the government’s perspective on this is that the equipment is being used over a 5-
year period and provides economic value over its entire “book” life of 5 years. (The company
may choose to use this equipment for more than 5 years.) Consequently, the government will
only allow the company to expense each year an “appropriate” amount for the “wear and tear” or
depreciation of the equipment. Since straight-line depreciation is being used, the depreciation
expense each year is 1000/5 = 200. (Salvage value at end of year 5 is assumed zero and the half-
year convention is being ignored here.)
There is NO out-of-pocket depreciation expense each year. That is, the 1000 is spent now;
the 200 is computed only for tax purposes. As explained in #1 above, from the after-tax cash
flow perspective, this 200 depreciation “allowance” yields a tax benefit of 0.40(200) = 80 each
year for the next 5 years. That is, the after-tax cash flow due to the capital investment for the
next 5 years (ignoring the salvage value due to possible sale of equipment) is:
0 1 2 3 4 5
-1,000 80 80 80 80 80
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Note how the undiscounted sum of the depreciation allowances over the 5-year horizon adds up
to 400, the total tax benefit. Again, the total tax benefit of 400 would be added to the –1,000 if
this were an ordinary expense (for materials, labor, etc.).
Suppose the company were to use a 10% cost of capital for purposes of determining the Net
Present Value of this cash flow stream, then the
NPV = -1,000 + {[1 – (1.10)-5]/(0.10)} 80 = -1,000 + 3.791(80) = -696.74,
which translates to a net cost of 69.7% per dollar spent on this capital equipment. Note that if this
equipment had been expensed, then the net cost would be 60% per dollar spent. The “loss” of
9.7% is due to the DELAY of receiving the benefit of 80 per year for 5 years, as above, as
opposed to receiving the total of 400 right NOW.
Which cash flow would a company prefer? For the purpose of after-tax cash flow, the
company would prefer to be able to “write-off” as much depreciation as quickly as it can. That is,
it would prefer accelerated depreciation. For the purpose of reporting profits, however, the
company would prefer to delay the expense! The IRS allows a company to keep “two sets of
books,” one for tax purposes and the other for reporting to shareholders.
B. Accounting for Depreciation in the Income Statement
Example 2. Suppose our company has a net operating income (R – C) for the year of 3,000
and a depreciation expense of 1,000.
According to what we have learned above, the taxes owed to the government this year would
be 0.40(3,000 – 1,000) = 800. The “Flow In” is therefore 3,000 and the “Flow Out” is 800 for a
net of 2,200. Here is the income statement approach to this calculation:
Income Statement Approach Flow In – Flow Out Approach

Net Revenue 3,000 Net Revenue 3,000
Expenses
Total 1,000 Taxes -800
Income tax 800
Net Income after tax 1,200
Adjustments
Depreciation 1,000
After tax cash flow 2,200 After tax cash flow 2,200
In general notation, the two approaches to after tax cash flow are, respectively:
Income Statement Approach: = (1 - τ)[R – C – Dep] + Dep = (1- τ)[R – C] + τ Dep,

Flow In – Flow Out Approach: = [R – C] - τ[R – C – Dep] = (1- τ)[R – C] + τ Dep,
which produce the same result, as it should. Note that if the depreciation adjustment “below the
line” (i.e. below the Net Income after tax) is NOT made, then the income statement approach
would incorrectly report an after tax cash flow of 1,200. The discrepancy would arise because
the depreciation allowance is NOT an “out of pocket” expense.
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Page 76 of 120 of Publication 946 15:26 - 13-MAY-2010
The type and rule above prints on all proofs including departmental reproduction proofs. MUST be removed before printing.
Appendix A
MACRS Percentage Table Guide
General Depreciation System (GDS)
Alternative Depreciation System (ADS)
Chart 1. Use this chart to find the correct percentage table to use for any property other than residential rental
and nonresidential real property. Use Chart 2 for residential rental and nonresidential real property.
Month or
Quarter
MACRS Depreciation Placed
System Method Recovery Period Convention Class in Service Table
GDS 200% GDS/3, 5, 7, 10 (Nonfarm) Half-Year 3, 5, 7, 10 Any A-1
GDS 200% GDS/3, 5, 7, 10 (Nonfarm) Mid-Quarter 3, 5, 7, 10 1st Qtr A-2
2nd Qtr A-3
3rd Qtr A-4
4th Qtr A-5
GDS 150% GDS/3, 5, 7, 10 Half-Year 3, 5, 7, 10 Any A-14
GDS 150% GDS/3, 5, 7, 10 Mid-Quarter 3, 5, 7, 10 1st Qtr A-15
2nd Qtr A-16
3rd Qtr A-17
4th Qtr A-18
GDS 150% GDS/15, 20 Half-Year 15 & 20 Any A-1
GDS 150% GDS/15, 20 Mid-Quarter 15 & 20 1st Qtr A-2
2nd Qtr A-3
3rd Qtr A-4
4th Qtr A-5
GDS SL GDS Half-Year Any Any A-8
ADS ADS
GDS SL GDS Mid-Quarter Any 1st Qtr A-9
ADS ADS 2nd Qtr A-10
3rd Qtr A-11
4th Qtr A-12
ADS 150% ADS Half-Year Any Any A-14
ADS 150% ADS Mid-Quarter Any 1st Qtr A-15
2nd Qtr A-16
3rd Qtr A-17
4th Qtr A-18
Chart 2. Use this chart to find the correct percentage table to use for residential rental and nonresidential real
property. Use Chart 1 for all other property.
Month or
Quarter
MACRS Depreciation Placed
System Method Recovery Period Convention Class in Service Table
GDS SL GDS/27.5 Mid-Month Residential Rental Any A-6
GDS SL GDS/31.5 Mid-Month Nonresidential Real Any A-7
SL GDS/39 A-7a
ADS SL ADS/40 Mid-Month Residential Rental Any A-13
and
Nonresidential Real
Chart 3. Income Inclusion Amount Rates

for MACRS Leased Listed Property
Table
Amount A Percentages A-19
Amount B Percentages A-20
Page 76 17 Publication 946 (2009)

Table A-1. 3-, 5-, 7-, 10-, 15-, and 20-Year Property
Half-Year Convention
Depreciation rate for recovery period
Year
3-year 5-year 7-year 10-year 15-year 20-year
1 33.33% 20.00% 14.29% 10.00% 5.00% 3.750%

2 44.45 32.00 24.49 18.00 9.50 7.219
3 14.81 19.20 17.49 14.40 8.55 6.677
4 7.41 11.52 12.49 11.52 7.70 6.177
5 11.52 8.93 9.22 6.93 5.713
6 5.76 8.92 7.37 6.23 5.285

7 8.93 6.55 5.90 4.888
8 4.46 6.55 5.90 4.522
9 6.56 5.91 4.462
10 6.55 5.90 4.461
11 3.28 5.91 4.462

12 5.90 4.461
13 5.91 4.462
14 5.90 4.461
15 5.91 4.462
16 2.95 4.461
17 4.462
18 4.461
19 4.462
20 4.461
21 2.231
Mid-Quarter Convention
Placed in Service in First Quarter
Year
1 58.33% 35.00% 25.00% 17.50% 8.75% 6.563%

2 27.78 26.00 21.43 16.50 9.13 7.000
3 12.35 15.60 15.31 13.20 8.21 6.482
4 1.54 11.01 10.93 10.56 7.39 5.996
5 11.01 8.75 8.45 6.65 5.546
6 1.38 8.74 6.76 5.99 5.130

7 8.75 6.55 5.90 4.746
8 1.09 6.55 5.91 4.459
9 6.56 5.90 4.459
10 6.55 5.91 4.459
11 0.82 5.90 4.459

12 5.91 4.460
13 5.90 4.459
14 5.91 4.460
15 5.90 4.459
16 0.74 4.460
17 4.459
18 4.460
19 4.459
20 4.460
21 0.565
Publication 946 (2009) 18 Page 77

Placed in Service in Second Quarter
Year
1 41.67% 25.00% 17.85% 12.50% 6.25% 4.688%

2 38.89 30.00 23.47 17.50 9.38 7.148
3 14.14 18.00 16.76 14.00 8.44 6.612
4 5.30 11.37 11.97 11.20 7.59 6.116
5 11.37 8.87 8.96 6.83 5.658
6 4.26 8.87 7.17 6.15 5.233

7 8.87 6.55 5.91 4.841
8 3.34 6.55 5.90 4.478
9 6.56 5.91 4.463
10 6.55 5.90 4.463
11 2.46 5.91 4.463

12 5.90 4.463
13 5.91 4.463
14 5.90 4.463
15 5.91 4.462
16 2.21 4.463
17 4.462
18 4.463
19 4.462
20 4.463
21 1.673
Placed in Service in Third Quarter
Year
1 25.00% 15.00% 10.71% 7.50% 3.75% 2.813%

2 50.00 34.00 25.51 18.50 9.63 7.289
3 16.67 20.40 18.22 14.80 8.66 6.742
4 8.33 12.24 13.02 11.84 7.80 6.237
5 11.30 9.30 9.47 7.02 5.769
6 7.06 8.85 7.58 6.31 5.336

7 8.86 6.55 5.90 4.936
8 5.53 6.55 5.90 4.566
9 6.56 5.91 4.460
10 6.55 5.90 4.460
11 4.10 5.91 4.460

12 5.90 4.460
13 5.91 4.461
14 5.90 4.460
15 5.91 4.461
16 3.69 4.460
17 4.461
18 4.460
19 4.461
20 4.460
21 2.788

Placed in Service in Fourth Quarter
Year
1 8.33% 5.00% 3.57% 2.50% 1.25% 0.938%

2 61.11 38.00 27.55 19.50 9.88 7.430
3 20.37 22.80 19.68 15.60 8.89 6.872
4 10.19 13.68 14.06 12.48 8.00 6.357
5 10.94 10.04 9.98 7.20 5.880
6 9.58 8.73 7.99 6.48 5.439

7 8.73 6.55 5.90 5.031
8 7.64 6.55 5.90 4.654
9 6.56 5.90 4.458
10 6.55 5.91 4.458
11 5.74 5.90 4.458

12 5.91 4.458
13 5.90 4.458
14 5.91 4.458
15 5.90 4.458
16 5.17 4.458
17 4.458
18 4.459
19 4.458
20 4.459
21 3.901
Table A-6. Residential Rental Property

Mid-Month Convention
Straight Line—27.5 Years
Month property placed in service
Year
1 2 3 4 5 6 7 8 9 10 11 12
1 3.485% 3.182% 2.879% 2.576% 2.273% 1.970% 1.667% 1.364% 1.061% 0.758% 0.455% 0.152%
2–9 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636
10 3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636
11 3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637
12 3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636
13 3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637
14 3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636
15 3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637
16 3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636
17 3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637
18 3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636
19 3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637
20 3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636
21 3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637
22 3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636
23 3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637
24 3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636
25 3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637
26 3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636
27 3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637
28 1.97 2.273 2.576 2.879 3.182 3.485 3.636 3.636 3.636 3.636 3.636 3.636
29 0.152 0.455 0.758 1.061 1.364 1.667

Appendix B — Table of Class Lives and Recovery Periods
The Table of Class Lives and Recov- being used and use the recovery pe- improvements. The land improve-
ery Periods has two sections. The first riod shown in the appropriate column ments have a 13-year class life and a
section, Specific Depreciable Assets following the description. 7-year recovery period for GDS. If he
Used In All Business Activities, Except elects to use ADS, the recovery period
Property not in either table. If the is 13 years. If Richard only looked at
As Noted, generally lists assets used activity or the property is not included Table B-1, he would select asset class
in all business activities. It is shown as in either table, check the end of Table 00.3, Land Improvements, and incor-
Table B-1. The second section, Depre- B-2 to find Certain Property for Which rectly use a recovery period of 15
ciable Assets Used In The Following Recovery Periods Assigned. This years for GDS or 20 years for ADS.
Activities, describes assets used only property generally has a recovery pe-
in certain activities. It is shown as Ta- riod of 7 years for GDS or 12 years for Example 2. Sam Plower produces
ble B-2. ADS. See Which Property Class Ap- rubber products. During the year, he
plies Under GDS and Which Recovery made substantial improvements to the
Period Applies in chapter 4 for the
How To Use the Tables class lives or the recovery periods for
land on which his rubber plant is lo-
cated. He checks Table B-1 and finds
You will need to look at both Table B-1 GDS and ADS for the following. land improvements under asset class
and B-2 to find the correct recovery • Residential rental property and 00.3. He then checks Table B-2 and
period. Generally, if the property is nonresidential real property (also finds his activity, producing rubber
listed in Table B-1 you use the recov- see Appendix A, Chart 2). products, under asset class 30.1,
ery period shown in that table. How- Manufacture of Rubber Products.
ever, if the property is specifically • Qualified rent-to-own property.
Reading the headings and descrip-
listed in Table B-2 under the type of • A motorsport entertainment com- tions under asset class 30.1, Sam
activity in which it is used, you use the plex placed in service before finds that it does not include land im-
recovery period listed under the activ- January 1, 2010. provements. Therefore, Sam uses the
ity in that table. Use the tables in the
order shown below to determine the • Any retail motor fuels outlet. recovery period under asset class
00.3. The land improvements have a
recovery period of your depreciable • Any qualified leasehold improve- 20-year class life and a 15-year recov-
property. ment property placed in service ery period for GDS. If he elects to use
before January 1, 2010. ADS, the recovery period is 20 years.
Table B-1. Check Table B-1 for a
description of the property. If it is de- • Any qualified restaurant property
scribed in Table B-1, also check Table placed in service before January Example 3. Pam Martin owns a re-
B-2 to find the activity in which the 1, 2010. tail clothing store. During the year, she
property is being used. If the activity is • Initial clearing and grading land purchased a desk and a cash register
described in Table B-2, read the text (if improvements for gas utility for use in her business. She checks
any) under the title to determine if the property and electric utility trans- Table B-1 and finds office furniture
property is specifically included in that mission and distribution plants. under asset class 00.11. Cash regis-
asset class. If it is, use the recovery ters are not listed in any of the asset
period shown in the appropriate col- • Any water utility property. classes in Table B-1. She then checks
umn of Table B-2 following the • Certain electric transmission Table B-2 and finds her activity, retail
description of the activity. If the activity property used in the transmission store, under asset class 57.0, Distribu-
is not described in Table B-2 or if the at 69 or more kilovolts of electric- tive Trades and Services, which in-
activity is described but the property ity for sale and placed in service cludes assets used in wholesale and
either is not specifically included in or after April 11, 2005. retail trade. This asset class does not
is specifically excluded from that asset specifically list office furniture or a
class, then use the recovery period • Natural gas gathering and distri- cash register. She looks back at Table
shown in the appropriate column fol- bution lines placed in service af-
lowing the description of the property ter April 11, 2005. B-1 and uses asset class 00.11 for the
in Table B-1. desk. The desk has a 10-year class life
and a 7-year recovery period for GDS.
Tax-exempt use property subject to Example 1. Richard Green is a pa- If she elects to use ADS, the recovery
a lease. The recovery period for ADS per manufacturer. During the year, he period is 10 years. For the cash regis-
cannot be less than 125 percent of the made substantial improvements to the ter, she uses asset class 57.0 because
lease term for any property leased land on which his paper plant is lo- cash registers are not listed in Table
under a leasing arrangement to a cated. He checks Table B-1 and finds B-1 but it is an asset used in her retail
tax-exempt organization, governmen- land improvements under asset class business. The cash register has a
tal unit, or foreign person or entity 00.3. He then checks Table B-2 and 9-year class life and a 5-year recovery
(other than a partnership). finds his activity, paper manufacturing, period for GDS. If she elects to use the
under asset class 26.1, Manufacture ADS method, the recovery period is 9
Table B-2. If the property is not listed of Pulp and Paper. He uses the recov- years.
in Table B-1, check Table B-2 to find ery period under this asset class be-
the activity in which the property is cause it specifically includes land ■

EPS Filename: 13081f31 Size - Width = 44 picas Depth = 58 picas
Table B-1. Table of Class Lives and Recovery Periods

Recovery Periods
(in years)
Asset Class Life GDS
class Description of assets included (in years) (MACRS) ADS
SPECIFIC DEPRECIABLE ASSETS USED IN ALL BUSINESS ACTIVITIES, EXCEPT AS NOTED:
00.11 Office Furniture, Fixtures, and Equipment:
Includes furniture and fixtures that are not a structural component of a building. Includes such 10 7 10
assets as desks, files, safes, and communications equipment. Does not include
communications equipment that is included in other classes.
00.12 Information Systems:
Includes computers and their peripheral equipment used in administering normal business 6 5 5
transactions and the maintenance of business records, their retrieval and analysis.
Information systems are defined as:
1) Computers: A computer is a programmable electronically activated device capable of
accepting information, applying prescribed processes to the information, and supplying the
results of these processes with or without human intervention. It usually consists of a central
processing unit containing extensive storage, logic, arithmetic, and control capabilities.
Excluded from this category are adding machines, electronic desk calculators, etc., and other
equipment described in class 00.13.
2) Peripheral equipment consists of the auxiliary machines which are designed to be placed
under control of the central processing unit. Nonlimiting examples are: Card readers, card
punches, magnetic tape feeds, high speed printers, optical character readers, tape cassettes,
mass storage units, paper tape equipment, keypunches, data entry devices, teleprinters,
terminals, tape drives, disc drives, disc files, disc packs, visual image projector tubes, card
sorters, plotters, and collators. Peripheral equipment may be used on-line or off-line.
Does not incude equipment that is an integral part of other capital equipment that is included
in other classes of economic activity, i.e., computers used primarily for process or production
control, switching, channeling, and automating distributive trades and services such as point
of sale (POS) computer systems. Also, does not include equipment of a kind used primarily for
amusement or entertainment of the user.
00.13 Data Handling Equipment; except Computers:
Includes only typewriters, calculators, adding and accounting machines, copiers, and 6 5 6
duplicating equipment.
00.21 Airplanes (airframes and engines), except those used in commercial or contract carrying 6 5 6
of passengers or freight, and all helicopters (airframes and engines)
00.22 Automobiles, Taxis 3 5 5
00.23 Buses 9 5 9
00.241 Light General Purpose Trucks:
Includes trucks for use over the road (actual weight less than 13,000 pounds) 4 5 5
00.242 Heavy General Purpose Trucks:
Includes heavy general purpose trucks, concrete ready mix-trucks, and ore trucks, for use 6 5 6
over the road (actual unloaded weight 13,000 pounds or more)
00.25 Railroad Cars and Locomotives, except those owned by railroad transportation 15 7 15
companies
00.26 Tractor Units for Use Over-The-Road 4 3 4
00.27 Trailers and Trailer-Mounted Containers 6 5 6
00.28 Vessels, Barges, Tugs, and Similar Water Transportation Equipment, except those used 18 10 18
in marine construction
00.3 Land Improvements:
Includes improvements directly to or added to land, whether such improvements are section 20 15 20
1245 property or section 1250 property, provided such improvements are depreciable.
Examples of such assets might include sidewalks, roads, canals, waterways, drainage
facilities, sewers (not including municipal sewers in Class 51), wharves and docks, bridges,
fences, landscaping shrubbery, or radio and television transmitting towers. Does not include
land improvements that are explicitly included in any other class, and buildings and structural
components as defined in section 1.48-1(e) of the regulations. Excludes public utility initial
clearing and grading land improvements as specified in Rev. Rul. 72-403, 1972-2 C.B. 102.
00.4 Industrial Steam and Electric Generation and/or Distribution Systems:
Includes assets, whether such assets are section 1245 property or 1250 property, providing 22 15 22
such assets are depreciable, used in the production and/or distribution of electricity with rated
total capacity in excess of 500 Kilowatts and/or assets used in the production and/or
distribution of steam with rated total capacity in excess of 12,500 pounds per hour for use by
the taxpayer in its industrial manufacturing process or plant activity and not ordinarily available
for sale to others. Does not include buildings and structural components as defined in section
1.48-1(e) of the regulations. Assets used to generate and/or distribute electricity or steam of
the type described above, but of lesser rated capacity, are not included, but are included in
the appropriate manufacturing equipment classes elsewhere specified. Also includes electric
generating and steam distribution assets, which may utilize steam produced by a waste
reduction and resource recovery plant, used by the taxpayer in its industrial manufacturing
process or plant activity. Steam and chemical recovery boiler systems used for the recovery
and regeneration of chemicals used in manufacturing, with rated capacity in excess of that
described above, with specifically related distribution and return systems are not included but
are included in appropriate manufacturing equipment classes elsewhere specified. An example
of an excluded steam and chemical recovery boiler system is that used in the pulp and paper
manufacturing equipment classes elsewhere specified. An example of an excluded steam and
chemical recovery boiler system is that used in the pulp and paper manufacturing industry.

PRO FORMA CASH FLOW EXAMPLE
Period 0 1 2 3 4 5 6 7
Price 30 27.67 25.51 23.53 21.7 20.01
Quantity 200 230 264 303 349 401
UnitCost 9 8.6 8.1 7.7 7.4 7
Revenue 6000 6364 6735 7130 7573 8024
Cost 1800 1978 2138 2333 2583 2807
GrossIncome 4200 4386 4597 4797 4990 5217
Rent 200 200 200 200 200 200
SGA 600 637 676 718 763 810
EBITDA 3400 3549 3721 3879 4027 4207
Depr 3500 3500 3500 3500 3500 3500
EBIT -100 49 221 379 527 707
Taxes 0 20 88 152 211 283
NetIncome -100 29 133 227 316 424
Depr 3500 3500 3500 3500 3500 3500
Investment 35000 0 0 0 0 0 0
FreeCashFlow -35000 3400 3529 3633 3727 3816 3924
ContinueValue 51012
PresentValue 34707 36125 37611 39199 40914 42778 44793
NetPresentValue -293 39525 41140 42832 44641 46594 48717
FCFPercentage 0.086 0.0858 0.0848 0.0835 0.0819 0.0805
23
24
Selecting a Bid Price
A municipality needs to dispose of 1 million tons of refuse each year for the next 5 years. It is
requesting bids from firms for the business. A bid of R means that the firm contractually agrees to receive
$R/ton each year for the next 5 years from the municipality in exchange for disposing of the refuse.
Additional information:
• A new fleet of trucks to pick up the refuse must be acquired. The cost of the trucks to handle the
proposed volume is $6 million. The projected market value of the trucks is $1 million at the end of 5
years. The trucks are classified as 5-year property and straight line depreciation (with half-year
convention) is used.
• A landfill is required for disposal. The municipality’s sole landfill owner is currently charging $5/ton
each year.
• Fuel and direct labor costs are projected at $1/ton per year. An administrative cost of $0.5 million
each year to plan and manage operations is needed.
• Half of the initial capital investment will be financed by a loan. The loan interest rate is 10%
compounded annually with principal repaid in five equal annual installments.
• Firm’s marginal tax rate is 40%.
• The cost of unlevered equity capital r0 for this type of project is 15%.
25
I. PROJECT VALUATION WITH NO DEBT
0 1 2 3 4 5
Revenues 1000R 1000R 1000R 1000R 1000R
Cost
Landfill cost 5000 5000 5000 5000 5000
Labor/fuel cost 1000 1000 1000 1000 1000
Administrative cost 500 500 500 500 500
EBITDA 1000R-6500 1000R-6500 1000R-6500 1000R-6500 1000R-6500
Interest expense 0 0 0 0 0
Depreciation 500 1000 1000 1000 500
EBT 1000R-7000 1000R-7500 1000R-7500 1000R-7500 1000R-7000
Taxes 400R-2800 400R-3000 400R-3000 400R-3000 400R-2800
Net Income 600R-4200 600R-4500 600R-4500 600R-4500 600R-4200
Adjustments
Loan principal cash flow
Depreciation 500 1000 1000 1000 500
Investment -6000 *1400
Free cash flow -6000 600R -3700 600R-3500 600R-3500 600R-3500 600R-2300
*BV = Cost basis – accumulated depreciation = 6000 – 4000 = 2000.
1400 = SV – τ(SV – BV) = 1000 – 0.4(1000-2000). (Assumes losses can be used to offset other income.)
NPV(Free cash flow) @ 15% :

= -6000 + (600R-3500)[ (1-(1.15)-5)/(0.15)] – 200/1.15 + 1200/(1.15)5
= -6000 + 2011.29R – 11732.54 – 173.91+ 596.61 = 2011.29R – 17309.84 ⇒ R = $8.61/ton.
26
II. PROJECT VALUE WITH DEBT
Assume the firm is able to borrow half of the 6 million from a bank. The loan interest rate is 10%
(compounded annually) with principal repaid in five equal annual installments.
A. Flow-to-Equity Approach
0 1 2 3 4 5
Revenues 1000R 1000R 1000R 1000R 1000R
Cost
Landfill cost 5000 5000 5000 5000 5000
Labor/fuel cost 1000 1000 1000 1000 1000
EBITDA 1000R-6500 1000R-6500 1000R-6500 1000R-6500 1000R-6500
Depreciation 500 1000 1000 1000 500
EBT 1000R-7300 1000R-7740 1000R-7680 1000R-7620 1000R-7060
Taxes 400R-2920 400R-3096 400R-3072 400R-3048 400R-2824
Net Income 600R-4380 600R-4644 600R-4608 600R-4572 600R-4236
Adjustments
Loan principal cash flow 3000 -600 -600 -600 -600 -600
Depreciation 500 1000 1000 1000 500
Investment -6000 1400
Net equity cash flow -3000 600R-4480 600R-4244 600R-4208 600R-4172 600R-2936
Cost of levered equity capital re = r0 + (1- τ)(r0 – i)(B/S) = 0.18.
NPV(NECF) @ 18% :
= -3000 - [ 4480/(1.18) + 4244/(1.18)2 + 4208/(1.18)3 + 4172/(1.18)4 + 2936/(1.18)5 ] + 600R[ (1-(1.18)-5)/(0.18)]
= 1876.30R – 15840.93 ⇒ R = $8.45/ton.
27
Component Analysis:
0 1 2 3 4 5
Revenues 8450 8450 8450 8450 8450
Cost
Landfill cost 5000 5000 5000 5000 5000
Labor/fuel cost 1000 1000 1000 1000 1000
EBITDA 1950 1950 1950 1950 1950
Depreciation 500 1000 1000 1000 500
EBT 1150 710 770 830 1390
Taxes 460 284 308 332 556
Net Income 690 426 462 498 834
Adjustments
Loan principal cash flow 3000 -600 -600 -600 -600 -600
Depreciation 500 1000 1000 1000 500
Investment -6000 1400
Net equity cash flow -3000 590 826 862 898 2134
After Tax Cash Flow (ATCF) due to

1. operating income: 600R – 3900= 1170 in years 1-5.
2. depreciation: 200 year 1, 400 in years 2-4, 200 in year 5.
3. equipment sale: 611.95 = PV at time 0 of 1400 in year 5.
4. investment: -6000 at time 0.
5. loan:
0 1 2 3 4 5
LB 3,000 2,400 1,800 1,200 600 0
IP -300 -240 -180 -120 -60
PP -600 -600 -600 -600 -600
TP -900 -840 -780 -720 -660
tax shield 120 96 72 48 24
ATCF -780 -744 -708 -672 -636
PV of ATCF at 18%: (P/A, 18%, 5) = [1-(1.18)-5]/0.18 = 3.12717. (P/F, 18%, 5) = (1.18)-5 = 0.43711.
1. operating income: 1876.30R – 12195.97 = 3658.77
2. depreciation: 993.96
3. equipment sale: 611.95
4. capital investment: -6000
5. loan value: 749.13
TOTAL: 1876.30R - 15840.93 = 13.81
28
B. WEIGHTED AVERAGE COST OF CAPITAL (WACC) APPROACH
Ignore financing but value after-tax cash flows of remaining components using
rWACC = (3000/6000)(1 – 0.40)(0.10) + (3000/6000)(0.18) = 0.12. rWACC = r0(1 - τ B/(B+S)) = 0.15(1 – 0.4(0.5)).
PV of ATCF at 12%: (P/A, 12%, 5) = [1-(1.12)-5]/0.12 = 3.60478. (P/F, 12%, 5) = (1.12)-5 = 0.56743.
1. operating income: 2162.87R – 14058.63
4. investment: -6000
TOTAL: 2162.87R - 18114.38 ⇒ R = $8.38/ton.
C. ADJUSTED PRESENT VALUE (APV) APPROACH
Value after-tax cash flows of components (except loan) using cost of equity capital assuming no debt (r0),
and then add to this the value of the loan after tax cash flow at cost of debt.
PV of ATCF: (P/A, 15%, 5) = [1-(1.15)-5]/0.15 = 3.35216. (P/F, 15%, 5) = (1.15)-5 = 0.49718.

1. operating income: 2011.29R – 13073.40
4. investment: -6000
5. loan (at 10%): 290.21
TOTAL: 2011.29R - 17019.63 ⇒ R = $8.46/ton.
IV. GENERAL REMARKS
1. Need to lock-in landfill cost or else the owner can appropriate your economic profit!
2. Formulas used here are derived assuming, among other things, a “perpetual no-growth cash flow”
model. The amount of debt in relation to project value changes over time here. So, in principle, one
“should” adjust the re over time to reflect this, which is cumbersome. Ditto for the rWACC. This is
why the APV approach here is recommended. (Some analysts recommend using a discount rate higher
than the loan interest rate to value the loan cash flow.) For a large firm in which financing is
centralized for all projects, the WACC approach is commonly used and is arguably the preferred
approach. This is because the WACC approach separates the valuation of the operating cash flows,
typically made by operations analysts, from the financing decisions made by financial executives.
3. For the APV approach, strictly speaking, B/(B+S) does not equal 0.5. The way the bid price is set
implies that the unlevered value of the project here equals 6000 minus loan value of 290 or 5710. So
B/(B+S) = 0.525. (It is possible to determine the amount of debt so that the loan to value ratio equals
the target ratio of 0.50.)
29
6
30
CASH FLOW ANALYSIS HOMEWORK PROBLEMS
I. Cash Flow Equivalence
1. You invest $1000 today in a bank. Stated annual interest is 4%. How much money will you have (to
the nearest penny) if this investment is
a. compounded annually for 4 years?

b. compounded semi-annually for 4 years?
c. compounded continuously for 4 years?
2. You invest $1000 today in a bank. Stated annual interest is 8%. How much money will you have (to
the nearest penny) if this investment is
a. compounded annually at 8% for 4 years?

b. compounded semi-annually for 4 years?
c. compounded quarterly for 7.5 years?
d. compounded continuously for 4 years?
3. Consider the cash flow stream (C0, C1, C2, C3, C4, C5, C6, C7, C8, … , C40, C41) = (100, 110, 100, 110,
100, 110, … , 100, 110). (The pattern (100, 110) repeats itself.) The appropriate per-period rate of interest
is 10%. Determine the present value of this cash flow stream.
4. Stated annual interest is 10% and annual compounding applies. Determine the value (to the nearest
dollar) of the infinite cash flow stream (1, 1100), (2, 1210), (3, 1331), (4, 1100), (5, 1210), (6, 1331), (7,
1100), (8, 1210), (9, 1331), …., etc.
II. Fixed Rate Mortgage Analysis
5. Ms. Jones financed her home purchase with a fixed-rate 20-yr mortgage at 6%. The original loan
balance was 400,000.00. With her monthly mortgage just paid her current loan balance is 301,903.98.
a. What is Jones’s monthly payment to the bank?

b. How many months remain until the loan is paid off?
c. Jones would like to pay off her loan sooner. She has decided that she would like to pay off her loan in
10 years, and is willing to add $A per month to her payment. What is the value for A?
6. Jones financed his home purchase with a conventional fixed-rate 30-yr mortgage at 9%. The original
loan balance was 200,000.00. With his monthly mortgage just paid his current loan balance is 173,719.16.
a. What is Jones’s monthly payment to the bank?

b. How many months remain until the loan is paid off?
c. Jones would like to pay off his loan sooner. He has decided that he can afford an extra 50 per month.
How many months will it take to pay off his loan?
7. Consider a 15-year fixed-rate mortgage for 200,000 at 6.25%. Provide both discrete- and continuous-
time answers:
a. What is the monthly payment?

b. What is the loan balance after 4 years, 3 months?
c. Suppose the remaining duration of the loan is 10 years and 9 months. How quickly will the loan be
paid off if the 2000 is paid each month instead of the original monthly payment?
d. Suppose the remaining duration of the loan is 10 years and 9 months. How much must be added to the
original monthly payment to pay off the loan in 5 years?
31
III. Equipment Selection
8. A company has two options for a machine it must purchase. The manufacturer’s discount rate is 10%.
Ignore taxes and depreciation.
Type I: Initial cost = 250,000. Annual cost = 40,000. 4-yr lifetime. Salvage value = 80,000.
Type II: Initial cost = 400,000. Annual cost = 20,000. 7-yr lifetime. Salvage value = 50,000.
Use the annual equivalent method to determine which machine to purchase.
9. A company must purchase a piece of equipment. Two types are being considered:
TYPE A: initial cost = 1000, annual cost = 400, salvage value = 300, 5-yr lifetime.
TYPE B: initial cost = 2000, annual cost = 200, salvage value = 800, 8-yr lifetime.
Discount rate is 10%. Use the annual equivalent method to recommend which equipment type to purchase.
Ignore taxes and use annual compounding.
IV. After Tax Cash Flow Analysis
10. Company X is considering investing in one of two mutually exclusive projects, A and B. The
Company’s cost of capital is 12% (annual compounding). The after tax cash flows for projects A and B are
as follows:
Project 0 1 2
A -18,000 5,650 16,600
B -6,000 4,600 2,645
The IRR for project A is 13% and the IRR for project B is 15%. Which project (if any) do you recommend
for investment?
11. The after-tax project cash flows for the first five years are 110,000, 121,000, 133,100, 146,410,
161,051, respectively. The project cash flows thereafter are assumed to grow at an annual rate of 2% in
perpetuity. (So, for example, the after-tax project cash flow in year 6 is 1.02(161,051).) The required
investment at time 0 is 1,800,000. There is no debt. The cost of unlevered equity capital r0 is 10% per
year.
a. Should the company invest in this project? Explain.

b. Suppose the company can borrow 1 million at an annual rate of interest of 6% with principal to repaid
in equal annual installments over 5 years. Use the Adjusted Present Value approach to determine the
value of this project with debt and whether or not the company should invest in the levered project.
12. The after-tax project cash flows for the first 3 years are 110,000, 121,000, 133,100, respectively. The
project cash flows thereafter are assumed to grow at an annual rate of 5% in perpetuity. (So, for example,
the after-tax project cash flow in year 4 is 1.05(133,100).) The required investment at time 0 is 3,000,000.
The cost of unlevered equity capital r0 is 10% per year. Suppose the company can finance the entire
investment by borrowing 3 million at an annual rate of interest of 8% with principal to repaid in equal
annual installments over 3 years. The marginal tax rate is 40%. Use the Adjusted Present Value approach
to determine the value of this project with debt, and whether or not the company should invest in the
levered project.
32
13. A manufacturer must acquire equipment to produce a product for a customer for a period of exactly
two years. Relevant data are:
• Revenues are projected to be 600,000 in the first year and 800,000 in the second year.
• The manufacturer’s cost of levered equity capital is 20% and its marginal tax rate is 30%.
• For tax purposes MACRS depreciation schedule (with half year convention) is used.
• The equipment’s market value depreciates at a rate of 30% per year, i.e., its value at the end of the
year is 70% of the value at the beginning of the year.
• The equipment will be classified as 5-year property.
• The equipment initially costs 350,000, of which 150,000 will be financed by a 2-year loan at 12%
interest, with principal repaid in two equal annual installments.
• First year annual operating costs will be 250,000. Each successive year these costs rise by 10%.
• Use annual compounding.
Obtain the after-tax cash flows by filling out the following table.
Project cash flow analysis

0 1 2
Revenues
Expenses
EBITDA
Interest
Depreciation
EBIT
Taxes
Net Income
Adjustments
Depreciation
Investment
Free cash flow
Net present value
two years. Relevant data are:
• Revenues are projected to be 500,000 in the first year and 700,000 in the second year.
• For tax purposes MACRS depreciation schedule (with half year convention) is used.
• The equipment’s market value depreciates at a rate of 40% per year, i.e., its value at the end of the
year is 60% of the value at the beginning of the year.
• The equipment will be classified as 5-year property.
interest, with principal repaid in two equal annual installments.
• First year annual operating costs will be 400,000. Each successive year these costs rise by 25%.
• Use annual compounding.
33
Obtain the after-tax cash flows by filling out the following table.

0 1 2
Revenues
Expenses
EBITDA
Interest
Depreciation
EBIT
Taxes
Net Income
Adjustments
Depreciation
Investment
Free cash flow
Net present value
four years. Relevant data are:
• Revenues are projected to be 300,000 in the first year, and are projected to grow at an annual rate
of 10% each year thereafter. First year annual operating costs will be 200,000. Each successive
year these costs decline by 5%.
interest, with principal repaid in four equal annual installments. The equipment’s market value
depreciates at a rate of 20% per year. The equipment will be classified as 5-year property. For tax
purposes MACRS depreciation schedule (with half year convention) is used.
Obtain the last project year’s free cash flow by filling out the following table.
Year 4 project cash flow
Revenue
Cost
EBITDA
Interest expense
Depreciation
EBT
Income tax
Net income
Adjustments
Depreciation
Investment
Free Cash Flow
34
V. Project Balance
16. A company is considering investing in a project whose after-tax cash flows for the next two years are
11200 at the end of the first year and 50176 at the end of the second year. The appropriate cost of
capital is 12% (compounded annually). The initial investment at time 0 is 52000.
a. Show the project balance schedule for this project.

b. Should the company invest in this project? Explain by applying the project balance concept.
c. What can you conclude about the IRR for this investment project? Explain. Do NOT calculate the
IRR.
17. A company is considering investing in a project whose after-tax cash flows for the next two years are
10,000 at the end of the first year and 20,000 at the end of the second year. The appropriate cost of capital
is 10% (compounded annually). The initial investment at time 0 is 24,000.
a. Show the project balance schedule for this project.

b. Should the company invest in this project? Explain by applying the project balance concept.
35
36
CASH FLOW ANALYSIS HOMEWORK PROBLEM SOLUTIONS
1. a. (1000)(1.04)4 = 1169.86.
b. 1000(1.02)8 = 1171.66.
c. 1000e0.16 = 1173.51.
2. a. 1000(1.08)4 = 1360.49.
b. 1000(1.04)8 = 1368.57.
c. 1000(1.02)30 = 1811.36.
d. 1000e.32 = 1377.13.
3. The PV with r = 10% of (C0, C1) = (100, 110) at time 0 is, of course, 200.
The cash flow stream is therefore equivalent to (200, 0, 200, 0, 200, … , 200, 0), where the
last 200 occurs at time 40. This cash flow stream is equivalent to 200 at each time t = 0, 1, 2,
.... , 20, where the period length is 2 years. Since (1.1)2 – 1 = 0.21, the PV equals
200[1 + (1 – (1.21)-20 )/0.21] = 1131.34.
4. PV at time 0 of the cash flow stream (1, 1100), (2, 1210), (3, 1331) at 10% is 3000. The
given infinite cash flow stream is equivalent to receiving a cash flow of 3000 at time 0 and
thereafter every three years. The appropriate interest rate for three years is 33.1%. Thus,
PV = 3000 + 3000/0.331 = 12063.
5. a. M = (0.005)(400,000)/[1 – (1.005)-240] = 2865.72.

b. The ratio LB(t)/LB(0) = 301,903.48/400,000. We know that
LB(t)/LB(0) = [1 – (1.005)–(240-t) ]/[1 – (1.005)-240].
Thus, the number of months remaining is (240-t) = 150.
Alternatively, 301,903.48 = [2865.72/0.005][1 – (1.005)–n], which gives n = 150.
c. We seek the value of A such that
[(2865.72 + A)/0.005][1 – (1.005)-120] = 301,903.48.
6. a. M = 200,000(0.09/12)/[1 – (1 + 0.09/12)-360] = 1609.25.

b. 173,719.16/200,000 = [1 – (1.0075)-n]/[1 – (1.0075)-360] and so n = 222.
c. Seek n such that 173,719.16 = (1659.25/0.0075) [1 – (1.0075)-n] and so n = 206.
7. a. Monthly payment = 1714.85. Continuous-time answer = 1712.16.

b. LB(51) = 160,792.27. Continuous-time answer LB(4.25) = 160,833.17.
c. 104.44 months or 8.70 years. Continuous-time answer = 8.68 years.
d. Additional amount = 1412.44. Continuous-time answer = 1409.01.
8. PVI = 250,000 + 40,000[1 – (1.1)-4]/(0.1) – 80,000/(1.1)4 = 322,154.

AEI = [0.1PVI]/[1 – (1.1)-4] = 101,630.
PVII = 400,000 + 20,000[1 – (1.1)-7]/(0.1) – 50,000/(1.1)7 = 471,710.
AEII = [0.1PVII]/[1 – (1.1)-7] = 96,892.
Recommend Type II machine.
9. PVA = 1000 + (400/0.1)[1 – (1.1)-5] - 300(1.1)-5 = 2330.04.

AEA = 0.1(2330.04)/[1 – (1.1)-5] = 614.66.
PVB = 2000 + (200/0.1)[1 – (1.1)-8] - 800(1.1)-8 = 2693.78.
AEB = 0.1(2693.78)/[1 – (1.1)-8] = 504.93.
Recommend equipment type B.
37
10. NPVA = -18,000 + 5,560/1.12 + 16,600/(1.12)2 = 278.06.
NPVB = -6,000 + 4,600/1.12 + 2,645/(1.12)2 = 215.72.
Since NPVA > NPVB > 0, project A is recommended. (The IRR’s are irrelevant.)
11. a. PV of cash flow = 400,000 + [161,051/(0.10 – 0.02)]/(1.1)4 = 1,775,000. NPV = -25,000. NO.
b.
0 1 2 3 4 5
LB 1,000,000 800,000 600,000 400,000 200,000 0
IP -60,000 -48,000 -36,000 -24,000 -12,000
PP -200,000 -200,000 -200,000 -200,000 -200,000
TP -260,000 -248,000 -236,000 -224,000 -212,000
tax shield 24,000 19,200 14,400 9,600 4,800
ATCF -236,000 -228,800 -221,600 -214,400 -207,200
PV of loan at 6% = 63,011. APV = -25,000 + 63,011 = 38,011. YES.
12. PV of cash flow = 200,000 + [133,100/(0.10 – 0.05)]/(1.1)2 = 2,400,000. NPV = -600,000. NO.
0 1 2 3
LB 3,000,000
IP -240,000 -160,000 -80,000
PP -1,000,000 -1,000,000 -1,000,000
TP -1,240,000 -1,160,000 -1,080,000
tax shield 96,000 64,000 32,000
ATCF -1,144,000 -1,096,000 -1,048,000
PV of loan at 8% = 169,161. APV = -600,000 + 169,161 = -430,839. NO.
13.
0 1 2
Revenues 600,000 800,000
Expenses 250,000 275,000
EBITDA 350,000 525,000
Interest 18,000 9,000
Depreciation 70,000 56,000
EBIT 262,000 460,000
Taxes 78,600 138,000
Net Income 183,400 322,000
Adjustments
Loan principal cash flow 150,000 (75,000) (75,000)
Investment (350,000) *187,250
Free cash flow (200,000) 178,400 490,250
Net present value 289,118 586,942 490,250
*187,250 = 171,500 – 0.3(171,500 – 224,000)
38
14.

0 1 2
Revenues 500,000 700,000
Expenses 400,000 500,000
EBITDA 100,000 200,000
Interest 10,000 5,000
EBIT 40,000 155,000
Taxes 14,000 54,250
Net Income 26,000 100,750
Adjustments
Loan principal cash flow 100,000 (50,000) (50,000)
Investment (250,000) *114,500
Free cash flow (150,000) 26,000 205,250
Net present value 19,441 199,941 205,250
*114,500 = 90,000 – 0.35(90,000 – 160,000)
15.
Year 4 project cash flow
Revenue 399,300
Cost 171,475
EBITDA 227,825
Interest expense 5,000
Depreciation 11,520
EBT 211,305
Income tax 84,522
Net income 126,783
Adjustments
Loan principal cash flow (50,000)
Depreciation 11,520
Investment *69,184
Free Cash Flow 157,487
*69,184 = 81,920 – 0.4(81,920 – 50,080)
16. a. PB(0) = -52,000.

PB(1) = -52,000(1.12) + 11,200 = -47,040.
PB(2) = -47,040(1.12) + 50,176 = -2,508.80.
b. No. Final project balance is negative, which means the NPV at time 0 is also negative.
c. IRR has to be less than 12%, since PB is negative at the end of project.
17. a. PB(0) = -24,000.

PB(1) = -24,000(1.1) + 10,000 = -16,400.
PB(2) = -16,400(1.1) + 20,000 = 1,960.
b. Yes. Final project balance is positive, which means the NPV at time 0 is also positive.
(IRR has to be greater than 10%, since PB is positive at the end of project.)
39
40
DYNAMIC CASH FLOW ANALYSIS
HANDOUTS
41
42
I. Fishing Example
You own both a lake and a fishing boat as an investment package. You plan to profit by taking fish
from the lake. Each season you decide either to fish or not fish. You have only three seasons to fish.
Here are the relevant data:
• If you do not fish, the fish population will double by the start of next season.
• If you do fish, you will extract 70% of the fish population at the beginning of the season. At the
start of the next season, the fish population will be the same as it was at the beginning of the
current season.
• The initial fish population is 10 tons.
• The profit per ton is $1 (unit of money), which is constant.
• The cost of capital is 25%.
43
44
DCFA_FishingExample.hava
r 0.25
planningHorizon 3
I0 10
P 1
Actions (NONE, FISH)
prodPercentage(NONE) 0
prodPercentage(FISH) 0.7
newInventoryFactor(NONE) 2
newInventoryFactor(FISH) 1
initialState State(3, 10)

ProjectValue 20.16
DDP_AO ddp_Result state value

n I policy information
action value
0 10 IGNORE 0.0
0 20 IGNORE 0.0
0 40 IGNORE 0.0
0 80 IGNORE 0.0
1 10 FISH 7.0 10
1 20 FISH 14.0 20
1 40 FISH 28.0 40
2 10 FISH 12.6 10
2 20 FISH 25.2 20
3 10 NONE 20.16 20
DDP_AO ddp_Value state action value
n I
1 10 NONE 0.0
1 10 FISH 7.0
1 20 NONE 0.0
1 20 FISH 14.0
1 40 NONE 0.0
1 40 FISH 28.0
2 10 NONE 11.2
2 10 FISH 12.6
2 20 NONE 22.4
2 20 FISH 25.2
3 10 NONE 20.16
3 10 FISH 17.08
DDP_AO ddp_PresentValue state action value
n I
1 10 NONE 0.0
1 10 FISH 0.0
1 20 NONE 0.0
1 20 FISH 0.0
1 40 NONE 0.0
1 40 FISH 0.0
2 10 NONE 11.2
2 10 FISH 5.6
2 20 NONE 22.4
2 20 FISH 11.2
3 10 NONE 20.16
3 10 FISH 10.08
ddp_CashFlow state action value
n I
1 10 NONE 0
1 10 FISH 7.0
1 20 NONE 0
1 20 FISH 14.0
1 40 NONE 0
1 40 FISH 28.0
2 10 NONE 0
2 10 FISH 7.0
2 20 NONE 0
2 20 FISH 14.0
3 10 NONE 0
3 10 FISH 7.0
45
46
II. Oil Pump Example
You have purchased a lease for an oil well. The lease duration is three years.
• In each year, you have three choices of how to operate the well:
o Not pump. No operating cost and no change in oil reserves.
o Normal pump. Operating cost is $50 thousand and 20% of current reserves will be
extracted.
o Enhance pump. Operating cost is $120 thousand and 36% of current reserves will be
extracted.
• The price of oil is constant at $10 per barrel.
• This well has initial reserves of 100 thousand barrels of oil.
47
48
DCFA_OilPumpExample.hava
r 0.1
planningHorizon 3
I0 100000
P 10
Actions (NONE, NORMAL, ENHANCE)
prodPercentage(NONE) 0
prodPercentage(NORMAL) 0.2
prodPercentage(ENHANCE) 0.36
cost(NONE) 0
cost(NORMAL) 50000
cost(ENHANCE) 120000

ProjectValue 366744

action value
0 26214.4 IGNORE 0
0 32768.0 IGNORE 0
0 40960.0 IGNORE 0
0 51200.0 IGNORE 0
0 64000.0 IGNORE 0
0 80000.0 IGNORE 0
0 100000 IGNORE 0
1 40960.0 NORMAL 31920.0 32768.0
1 51200.0 ENHANCE 64320.0 32768.0
1 64000.0 ENHANCE 110400 40960.0
1 80000.0 ENHANCE 168000 51200.0
1 100000 ENHANCE 240000 64000.0
2 64000.0 ENHANCE 139418 40960.0
2 80000.0 ENHANCE 226473 51200.0
2 100000 ENHANCE 340364 64000.0
3 100000 ENHANCE 366744 64000.0
n I
1 40960.0 NONE 0.0
1 40960.0 NORMAL 31920.0
1 40960.0 ENHANCE 27456.0
1 51200.0 NONE 0.0
1 51200.0 NORMAL 52400.0
1 51200.0 ENHANCE 64320.0
1 64000.0 NONE 0.0
1 64000.0 NORMAL 78000.0
1 64000.0 ENHANCE 110400
1 80000.0 NONE 0.0
1 80000.0 NORMAL 110000
1 80000.0 ENHANCE 168000
1 100000 NONE 0.0
1 100000 NORMAL 150000
1 100000 ENHANCE 240000
2 64000.0 NONE 100364
2 64000.0 NORMAL 136473
2 64000.0 ENHANCE 139418
2 80000.0 NONE 152727
2 80000.0 NORMAL 210364
2 80000.0 ENHANCE 226473
2 100000 NONE 218182
2 100000 NORMAL 302727
2 100000 ENHANCE 340364
3 100000 NONE 309422
3 100000 NORMAL 355885
3 100000 ENHANCE 366744
49
n I
1 40960.0 NONE 0.0
1 40960.0 NORMAL 0.0
1 40960.0 ENHANCE 0.0
1 51200.0 NONE 0.0
1 51200.0 NORMAL 0.0
1 51200.0 ENHANCE 0.0
1 64000.0 NONE 0.0
1 64000.0 NORMAL 0.0
1 64000.0 ENHANCE 0.0
1 80000.0 NONE 0.0
1 80000.0 NORMAL 0.0
1 80000.0 ENHANCE 0.0
1 100000 NONE 0.0
1 100000 NORMAL 0.0
1 100000 ENHANCE 0.0
2 64000.0 NONE 100364
2 64000.0 NORMAL 58472.7
2 64000.0 ENHANCE 29018.2
2 80000.0 NONE 152727
2 80000.0 NORMAL 100364
2 80000.0 ENHANCE 58472.7
2 100000 NONE 218182
2 100000 NORMAL 152727
2 100000 ENHANCE 100364
3 100000 NONE 309422
3 100000 NORMAL 205885
3 100000 ENHANCE 126744
n I
1 40960.0 NONE 0.0
1 40960.0 NORMAL 31920.0
1 40960.0 ENHANCE 27456.0
1 51200.0 NONE 0.0
1 51200.0 NORMAL 52400.0
1 51200.0 ENHANCE 64320.0
1 64000.0 NONE 0.0
1 64000.0 NORMAL 78000.0
1 64000.0 ENHANCE 110400
1 80000.0 NONE 0.0
1 80000.0 NORMAL 110000
1 80000.0 ENHANCE 168000
1 100000 NONE 0
1 100000 NORMAL 150000
1 100000 ENHANCE 240000
2 64000.0 NONE 0.0
2 64000.0 NORMAL 78000.0
2 64000.0 ENHANCE 110400
2 80000.0 NONE 0.0
2 80000.0 NORMAL 110000
2 80000.0 ENHANCE 168000
2 100000 NONE 0
2 100000 NORMAL 150000
2 100000 ENHANCE 240000
3 100000 NONE 0
3 100000 NORMAL 150000
3 100000 ENHANCE 240000
50
III. Machine Replacement Analysis
A company has to purchase a machine to produce a new product within its manufacturing plant. The
product’s life is 10 years.
Here is the relevant data obtained from the vendor who sells the machine:
• Purchase price is $15 million.
• The market value depreciation is 20% per year.
• The maintenance and operations cost in the first year is $0.50 million. Each year thereafter this
cost grows at 65% per year.
• The equipment can be replaced at any time for a new machine. No technological improvements
are expected, and all of the current machine’s characteristics listed above will apply in the future.
• The annual cost of capital is 18%.
51
52
MRA_NewMachineAnalysis.hava
r 0.18
P 15.0
mvd 0.2
mc1 0.5
mcg 0.65
PH 5
initialState State(5)
ProjectValue 17.4747
ddp_Obj ddp_MIN

n policy information
action value n
0 IGNORE 0.0
1 1 5.2542 0
2 2 9.1217 0
3 3 12.1704 0
4 4 14.8342 0
5 5 17.4747 0
DDP_AO ddp_TerminalResult state value
n policy information
action value
0 IGNORE 0.0
n
1 1 5.2542
2 1 9.7069
2 2 9.1217
3 1 12.9845
3 2 12.8951
3 3 12.1704
4 1 15.5681
4 2 15.6727
4 3 15.3683
4 4 14.8342
5 1 17.8256
5 2 17.8623
5 3 17.7222
5 4 17.5443
5 5 17.4747
53
n
1 1 0.0
2 1 4.45271
2 2 0.0
3 1 7.73025
3 2 3.77348
3 3 0.0
4 1 10.3139
4 2 6.55106
4 3 3.19787
4 4 0.0
5 1 12.5714
5 2 8.74059
5 3 5.55175
5 4 2.71006
5 5 0.0
n
1 1 5.25424
2 1 5.25424
2 2 9.12166
3 1 5.25424
3 2 9.12166
3 3 12.1704
4 1 5.25424
4 2 9.12166
4 3 12.1704
4 4 14.8342
5 1 5.25424
5 2 9.12166
5 3 12.1704
5 4 14.8342
5 5 17.4747
pvMCost action value
1 0.423729
2 1.01623
3 1.84473
4 3.00322
5 4.62315
pvSValue action value
1 10.1695
2 6.89457
3 4.67429
4 3.16901
5 2.14848
ANNUAL EQUIVALENT METHOD
AE n value
1 6.2
2 5.82615
3 5.59748
4 5.51445
5 5.58801
nStar 4
infHorizonPolicyCost 17.5443
54
MRA_ExistingMachineAnalysis.hava
r 0.18
P 15.0
mvd 0.2
mc1 0.5
mcg 0.65
PH 5
age 3
ProjectValue 9.268
ddp_Obj ddp_MIN

n age policy information
action value n age
0 0 IGNORE 0.0
1 0 1 5.2542 0 0
2 0 2 9.1217 0 0
3 0 3 12.1704 0 0
4 0 4 14.8342 0 0
5 0 5 17.4747 0 0
5 3 1 9.268 4 0
n age
1 0 1 5.2542
2 0 1 9.7069
2 0 2 9.1217
3 0 1 12.9845
3 0 2 12.8951
3 0 3 12.1704
4 0 1 15.5681
4 0 2 15.6727
4 0 3 15.3683
4 0 4 14.8342
5 0 1 17.8256
5 0 2 17.8623
5 0 3 17.7222
5 0 4 17.5443
5 0 5 17.4747
5 3 0 9.7947
5 3 1 9.268
5 3 2 9.7756
5 3 3 11.4453
5 3 4 14.5784
5 3 5 19.6678
n age
1 0 1 0.0
2 0 1 4.45271
2 0 2 0.0
3 0 1 7.73025
3 0 2 3.77348
3 0 3 0.0
4 0 1 10.3139
4 0 2 6.55106
4 0 3 3.19787
4 0 4 0.0
5 0 1 12.5714
5 0 2 8.74059
5 0 3 5.55175
5 0 4 2.71006
5 0 5 0.0
5 3 0 17.4747
5 3 1 12.5714
5 3 2 8.74059
5 3 3 5.55175
5 3 4 2.71006
5 3 5 0.0
55
n age
1 0 1 5.25424
2 0 1 5.25424
2 0 2 9.12166
3 0 1 5.25424
3 0 2 9.12166
3 0 3 12.1704
4 0 1 5.25424
4 0 2 9.12166
4 0 3 12.1704
4 0 4 14.8342
5 0 1 5.25424
5 0 2 9.12166
5 0 3 12.1704
5 0 4 14.8342
5 0 5 17.4747
5 3 0 -7.68
5 3 1 -3.30334
5 3 2 1.03502
5 3 3 5.89352
5 3 4 11.8683
5 3 5 19.6678
pvMCost state action value
n age
1 0 1 0.423729
2 0 1 0.423729
2 0 2 1.01623
3 0 1 0.423729
3 0 2 1.01623
3 0 3 1.84473
4 0 1 0.423729
4 0 2 1.01623
4 0 3 1.84473
4 0 4 3.00322
5 0 1 0.423729
5 0 2 1.01623
5 0 3 1.84473
5 0 4 3.00322
5 0 5 4.62315
5 3 0 0
5 3 1 1.90344
5 3 2 4.56504
5 3 3 8.28676
5 3 4 13.4909
5 3 5 20.7678
pvSValue state action value
n age
1 0 1 10.1695
2 0 1 10.1695
2 0 2 6.89457
3 0 1 10.1695
3 0 2 6.89457
3 0 3 4.67429
4 0 1 10.1695
4 0 2 6.89457
4 0 3 4.67429
4 0 4 3.16901
5 0 1 10.1695
5 0 2 6.89457
5 0 3 4.67429
5 0 4 3.16901
5 0 5 2.14848
5 3 0 7.68
5 3 1 5.20678
5 3 2 3.53002
5 3 3 2.39323
5 3 4 1.62253
5 3 5 1.10002
56
IV. Natural Resource Analysis
A company has the option to acquire a ten-year lease to extract gold from a gold mine. The lease
should be acquired if its cost is less than the value of the lease.
Here is relevant data:
• Price of gold is constant over the life of the lease. It is currently P = $400 per ounce.
• The mine’s capacity is 50,000 ounces.
• Operating costs reflect inherent nonlinearities in mining, namely, decreasing returns-to-scale and
increasing costs as reserves are depleted. Specifically, when the begin-of-year mine inventory is I,
the cost to mine Q ounces for the upcoming year is C*Q2/I, where C = 500.
• The annual cost of capital is 10%.
The following assumptions are made:
• Cash flows will be estimated on an annual basis.
• Taxes will be ignored.
• Production occurs instantaneously.
• Production quantities will be multiples of the lot size, in this case 1000 ounces.
• Profits each year accrue at the beginning of the year.
A production policy specifies the quantity and timing of production. Each production policy yields a
corresponding profit cash flow stream, that is, yearly profits over time. The present value of yearly profits
(at the appropriate cost of capital) represents the value of the leave given this production policy. A
reasonable objective is to find the production policy that maximizes the present value of yearly profits. The
resulting present value is the value of this lease.
57
58
NRA_OptimalAnalysis.01.hava
r 0.0953102
p 400
dt 1
planningHorizon 2
I0 10
numPeriods 2
ProjectValue 1256.49

action value
0 1 IGNORE 0.0
0 2 IGNORE 0.0
0 3 IGNORE 0.0
0 4 IGNORE 0.0
0 5 IGNORE 0.0
0 6 IGNORE 0.0
0 7 IGNORE 0.0
0 8 IGNORE 0.0
0 9 IGNORE 0.0
0 10 IGNORE 0.0
1 1 0 0.0 1
1 2 1 150.0 1
1 3 1 233.333 2
1 4 2 300.0 2
1 5 2 400.0 3
1 6 2 466.667 4
1 7 3 557.143 4
1 8 3 637.5 5
1 9 4 711.111 5
1 10 4 800.0 6
2 10 3 1256.49 7
DDP_AO ddp_TerminalResult state value
action value
0 1 IGNORE 0.0
0 2 IGNORE 0.0
0 3 IGNORE 0.0
0 4 IGNORE 0.0
0 5 IGNORE 0.0
0 6 IGNORE 0.0
0 7 IGNORE 0.0
0 8 IGNORE 0.0
0 9 IGNORE 0.0
0 10 IGNORE 0.0
59
n I
1 1 0 0.0
1 2 0 0.0
1 2 1 150.0
1 3 0 0.0
1 3 1 233.333
1 3 2 133.333
1 4 0 0.0
1 4 1 275.0
1 4 2 300.0
1 4 3 75.0
1 5 0 0.0
1 5 1 300.0
1 5 2 400.0
1 5 3 300.0
1 5 4 0.0
1 6 0 0.0
1 6 1 316.667
1 6 2 466.667
1 6 3 450.0
1 6 4 266.667
1 6 5 -83.3333
1 7 0 0.0
1 7 1 328.571
1 7 2 514.286
1 7 3 557.143
1 7 4 457.143
1 7 5 214.286
1 7 6 -171.429
1 8 0 0.0
1 8 1 337.5
1 8 2 550.0
1 8 3 637.5
1 8 4 600.0
1 8 5 437.5
1 8 6 150.0
1 8 7 -262.5
1 9 0 0.0
1 9 1 344.444
1 9 2 577.778
1 9 3 700.0
1 9 4 711.111
1 9 5 611.111
1 9 6 400.0
1 9 7 77.7778
1 9 8 -355.556
1 10 0 0.0
1 10 1 350.0
1 10 2 600.0
1 10 3 750.0
1 10 4 800.0
1 10 5 750.0
1 10 6 600.0
1 10 7 350.0
1 10 8 0.0
1 10 9 -450.0
2 10 0 727.273
2 10 1 996.465
2 10 2 1179.55
2 10 3 1256.49
2 10 4 1224.24
2 10 5 1113.64
2 10 6 872.727
2 10 7 562.121
2 10 8 136.364
2 10 9 -450.0
60
n I
1 1 0 0.0
1 2 0 0.0
1 2 1 0.0
1 3 0 0.0
1 3 1 0.0
1 3 2 0.0
1 4 0 0.0
1 4 1 0.0
1 4 2 0.0
1 4 3 0.0
1 5 0 0.0
1 5 1 0.0
1 5 2 0.0
1 5 3 0.0
1 5 4 0.0
1 6 0 0.0
1 6 1 0.0
1 6 2 0.0
1 6 3 0.0
1 6 4 0.0
1 6 5 0.0
1 7 0 0.0
1 7 1 0.0
1 7 2 0.0
1 7 3 0.0
1 7 4 0.0
1 7 5 0.0
1 7 6 0.0
1 8 0 0.0
1 8 1 0.0
1 8 2 0.0
1 8 3 0.0
1 8 4 0.0
1 8 5 0.0
1 8 6 0.0
1 8 7 0.0
1 9 0 0.0
1 9 1 0.0
1 9 2 0.0
1 9 3 0.0
1 9 4 0.0
1 9 5 0.0
1 9 6 0.0
1 9 7 0.0
1 9 8 0.0
1 10 0 0.0
1 10 1 0.0
1 10 2 0.0
1 10 3 0.0
1 10 4 0.0
1 10 5 0.0
1 10 6 0.0
1 10 7 0.0
1 10 8 0.0
1 10 9 0.0
2 10 0 727.273
2 10 1 646.465
2 10 2 579.545
2 10 3 506.494
2 10 4 424.242
2 10 5 363.636
2 10 6 272.727
2 10 7 212.121
2 10 8 136.364
2 10 9 0.0
61
n I
1 1 0 0.0
1 2 0 0.0
1 2 1 150
1 3 0 0.0
1 3 1 233.333
1 3 2 133.333
1 4 0 0.0
1 4 1 275
1 4 2 300
1 4 3 75
1 5 0 0.0
1 5 1 300
1 5 2 400
1 5 3 300
1 5 4 0
1 6 0 0.0
1 6 1 316.667
1 6 2 466.667
1 6 3 450
1 6 4 266.667
1 6 5 -83.3333
1 7 0 0.0
1 7 1 328.571
1 7 2 514.286
1 7 3 557.143
1 7 4 457.143
1 7 5 214.286
1 7 6 -171.429
1 8 0 0.0
1 8 1 337.5
1 8 2 550
1 8 3 637.5
1 8 4 600
1 8 5 437.5
1 8 6 150
1 8 7 -262.5
1 9 0 0.0
1 9 1 344.444
1 9 2 577.778
1 9 3 700
1 9 4 711.111
1 9 5 611.111
1 9 6 400
1 9 7 77.7778
1 9 8 -355.556
1 10 0 0.0
1 10 1 350
1 10 2 600
1 10 3 750
1 10 4 800
1 10 5 750
1 10 6 600
1 10 7 350
1 10 8 0
1 10 9 -450
2 10 0 0.0
2 10 1 350
2 10 2 600
2 10 3 750
2 10 4 800
2 10 5 750
2 10 6 600
2 10 7 350
2 10 8 0
2 10 9 -450
62
DYNAMIC CASH FLOW ANALYSIS HOMEWORK PROBLEMS
1. Recall the fishing problem described in the handout. You own a lake. Each season you decide either
to fish or not to fish. If you do not fish, the fishing population will increase by 50% by the start of the next
season. (In the example, the population doubled if you did not fish.) If you do fish, you will extract 70%
of the fish that were in the lake in the beginning of the season, and the fish population at the beginning of
the next season will be the same as at the beginning of the season. The initial fish population is 10 tons.
Your profit is $1 per ton. The discount factor is d = 0.80. You have three seasons to fish. Determine the
value of your lake, and the optimal fishing strategy over time.
2. A company has purchased a lease for an oil well. Here are the relevant data:
• In each year, the company has three choices of how to operate the well:
o Not pump. No operating cost and no change in oil reserves.
o Normal pump. Operating cost is $75 thousand and 30% of current reserves will be extracted.
o Enhance pump. Operating cost is $200 thousand and 51% of current reserves will be
extracted.
• The price of oil is constant at $10 per barrel.
• This well has initial reserves of 100 thousand barrels of oil.
• Profits accrue at the beginning of the year.
a. Determine the value of a two-year lease and the optimal pumping strategy using the method of
dynamic programming.
b. The company’s actual lease duration was 10 years. It is the end of the 4th year (i.e. t = 4) and the
company is deciding what its pumping strategy should be for year 5. The company’s production strategy
for the first four years had been to pump normal, no pump, pump normal, no pump. What is the optimal
pumping strategy for year 5?
3. A manufacturer must acquire a machine. The machine has an initial cost of 100,000. Maintenance
cost for the first year (billable at time t = 1) is 20,000. Maintenance cost is expected to double each year.
Market value depreciation occurs at a rate of 20% per year. The machine is classified as 5-year property
and MACRS depreciation schedule (with half-year convention) is used. Assume a new machine can be
purchased with the same economic characteristics. For an infinite horizon analysis, determine the optimal
replacement policy. The manufacturer’s discount rate is 10% and the marginal tax rate is 40%. Use annual
compounding.
63
4. Consider the gold mining problem analyzed in class. Relevant data pertaining to the optimal policy are
provided in the following table:
Optimal Production Schedule

0 1 2 3 4 5 6 7 8 9
K values 213.8149 211.454 208.17 203.58 197.126 187.965 174.79 155.47 126.281 80
Percentage 0.207769 0.21075 0.21493 0.22079 0.22912 0.2411 0.25866 0.2852 0.32727 0.4
Inventory 50000 39611.5 31263.2 24543.9 19124.7 14742.8 11188.3 8294.31 5928.78 3988.45
Production 10388.45 8348.32 6719.31 5419.17 4381.92 3554.5 2894.01 2365.53 1940.33 1595.38
Profit 3076182 2459604 1965644 1569406 1250769 993304 783317 608889 458623 319076
PV 3076182 2236004 1624499 1179118 854292 616763 442162 312456 213951 135320
Value 10690747
a. What is the inventory at the end of the 10-year lease?

b. Suppose the gold mine has been in operation for exactly 7 years. The inventory left is 15,000 ounces.
What is the value of the gold mine?
c. Your answer to part b assumes what?
d. Given the situation in part b, what is the optimal production plan to the end of the lease?
5. Produce the Optimal Production Schedule table shown in problem #3 for the gold mine lease when the
profit flow is π(I, z) = z*(I-z) instead of g*z – Cz2/I. (Take I0 = 50, i.e., measure in units of thousands.)
64
DYNAMIC CASH FLOW ANALYSIS HOMEWORK PROBLEM SOLUTIONS
1. Use DCFA_FishingExample.hava.
2. Use DCFA_OilPumpExample.hava.
V(1, 100,000) = max{0, 10(30,000) – 75,000, 10(51,000) – 200,000} = 310,000. Enhance.

V(1, 70,000) = max{0, 10(21,000) – 75,000, 10(35,700) – 200,000} = 157,000. Enhance.
V(1, 49,000) = max{0, 10(14,700) – 75,000, 10(24,990) – 200,000} = 72,000. Normal.
V(0, 100,000) = max{0, [10(30,000)-75,000] + (1/1.15)[157,000],
[10(51,000)-200,000] + (1/1.15)[72,000]} = 372,609. Enhance.
Optimal pumping strategy is to enhance pump first year, then pump normal in second year.
Value of the two-year lease is 372,609.
The amount of inventory at the beginning of year 5 is 49,000. The cash flow using normal pump is
10(0.3)(49,000) - 75,000 = 72,000 and the remaining inventory will be 34,300. The cash flow using
enhance pump is 10(0.51)(49,000) - 200,000 = 49,900, and the remaining inventory will be 24,010. As
both cash flows are positive, it is optimal to pump at some level. Since the cash flow using normal pump is
HIGHER than the cash flow using enhance pump, and since the remaining inventory will obviously be
higher when using normal pump, the optimal pumping strategy is to pump normal.
NOTE: You cannot use your reasoning in part (a) to answer part (b). This is because the optimal
decision for the last period of part (a) may not be the optimal solution for year 5 in a 10-year horizon. The
future value of all cash flow obtained from years 6-10 as a result of the decision in year 5 must be
considered when deciding the optimal decision in year 5.
3. Cash flow table worksheet:

0 1 2 3 4
Maintenance Schedule 20,000 26,000 33,800 43,940
Depreciation Schedule 20,000 32,000 19,200 11,520
Salvage value 80,000 64,000 51,200 40,960
Book value 80,000 64,000 38,400 23,040
Investment (if sold) 100,000 80,000 64,000 46,080 33,792
Keep one year:

0 1 2 3 4
Maintenance (12,000)
Depreciation 8,000
Investment 80,000
ATCF (100,000) 76,000 AE = (34,000)
Keep two years:

0 1 2 3 4
Maintenance (12,000) (15,600)
Investment 64,000
ATCF (100,000) (4,000) 54,800 AE = (33,619)
Keep three years:

0 1 2 3 4
Maintenance (12,000) (15,600) (20,280)
Depreciation 8,000 12,800 3,840
Investment 46,080
ATCF (100,000) (4,000) (2,800) 29,640 AE = (33,650)
65
4. (a) x10 = x9 – z9 = 3,988.45 – 1,595.38 = 2,393.
(b) V7(x7) = K7x7 = 155.47(15,000) = 2,322,050.
(c) Assumes the gold mine will be operated in the optimal way until the end of the lease.
(d) z7 = 0.2852(15,000) = 4,278.
x8 = x7 – z7 = 15,000 – 4,278 = 10,722.
z8 = 0.32727(10,722) = 3,509.
x9 = x8 – z8 = 10,722 – 3,509 = 7,213.
z9 = 0.40(7,213) = 2,885.
5. See GoldMineHmkSoln.hava for new formulas for the K and P values over time.
Kvalue Pvalue Inv Qty Profit PV VALUE

0 0.383816 0.232369 50.00000 11.61844 445.9339 445.9339 959.539
1 0.383510 0.232980 38.38156 8.942129 263.2512 239.3193
2 0.382939 0.234121 29.43943 6.892399 155.4031 128.4323
3 0.381871 0.236259 22.54703 5.326936 91.7303 68.9184
4 0.379861 0.240279 17.22009 4.137620 54.1303 36.9717
5 0.376050 0.247899 13.08247 3.243135 31.9103 19.8138
6 0.368715 0.262570 9.83934 2.583514 18.7455 10.5814
7 0.354167 0.291667 7.255826 2.116283 10.8767 5.58148
8 0.323529 0.352941 5.139544 1.813957 6.03247 2.81419
9 0.250000 0.500000 3.325587 1.662794 2.76488 1.17258
10 0 0 1.662794 0 0 0
66
FINANCIAL OPTION ANALYSIS
HANDOUTS
67
68
FAIR PRICING
There is a market for an object called “S”. The prevailing price “today” is S0 = 100. At this price the
object “S” can be bought or sold by anyone for any number. A person buying the object “S” today must
pay 100 now, and a person selling the object “S” will receive 100 now. It is common knowledge that the
prevailing price “tomorrow” S1 will either be S1(u) = 125 if the market for “S” is “up” or S1(d) = 80 if the
market for “S” is “down”. A person who purchases a unit of “S” today will receive either 125 or 80
tomorrow (depending on the outcome), and the person who sells a unit of “S” today is obligated to “buy
back” a unit of “S” at the new prevailing market price (125 or 80).
There is also a market for an object called “C”. It may be bought or sold by anyone for any number.
A person who buys the object “C” today must pay $C0 now, and a person who sells the object “C” will
receive $C0 now. A person who buys “C” today has the option but not the obligation to buy 1 unit of the
object “S” tomorrow at today’s market price of 100. A person who sells “C” today has the obligation of
supplying a unit of “S” tomorrow for the price of 100 if a holder of a “C” wishes to exercise his option.
There is also a market for dollars, the so-called money market M. A person who buys m dollars today
receives m dollars today and owes (1.10)m tomorrow; that is, the person is taking out a loan. A person who
sells m dollars today must give m dollars today (to the person buying), and will receive (1.10)m the next
period; that is, when a person sells dollars today, they are acting like a banker in that they are loaning
money to the person buying.
QUESTION: How much is a unit of “C” worth to you? How do you assess its value?
69
OPTION EXAMPLE 1
In each period the stock price may go up by a factor of U = 1.25 or down by a factor of D = 0.80. The
stock price at time 0 is 100. Risk-free rate each period is a constant 10%. Price a one-period call option
with strike price 100. Determine the self-financed replicating portfolio.
125
25
2/3
100
15.15
(0.555S, – 40.40M)
1/3 80
0
NOTES
1. 0.5555 = ΔC/ΔS = [25 – 0] ÷ [125 – 80]

2. The value of the call option at time 0 = (1/1.11)[ 2/3*25 + 1/3*0] = 15.15
3. The money market amount = 15.15 – 0.5555[100] = -40.40
4. State Equations:
h*S1(u) + m*R = C1(u) 125h + 1.1m = 25

h*S1(d) + m*R = C1(d) 80h + 1.1m = 0
70
OPTION EXAMPLE 2
stock price at time 0 is 100. Risk-free rate each period is a constant 10%. Price a one-period put option
with strike price 100. Determine the self-financed replicating portfolio.
125
0
2/3
100
6.06
(-0.444S, 50.50M)
1/3 80
20
NOTES
5. -0.444 = ΔC/ΔS = [0 – 20] ÷ [125 – 80]

6. The value of the put option at time 0 = (1/1.11)[ 2/3*0 + 1/3*20] = 6.06
7. The money market amount = 6.06 – -0.444*[100] = 50.50
8. State Equations:
h*S1(u) + m*R = P1(u) 125h + 1.1m = 0

h*S1(d) + m*R = P1(d) 80h + 1.1m = 25
71
OPTION EXAMPLE 3
stock price at time 0 is 100. Risk-free rate each period is a constant 10%. Price a 2-period call option with
strike price 100. Determine the self-financed replicating portfolio.
156.25
56.25
2/3
125
34.09
2/3 (1.00S, – 90.90M)
100 1/3 100

20.666 0
(0.7575S, – 55.10M) 2/3
1/3 80
0
1/3 64
0
NOTES
9. a. 56.25 = max(156.25 – 100, 0).

b. 0 = max(100 – 100, 0)
c. 0 = max(64 – 100, 0)
d. 34.09 = (1/1.1)[2/3*56.25 + 1/3*0]
e. 1.00 = ΔC/ΔS = [56.25 – 0] ÷ [156.25 – 100]
f. -90.90 = 34.09 – 1.00*125
g. 20.666 = (1/1.1)[2/3*34.09 + 1/3*0]
h. 0.7575 = ΔC/ΔS = [34.09 – 0] ÷ [125 – 80]
i. -55.10 = 20.66 – 0.7575*100
10. The value of the call option at time 0 = (1/1.21)[ 4/9*56.25 + 4/9*0 + 1/9*0 ]
72
OPTION EXAMPLE 4
stock price at time 0 is 100. Risk-free rate each period is a constant 10%. Price a 2-period put option with
156.25
0
2/3
125
0
2/3
100 1/3 100

3.306 0
(-0.242S, 27.55M) 2/3
1/3 80
10.90
(-1.00S, 90.90M)
1/3 64
36
NOTES
11. a. 0 = max(100 – 156.25, 0).

b. 0 = max(100 – 100, 0)
c. 36 = max(100 – 64, 0)
d. 10.90 = (1/1.1)[2/3*0 + 1/3*36]
e. -1.00 = ΔC/ΔS = [0 – 36] ÷ [100 – 64]
f. 90.90 = 10.90 – -1.00*80
g 3.306 = (1/1.1)[2/3*0 + 1/3*10.90]
h 0.2424 = ΔC/ΔS = [0 – 10.90] ÷ [125 – 80]
i 27.55 = 3.306 – -0.2424*100
12. The value of the put option at time 0 = (1/1.21)[ 4/9*0 + 4/9*0 + 1/9*36 ]
13. European Put-Call Parity:
ST + PT – CT = K at time T, which implies that S0 + P0 – C0 = K/(1.1)2.
Verification: 100 + 3.306 – 20.666 = 100/1.21 = 82.645.
73
OPTION EXAMPLE 5
stock price at time 0 is 100. Risk-free rate each period is a constant 10%. Price a 2-period call option with
156.25
76.25
2/3
125
52.27
2/3 (1.00S, – 72.72M)
100 1/3 100

35.36 20
(0.8922S, – 53.87M) 2/3
1/3 80
12.12
(0.555S, – 32.32M)
1/3 64
0
NOTES
14. a. 76.25 = max(156.25 – 80, 0).

b. 20 = max(100 – 80, 0)
c. 0 = max(64 – 80, 0)
d. 52.27 = (1/1.1)[2/3*76.25 + 1/3*20]
e. 1.00 = ΔC/ΔS = [76.25 – 20] ÷ [156.25 – 100]
f. -72.72 = 52.27 – 1.00*125
g. 12.12 = (1/1.1)[2/3*20 + 1/3*0]
h. 0.5556 = ΔC/ΔS = [20 – 0] ÷ [100 – 64]
i. -32.32 = 12.12 – 0.5556*80
j. 35.36 = (1/1.1)[2/3*52.27 + 1/3*12.12]
k. 0.8922 = ΔC/ΔS = [52.27 – 12.12] ÷ [125 – 80]
l. -53.87 = 35.36 – 0.8922*100
15. The value of the call option at time 0 = (1/1.21)[ 4/9*76.25 + 4/9*20 + 1/9*0 ]
74
OPTION EXAMPLE 6
stock price at time 0 is 100. Risk-free rate each period is a constant 10%. Price a 2-period put option with
156.25
0
2/3
125
0
2/3
100 1/3 100

1.469 0
(-0.107S, 12.24M) 2/3
1/3 80
4.84
(-0.444S, 40.40M)
1/3 64
16
NOTES
16. a. 0 = max(80 – 156.25, 0).

b. 0 = max(80 – 100, 0)
c. 16 = max(80 – 64, 0)
d. 4.84 = (1/1.1)[2/3*0 + 1/3*16]
e. -0.444 = ΔC/ΔS = [0 – 16] ÷ [100 – 64]
f. 40.40 = 4.84 – -0.444*80
g. 1.469 = (1/1.1)[2/3*0 + 1/3*4.84]
h. -0.107 = ΔC/ΔS = [0 – 4.84] ÷ [125 – 80]
i. 12.24 = 1.469 – -0.1077*100
17. The value of the put option at time 0 = (1/1.21)[ 4/9*0 + 4/9*0 + 1/9*16 ]
18. European Put-Call Parity:
ST + PT – CT = K at time T, which implies that S0 + P0 – C0 = K/(1.1)2.
Verification: 100 + 1.469 – 35.36 = 80/1.21 = 66.116.
75
76
CHOOSER OPTION
Consider a non-dividend paying stock whose initial stock price is 62 and which has a
log-volatility of σ = 0.20. The interest rate r = 2.5% continuously compounded.
Consider a 5-month option with a strike price of 60 in which after exactly 3 months the
purchaser may declare this option to be a (European) call or put option.
QUESTIONS:
1. Determine the value of U and D for the binomial lattice.
The value for U = exp{σ(Δt)1/2} = exp{0.20(1/12)1/2} = 1.05943.

Note that D = 1/U = 0.94390.
2. Determine the values for the binomial lattice for 5 1-month periods.
0 1 2 3 4 5
62.00 65.68 69.59 73.72 78.11 82.75
58.52 62.00 65.68 69.59 73.72
55.24 58.52 62.00 65.68
Stock Price 52.14 55.24 58.52
49.21 52.14
46.45
3. Determine the appropriate risk-free rate.
The interest rate per month R = exp(0.025*1/12) = 1.00209.
4. Determine the risk-neutral probability q of going “UP”.
The value for q satisfies q(US0) + (1-q)(DS0) = RS0, which implies that
q = (R-D)/(U-D) = 0.5036.
77
5. Determine the values for the call option and put option along the lattice.
0 1 2 3 4 5
4.6686 7.0172 10.1423 13.9743 18.2315 22.7488
2.3054 3.876 6.2971 9.7137 13.7248
0.7216 1.4359 2.8571 5.6849
Call Option 0 0 0
0 0
0
0 1 2 3 4 5
2.0469 0.8344 0.1797 0 0 0
3.2858 1.5022 0.3627 0 0
5.1091 2.6646 0.7322 0
Put Option 7.6107 4.6364 1.4782
10.6604 7.8602
13.5462
6. Find the value of this Chooser Option.
Compute the terminal value of the Chooser Option at t = 3 as the maximum of the call
and put options at t = 3. From there we work backwards in the usual manner.
0 1 2 3 4 5
6.0483 7.3187 10.1423 13.9743
4.7847 4.4847 6.2971
5.1091 2.6646
Chooser Option 7.6107
78
Table 1: A stochastic volatility, random interest rate model
t=0 t=1 t=2

S0 = 4, r0 = 25% S1 (U ) = 8, r1 (U ) = 25% S2 (U U ) = 12
S1 (D) = 2, r1 (D) = 50% S2 (U D) = S2 (DU ) = 8
S2 (DD) = 2
Option Analysis with Stochastic Interest Rates
In this problem we consider a two-period, stochastic volatility, random interest rate model.
The stock prices and interest rates are provided in Table 1.
Consider the European option whose final payoffs are V2 = max{S2 − 7, 0}. Determine the
value of this option at times 0 and 1.
79
Table 2: Solution to the stochastic volatility, random interest rate model
t=0 t=1 t=2

1 1
1.004̄ = 1.25 [0.5(2.4) + 0.5(0.1̄)] 2.4 = 1.25 [0.5(5) + 0.5(1)] 5
1
0.1̄ = 1.5 [(1/6)(1) + (5/6)(0)] 1
0
The risk-neutral q changes along the tree since the risk-free rate is stochastic. Otherwise,
all the calculations are the same, since at each node the replicating portfolio and corresponding
risk-neutral discounted expectation ideas still apply. The solution is provided in Table 2.
80
Asian Option
Consider a non-dividend paying stock S whose price process follows a binomial lattice with
U = 2 and D = 0.5. R = 1.25 and S0 = 4. Define
t
X
Yt := Sk , t = 0, 1, 2, 3
k=0
to be the sum of the stock prices between times zero and t.
1. Consider a (European) Asian call option that expires at time three and has a strike price
K = 4; that is, its payoff at time three is
nY o
3
max − 4, 0 .
4
This is like a European call option, except the payoff of the option is based on the average
stock price rather than the final stock price. Let Vt (s, y) denote the price of this option
at time n if St = s and Yt = y. In particular,
ny o
V3 (s, y) = max − 4, 0 .
4
(a) Develop an algorithm for computing Vt recursively. In particular, write a formula
for Vt in terms of Vt+1 .
(b) Apply the algorithm developed in (a) to compute V0 (4, 4), the price of the Asian
option at time zero.
(c) Provide a formula for δt (s, y), the number of shares of stock that should be held by
the replicating portfolio at time t if St = s and Yt = y.
2. What is the value of a (European) Asian put option that expires at time three and has a
strike price K = 4; that is, its payoff at time three is
n Y3 o
max 4 − ,0 .
4
81
1. Risk-neutral q = 0.5.

(a) Vt (s, y) = (1/1.25) 0.5Vt+1 (us, y + us) + 0.5Vt+1 (ds, y + ds) .
(b) V3 (32, 60) = 11; V3 (8, 36) = 5; V3 (8, 24) = 2; V3 (2, 18) = 0.5; V3 (8, 18) = 0.5;
V3 (2, 12) = V3 (2, 9) = V3 (0.5, 7.5) = 0.
V2 (16, 28) = (1/1.25)[0.5(11) + 0.5(5)] = 6.40.

V2 (4, 16) = (1/1.25)[0.5(2) + 0.5(0.5)] = 1.0.
V2 (4, 10) = (1/1.25)[0.5(0.5) + 0.5(0)] = 0.20.
V2 (1, 7) = (1/1.25)[0.5(0) + 0.5(0)] = 0.
V1 (8, 12) = (1/1.25)[0.5(6.4) + 0.5(1.0)] = 2.96.

V1 (2, 6) = (1/1.25)[0.5(0.2) + 0.5(0)] = 0.08.
V0 (4, 4) = (1/1.25)[0.5(2.96) + 0.5(0.08)] = 1.216.
Remark. The value of this Asian option, 1.216, equals the discounted expectation of
the final payoffs using the risk-free rate and the risk-neutral probability, i.e.,
1 11 + 5 + 2 + 0.5 + 0.5 + 0 + 0 + 0
.
(1.25)3 8
Simulation is an especially useful computational approach for valuing path-

dependent, European-style derivative securities, since their value can be obtained
as a (discounted) sample average of the value along a “sample path.”
(c)
Vt+1 (us, y + us) − Vt+1 (ds, y + ds)
δt (s, y) = .
(u − d)S
82
No Arbitrage Bounds
Consider a family of call options on a non-dividend paying stock, each option being identical
except for its strike price. The value of the call with strike price K is denoted by C(K). Prove
the following two general relations using arbitrage arguments:
1. If K2 > K1 , then
K2 − K1 ≥ C(K1 ) − C(K2 ).
2. If K3 > K2 > K1 , then

K − K K − K
3 2 2 1
C(K2 ) ≤ C(K1 ) + C(K3 ).
K3 − K1 K3 − K1
Hint: For both parts find a portfolio that is guaranteed to have no negative but sometimes
positive final payoffs. If there is to be no arbitrage, such a portfolio must cost something to
acquire today. In each part plot the final payoffs for each portfolio, otherwise known as the
payoff diagram.
83
Solution: For both parts below one finds a portfolio that is guaranteed to have no negative
but sometimes positive final payoffs. If there is to be no arbitrage, such a portfolio must cost
something to acquire today. In each case below it will be instructive to plot the final payoffs
for each portfolio, otherwise known as the payoff diagram.
1. Verify that the portfolio −C(K1 ) + C(K2 ) + (K2 − K1 ) has no negative but sometimes
positive final payoffs. Hence, its cost today must be nonnegative, which establishes the
result.
2. Consider the portfolio mC(K1 ) − C(K2 ) + nC(K3 ) with m, n > 0 and m < 1. This
portfolio’s final payoffs are zero if ST ≤ K1 and will be positive on the interval K1 ≤
ST ≤ K2 . Since m < 1 the payoffs decline on the interval K2 ≤ ST ≤ K3 . If we set m so
that
m(K3 − K1 ) = (K3 − K2 ),
then the payoffs will remain nonnegative in the interval K2 ≤ ST ≤ K3 . In particular,
the payoff when ST = K3 will be zero. If we further set n so that m + n = 1, the final
payoffs will be zero on the interval ST ≥ K3 . We conclude that the portfolio
K − K K − K
3 2 2 1
C(K1 ) − C(K2 ) + C(K3 )
K3 − K1 K3 − K1
has no negative but sometimes positive final payoffs. Hence, its cost today must be
nonnegative, which establishes the result.
84
FINANCIAL OPTION ANALYSIS PROBLEMS
A. We consider a single period binomial lattice with S0 = 50, U = 1.20 (D = 1/1.20) and R = 1.04.
1. a. What is the objective probability of an upward movement in the stock price, p, if the market’s
required expected percentage return on the stock, rS, is 8%? [p = 0.6727]
b. Suppose the objective probability of an upward movement in the stock price p is 0.70. What is
the expected percentage return, rS , on the stock? [rS = 9%]
2. A derivative security C has final payoffs given by C1 = (max [S1 – 50, 0])2, where S1 is the final stock
price. Assume an objective probability of an upward movement in the stock price p = 0.70.
a. Determine the no-arbitrage value C0 for C. [54.1958]

b. Determine the market’s expected percentage return on C (using objective probabilities). [29.16%]
c. Determine the replicating portfolio (hS, mM). [(5.4545S, -218.5315M)]
d. Determine the portfolio weights, wS and wM, on the stock and the money market in the replicating
portfolio. [wS = 5.032, wM = -4.032]
e. Determine the portfolio’s expected percentage return using the portfolio weights and the expected
percentage returns on the stock and bond. [29.16%]
f. Compare your answers to (b) and (e).
85
B. A non-dividend paying stock has an initial price = 100. Its price path is modeled as a binomial lattice
with U = 1.3 and D = 1/1.3. Period length = 1 year. The risk-free rate is 6% per year.
1. Determine the value of a 2 year European put option with strike price K = 100. [7.43]
2. An American put permits the holder to exercise at any date t, and receive the intrinsic value
max (0, K – St). Hence, at each time t, the holder can take one of two possible actions: no exercise, as in a
European option, or exercise. Determine the value of a 2 year American put option with strike price K =
100. [9.84]
86
C. Smith knows that the value of a six month European call option with strike price K = 24 on a non-
dividend paying stock is 6.80. The current value of the stock is 26. However, he wishes to price a
European put option on the same stock with the same strike price and maturity. He knows that the risk-free
rate is 2.50% per year, but he is stuck because he does not know the log-volatility σ upon which he would
calculate the value of U. He comes to you for help. What say you? [4.50]
87
D. Do the following markets exhibit arbitrage? If so, demonstrate. If not, state why not.
1.
Securities
S1 S2
price at time 0 5 10
up state at time 1 20 60
down state at time 1 10 30
2.
Securities
S1 S2 S3
price at time 0 60 115 1
up state at time 1 90 100 1.05
down state at time 1 40 150 1.05
3.
Securities
S1 S2 S3 S4 S5 S6 S7 S8 S9
Price at time 0 20 1 100 100 100 100 200 200 305
Up state at time 1 28 1.05 100 110 140 50 260 160 385
Down state at time 1 14 1.05 110 100 70 160 160 260 245
88
E. The evolution of the stock price over 2 periods is shown in the figure below. Let S2 denote the
(random) value of the stock price at t = 2. The appropriate risk-adjusted rate of return (cost of capital) is
20% per period. The risk-free rate is 4% per period. In this problem we shall consider pricing a European
“square root” derivative security with strike price 140 that pays off ( | S2 – 140 | )1/2 at time t =2.
220
150
115 120
4.733
90
80
1. Determine the objective probabilities along the lattice.
2. Determine the final period payoffs for the “square root” option. (Enter them in the figure.)
3. Determine the Decision-Tree value of the “square root” option by (1) first computing the expectation of
the final period payoffs using the objective probabilities, and then (2) discounting using the risk-adjusted
rate of return.
4. Fill out the above figure by placing the correct value of the “square root” option as the 2nd entry, and
recording the self-financed replicating portfolio as the 3rd entry. Determine the risk-neutral probabilities
along the lattice and mark them with an asterisk.
5. Suppose the current market value of the “square root” option is the Decision-Tree value. Conceptually
explain how you would use your answer to (d) to obtain a risk-free profit from the incorrect pricing. Be
specific about your dynamic trading strategy. (No further calculations are required.)
89
Sample Worksheet 1:
220
150
115 120
5.881
90
80
Sample Worksheet 2:
220
150
115 120
90
80
90
Asset Price Dynamics Example
Data: σ = 0.30, risk-free rate = 0.08. S(0) = 36. 5-month horizon. u = exp(σ Δt ).
One-month intervals:
0 1 2 3 4 5 0 1 2 3 4 5
36.00 39.26 42.61 46.68 50.90 55.51
33.01 36.00 39.26 42.81 46.68
30.27 33.01 36.00 39.26
27.76 30.27 33.01
q = 0.51680 (0.51693) 25.46 27.76
23.35
4.74 2.69 1.10 0.17 0.00 0.00 4.36 2.51 1.04 0.17 0.00 0.00
6.99 4.43 2.10 0.36 0.00 6.40 4.11 1.98 0.36 0.00
9.73 6.99 4.00 0.74 8.94 6.46 3.74 0.74
12.24 9.73 6.99 11.71 9.46 6.99
American Put Option 14.54 12.24 European Put Option 14.28 12.24
16.65 16.65
Half-month intervals:
36.00 38.27 40.69 43.26 45.99 48.90 51.98 55.27 58.76 62.47 66.41
33.86 36.00 38.27 40.69 43.26 45.99 48.90 51.98 55.27 58.76
31.85 33.86 36.00 38.27 40.69 43.26 45.99 48.90 51.98
29.96 31.85 33.86 36.00 38.27 40.69 43.26 45.99
28.18 29.96 31.85 33.86 36.00 38.27 40.69
26.50 28.18 29.96 31.85 33.86 36.00
24.93 26.50 28.18 29.96 31.85
23.45 24.93 26.50 28.18
q = 0.51190 (0.51194) 22.06 23.45 24.93
20.75 22.06
19.51
4.73 3.26 2.03 1.08 0.45 0.11 0.00 0.00 0.00 0.00 0.00
6.30 4.57 3.04 1.76 0.80 0.22 0.00 0.00 0.00 0.00
8.15 6.21 4.40 2.78 1.42 0.46 0.00 0.00 0.00
10.04 8.15 6.14 4.23 2.43 0.95 0.00 0.00
11.82 10.04 8.15 6.14 4.00 1.95 0.00
13.50 11.82 10.04 8.15 6.14 4.00
15.07 13.50 11.82 10.04 8.15
16.55 15.07 13.50 11.82
American Put option 17.94 16.55 15.07
19.25 17.94
20.49
4.41 3.094 1.956 1.058 0.442 0.109 0.00 0.00 0.00 0.00 0.00
5.82 4.309 2.912 1.711 0.794 0.224 0.00 0.00 0.00 0.00
7.444 5.804 4.191 2.685 1.396 0.461 0.00 0.00 0.00
9.216 7.534 5.799 4.056 2.387 0.947 0.00 0.00
11.04 9.405 7.6668 5.833 3.914 1.946 0.00
12.83 11.29 9.644 7.884 6.006 4.00
14.54 13.10 11.56 9.909 8.15
16.15 14.8 13.36 11.82
European Put option 17.68 16.42 15.07
19.12 17.94
20.49
91
Asset Price Dynamics Example
Data: σ = 0.30, risk-free rate = 0.08. S(0) = 36. 5-month horizon. Period length = 0.5 months. u = exp(σ Δt ).
0 1 2 3 4 5 6 7 8 9 10 Prob S10/S0 ln [S10/S0]
(q = 0.5119)
36.00 38.27 40.69 43.26 45.99 48.90 51.98 55.27 58.76 62.47 66.41 0.001235524 1.844802889 0.612372436
33.86 36.00 38.27 40.69 43.26 45.99 48.90 51.98 55.27 58.76 0.011780805 1.632149650 0.489897949
31.85 33.86 36.00 38.27 40.69 43.26 45.99 48.90 51.98 0.050548837 1.444009273 0.367423461
29.96 31.85 33.86 36.00 38.27 40.69 43.26 45.99 0.128529724 1.277556123 0.244948974
28.18 29.96 31.85 33.86 36.00 38.27 40.69 0.214469383 1.130290283 0.122474487
26.50 28.18 29.96 31.85 33.86 36.00 0.245397552 1.000000000 0.000000000
24.93 26.50 28.18 29.96 31.85 0.194990143 0.884728476 -0.122474487
23.45 24.93 26.50 28.18 0.106242502 0.782744477 -0.244948974
22.06 23.45 24.93 0.037988595 0.692516329 -0.367423461
20.75 22.06 0.008049416 0.612688916 -0.489897949
19.51 0.000767517 0.542063331 -0.612372436
0.014574500
E[S10/S0] = 1.03384409
E(ln [S10/S0]) = 0.014574500
NOTES:
1. Δt = 1/24.
2. u = exp(0.30 1 / 24 ) = exp(0.061237244) = 1.063115111.
3. υ = (r – σ2/2) = (0.08 – (0.30)2/2) = 0.035.
4. q = 0.5(1 + 0.035/0.30 1 / 24 ) = 0.511907242.
q = (1.003383780 – 0.940600062)/(1.06315111 – 0.940600062) = 0.512303395.
5. (1 + 0.08/24)10 = 1.033837804.
6. exp(0.08(5/12)) = 1.033895114.
7. E (ln [S1/S0]) = 0.5119(0.061237244) + 0.4881(-0.061237244) = 0.001445199.
8. E (ln [S10/S0]) = 10(0.001445199) = 0.01445199.
9. υ(5/12) = 0.014583333.
10. P(S5 ≤ 38) = 0.593435725.
11. P(S10 ≤ 38) = P{ [ln S10/S0 - (0.035)(5/12)]/[0.30 5 / 12 ] ≤ [ln 38/36 - 0.01458333]/[0.193649167] } = Φ(0.203893921) = 0.580782.
92
FINANCIAL OPTION ANALYSIS SAMPLE PROBLEMS
I. Single-period
1. The price of asset S at time t = 0 is S0 = 20. The asset’s value at time t = 1 is S1(u) = 28 in the up state
is S1(d) = 14 in the down state. The risk-free rate is 5%. The objective probability of the up state is 0.60.
A derivative security V has final payoffs at time t = 1 of V1(u) = 126 in the up state and V1(d) = 84 in the
down state.
a. Determine the expected return, rS, on the asset S.

b. Determine the no-arbitrage value for V.
c. Determine the expected return on V under the objective probabilities.
d. Determine the replicating portfolio for V.
e. Determine the portfolio weights of S and M in the replicating portfolio for V.
f. Show how the answer to (c) can be obtained using the expected returns under the objective
probabilities of the underlying assets in the replicating portfolio.
2. The price of asset S at time t = 0 is S0 = 40. The asset’s value at time t = 1 is S1(u) = 100 in the up
state is S1(d) = 30 in the down state. The risk-free rate is 2.5%. The objective probability of the up state is
0.70. A derivative security V has final payoffs at time t = 1 of V1(u) = 80 in the up state and V1(d) = 50 in
the down state.
a. Determine the expected return, rS, on the asset S.

b. Determine the no-arbitrage value for V.
c. Determine the expected return on V under the objective probabilities.
d. Determine the replicating portfolio for V.
e. Determine the portfolio weights of S and M in the replicating portfolio for V.
f. Show how the answer to (c) can be obtained using the expected returns under the objective
probabilities of the underlying assets in the replicating portfolio.
II. Multi-period
3. A non-dividend paying stock has an initial price S0 = 100. Its price path is modeled as a binomial
lattice with U = 1.25 and D = 0.80. Period length is 1 year. The risk-free rate is 10% per year.
a. Determine the value of a 2 year American call option with strike price K = 90.
b. Determine the value of a 2 year European call option with strike price K = 90.
c. Use Put-Call Parity to value a 2 year European put option with strike price K = 90.
lattice with U = 1.25 and D = 0.80. Period length is 1 year. The risk-free rate is 10% per year.
a. Determine the value of a 2 year American put option with strike price K = 90.
b. Determine the value of a 2 year European put option with strike price K = 90.
c. Use Put-Call Parity to value a 2 year European call option with strike price K = 90.
5. The risk-free rate is 2.5% and the period length equals 3 months. Determine the value of the parameter
U in a binomial lattice if log-volatility σ = 0.60, and determine the value of the risk-neutral probability q.
6. The risk-free rate is 4% and the period length equals 6 months. Determine the value of the parameter
U in a binomial lattice if log-volatility σ = 0.80, and determine the value of the risk-neutral probability q.
93
7. The evolution of the stock price over 2 periods is shown in Figure 1 below. Let S2 denote the (random)
value of the stock price at t = 2. The appropriate risk-adjusted rate of return (cost of capital) is 20% per
period. The risk-free rate is 4% per period. In this problem we wish to price a European derivative
security that pays off ( | S2 – 64 | + | S2 – 114 | + | S2 – 181.50 | ) at time t =2.
a. For each box in the figure below place the correct value of the derivative security as the 2nd entry and
record the self-financed replicating portfolio as the 3rd entry.
181.50
130
100 114
80
64
b. Determine the value at time t = 0 of this derivative security according to DTA.
c. Suppose the current market value of the derivative security is 150. Exactly explain how you could
guarantee a risk-free profit from the incorrect pricing. Be specific with numbers.
94
8. The evolution of the stock price over 2 periods is shown in Figure 1 below. Let S2 denote the (random)
value of the stock price at t = 2. The appropriate risk-adjusted rate of return (cost of capital) is 12% per
period. The risk-free rate is 5% per period. In this problem we wish to price a European derivative
security that pays off | S2 – 119 |1/2 at time t =2.
a. For each box in the figure below place the correct value of the derivative security as the 2nd entry and
record the self-financed replicating portfolio as the 3rd entry.
189
150
100 119
70
49
b. Determine the value at time t = 0 of this derivative security according to DTA.
c. Suppose the current market value of the derivative security is priced according to DTA. Exactly
explain how you could guarantee a risk-free profit from the incorrect pricing. Be specific with numbers.
95
III. Path Dependent
lattice with U = 1.25 and D = 0.80. Period length is 1 year. The risk-free rate is 10% for the first year, and
2.5% for the second year. Determine the value of a 2-year European-style path-dependent derivative
security whose payoff at time t = 2 is max {S0 , S1 , S2 } – S2, namely, the difference between the
maximum stock price observed over the 2-year period and the stock price at time t = 2.
10. The price process of a non-dividend paying stock over the next 2 years is shown in the following table:
t=0 t=1 t=2

100 130 171
80 102
57
The risk-free rate is 5% per year. Define Y2 = S0 + S1 + S2 denote the sum of the stock prices between
times zero and 2. A European Asian put option that expires at time t = 2 and has strike price K = 104 has
its payoff at time t = 2 equal to max{104 - Y2 /3, 0}. (This is like a European put option, except that the
payoff of this option is based on the average stock price rather than the final stock price.) Determine the
no-arbitrage value of this path-dependent option.
11. Consider a binomial lattice with S0 = 4, U = 2 and D = 0.50. The risk-free rate if 25%. A 3-year,
lookback option is a European path-dependent derivative security that pays off
V3 = max{0 ≤ t ≤ 3} St – S3
at time three.
a. Determine the no-arbitrage value of this lookback option.

b. Determine the replicating portfolio at time t = 0.
12. A non-dividend paying stock has an initial price S0 = 36. Its price path is modeled as a binomial lattice
with U = 1.5 and D = 2/3. Period length is 1 year. The risk-free rate is 2.5% for the first year, and 10% for
the second year. Determine the value (to the nearest penny) of a 2-year American-style path-dependent
derivative security whose payoff at any time t, if exercised, is the stock price at time t less the minimum
stock price observed up to this time t.
13. A non-dividend paying stock has an initial price S0 = 36. Its price path is modeled as a binomial lattice
with U = 1.5 and D = 2/3. Period length is 1 year. The risk-free rate is 2.5% for the first year, and 10% for
the second year. Determine the value (to the nearest penny) of a 2-year American-style path-dependent
derivative security whose payoff at any time t, if exercised, is the maximum stock price observed up to this
time t less the stock price at time t.
96
IV. Arbitrage
14. Does the following market exhibit arbitrage? If so, provide a concrete example of arbitrage. If not,
state why not.
Securities
S1 S2 S3 S4 S5 S6 S7 S8 S9
Price at time 0 20 1 100 100 100 100 200 200 305
Up state at time 1 28 1.05 100 110 140 50 260 160 385
Down state at time 1 14 1.05 110 100 70 160 160 260 245
15. Consider dividend-price data for a complete, no-arbitrage market with the following three securities:
Security 1 Security 2 Security 3 Payoff Vector V

Price at t = 0 100 80 1.0 ?
Payoff in state 1 at t = 1 200 0 1.1 420
a. Use the replicating portfolio approach to determine the correct value of the payoff vector V at time 0.
b. Use the risk-neutral approach to determine the correct value of the payoff vector V at time 0.
16. a. Does the following market exhibit arbitrage? If so, provide a concrete example of arbitrage. If
not, state why not.
Securities
S1 S2 S3 S4 S5
Price at time 0 60 8 60 40 22
State 1 125 0 110 0 22
State 2 80 0 110 0 11
State 3 0 28 0 105 21
State 4 0 14 0 105 42
b. Determine the risk-free rate for this market.
17. Consider the following market data:
Securities
S1 S2 S3
Price at time 0 20 10 80
State 1 at time 1 26 10 68
State 2 at time 1 16 11 Z
a. Determine the state-prices y1 and y2.

b. Determine the value of Z in the table so that this market does not exhibit arbitrage.
c. Determine the risk-free rate for this market.
97
V. Asset Price Dynamics
18. Consider a non-dividend paying stock whose price follows Geometric Brownian motion,
dSt = μSt dt + σ St dBt with (annual) parameters μ = 0.20, σ = 0.40, and S0 = 100.
a. Determine the expected value for the stock price after 3 months (0.25 yr).
b. Determine the median value s* for the stock price after 3 months. Recall that s* is defined by the
equation P[S(0.25) ≥ s*] = 0.50.
c. Determine the standard deviation of the stock price after 3 months.
d. Consider a 1-year binomial lattice representation of S with 1-month periods. What is the probability
that a simulated stock price path will have its terminal stock price equal to 100?
19. Consider a non-dividend paying stock whose price follows Geometric Brownian motion,
dSt = μSt dt + σ St dBt with (annual) parameters μ = 0.12, σ = 0.60, and S0 = 100. Risk-free rate is 2.5%.
a. Determine the expected value for the stock price after 6 months (0.50 yr).
b. Determine the median value s* for the stock price after 6 months. Recall that s* is defined by the
equation P[S(0.50) ≥ s*] = 0.50.
c. Determine the standard deviation of the stock price after 6 months.
d. Consider a 1-year binomial lattice representation of S with 2-month periods. What is the probability
that a simulated stock price path will have its terminal stock price equal to 100?
e. Set up the Black-Scholes equation to value a six-month call option on this stock with a strike price of
105. Be explicit but do not calculate.
98
FINANCIAL OPTION ANALYSIS SAMPLE PROBLEM SOLUTIONS
1. a. rS = [0.6(28) + 0.4(14)]/20 - 1 = 0.12.

b. Since [0.5(28) + 0.5(14)]/1.05 = 20, q = 0.5. V0 = [0.5(126) + 0.5(84)]/1.05 = 100.
c. rV = [0.6(126) + 0.4(84)]/100 - 1 = 0.092 or 9.2%.
e. (126-84)/(28-14) = 3. So h = 3. Thus, replicating portfolio is (3S, 40M).
e. 60/100 is invested in S, so wS = 0.6 and wM = 0.4.
f. 0.6(12) + 0.4(5) = 9.2.
2. a. rS = [0.7(50) + 0.3(30)]/40 - 1 = 0.10.

b. Since [0.55(50) + 0.45(30)]/1.025 = 40, q = 0.55. V0 = [0.55(100) + 0.45(50)]/1.025 = 75.61.
c. rV = [0.7(100) + 0.3(50)]/75.61 - 1 = 0.1242 or 12.42%.
e. (100-50)/(50-30) = 2.5. So h = 2.5. Thus, replicating portfolio is (2.5S, -24.39M).
e. 100/75.61 is invested in S, so wS = 1.3226 and wM = -03226.
f. 1.3226(10) - 0.3226(2.5) = 12.42.
3. a.
t=0 t=1 t=2
100 125 [43.182] 156.25 [66.25]
28.0073 = 80 [6.061] 100 [10]
[2/3(43.182)+1/3(6.061)]/1.1 since exercise value = 0 64 [0]
b. [(4/9)(66.25)+(4/9)(10)]/(1.1)2 = 28.0073.
c. 90/(1.1)2 = S + P – C = 100 + P – 28.0073. P = 2.3875.
4. a.
t=0 t=1 t=2
100 125 [0] 156.25 [0]
3.03 = 1/3(10)/1.1 80* [10] 100 [0]
since 10 > 1/3(26)/1.1 64 [26]
b. (1/9)(26)/(1.1)2 = 2.3875.
c. 90/(1.1)2 = S + P – C = 100 + 2.3875 – C. C = 28.0073.
5. U = exp[0.60(0.25)1/2] = 1.3499. q = [exp(0.025*0.25) – 0.7408]/[1.3499 – 0.7408] = 0.4358.
6. U = exp[0.80(0.50)1/2] = 1.7607. q = [exp(0.040*0.50) – 0.5680]/[1.7607 – 0.5680] = 0.3791.
99
7. a. Note: Objective probabilities are in parentheses.
181.50
185
0.314 (0.622)
130
133.36
0.48 (0.80) (1S, 3.36M)
100 114
132.85 0.686 (0.377) 117.5
(-0.185S, 151.3M)
0.384 (0.64)
80
0.52 (0.20) 142.60
(-1S, 222.60M)
0.616 (0.36) 64
167.5
b. [185(0.80*0.622) + 117.5(0.80*0.377 + 0.20*0.64) + 167.5(0.20*0.36)] / (1.2)2 = 107.43.
c. Derivative security is overpriced, so you would want to sell it. Collect 150 and use 132.85 of it to
purchase the replicating portfolio of (–0.1848S, 151.33M). Invest the 17.15 in the bank or buy lunch. If
the price goes up next period to 130, rebalance the portfolio to (1S, 3.36M), which you can afford to do
since it will cost 133.36 and this is precisely what the portfolio (–0.1848S, 151.33M) equals when the price
= 130. If the price goes down next period to 80, rebalance the portfolio to (–1S, 222.60M), which you can
afford to do by the same reasoning as before. Finally, when period 2 comes around, your updated portfolio
will exactly match the final payoffs of the derivative security (185, 117.5 or 167.5) regardless of the final
state and so you will be able to meet your obligations. (If you were forced to buy back the derivative
security at time 1, you would have the exact money to do so.)
100
8. a. Note: Objective probabilities are in parentheses.
189
8.3667
0.55 (0.7)
150
4.3825
0.4375 (0.525) (0.1195S, -13.5459M)
100 119
4.6007 0.45 (0.3) 0
(-0.00996S, 5.5967M)
0.35 (0.42)
70
0.5625 (0.475) 5.1793
(-0.1195S, 13.5459M)
0.65 (0.58) 49
8.3667
b. 8.367[(0.525)(0.7) + (0.475)(0.58)] / (1.12)2 = 4.289.
c. Derivative security is underpriced, so you would want to buy it. Sell the RP for 4.6007, i.e., acquire
the portfolio (0.00996S, -5.5967M), and buy the derivative security for 4.289. Collect 0.3117 and invest it
in the bank. If the price goes up next period to 150, you owe 4.3825. Purchase the new RP of (-0.1195S,
13.5459M), collect 4.3825 and pay off the obligation. If the price goes down next period to 80, you owe
5.1793. Purchase the new RP of (0.1195S, -13.5459M), collect 5.1793 and pay off the obligation. Finally,
when period 2 comes around, your updated portfolio’s obligation will exactly match the final payoffs of the
derivative security (8.3667, 0 or 8.3667) regardless of the final state, and so you will be able to meet your
obligations.
9. There are four possible paths. The payoffs in the states uu, ud, du, dd are, respectively, 0, 25, 0, 36.
Thus, the time 0 no-arbitrage value is [(2/3)(0.5)(25)]/(1.1)(1.025) + [(1/3)(0.5)(36)]/(1.1)(1.025) = 12.71.
10. There are four possible paths. The average values along the uu, ud, du, and dd paths are, respectively,
133.67, 110.67, 94, and 79. The values of the Asian put option for these paths are, respectively, 0, 0, 10,
and 25. The q probability of path du is (0.5)(0.6) = 0.3, and the q probability of path dd is (0.5)(0.4) = 0.2.
Therefore, the time 0 no-arbitrage value is [(0.3)(10) + (0.2)(25)]/(1.05)2 = 7.2562.
11. a. The final payoffs of this lookback option in states uuu, uud, udu, udd, duu, dud, ddu, ddd are,
respectively, 32-32=0, 16-8=8, 8-8=0, 8-2=6, 8-8=0, 4-2=2, 4-2=2, 4-0.5=3.5. Since the q probability is
0.5, the time 0 no-arbitrage value is [(0+8+0+6+0+2+2+3.5)/8]/1.253 = 1.376.
b. To determine the RP at time t = 0, we have to find the time 1 no-arbitrage values of this lookback
option. The time 1 value when S = 8 is [(0+8+0+6)/4]/1.252 = 2.24, and the time 1 value when S = 2 is
[(0+2+2+3.5)/4]/1.252 = 1.20. (Notice how [0.5(2.24)+0.5(1.20)]/1.25 = 1.376, as it should.) So, the RP is
(0.1733S, 0.6827M).
101
12.
Stock price paths option value over time
36 54 uu: 81 12.0787 21.2727 45
ud: 36 0
24 du: 36 5.6727 12
dd: 16 0
Risk-neutral probability q1 = 0.43 and q2 = 52.

21.2727 = max{ [0.52(45) + 0.48(0)]/1.1, 54- 36 }.
5.6727 = max{ [0.52(12) + 0.48(0)]/1.1, 24- 24 }.
12.0787 = [0.43(21.2727) + 0.57(5.6727)]/1.025.
13.
Stock price paths option value over time
36 54 uu: 81 7.8545 0
ud: 36 18
24 du: 36 12* 0
dd: 16 20
Risk-neutral probability q1 = 0.43 and q2 = 52.

7.8545 = max{ [0.52(0) + 0.48(18)]/1.1, 54- 54 }.
12 = max{ [0.52(0) + 0.48(18)]/1.1, 36- 24 }. (Exercise.)
9.9682 = [0.43(7.8545) + 0.57(12)]/1.025.
14. First four securities show that q = 0.5.

To be consistent, the value S9 = [0.5(385) + 0.5(245)]/1.05 = 300, which is less than 305.
The portfolio (10S1, 100S2) replicates S9 and costs 300.
So sell S9 for 305 and buy this replicating portfolio for 300, and pocket the difference of 5.
15. a. Since S2 does not payoff in either state 1 or 2 only S1 and S3 can be used to replicate the payoffs
of the Vector V in these two states. (S3 is of course our old friend M.) We’re back to the “(hS1, M)”:
here, h = (420-460)/(200-240) = 1 and M = S3 = 200. Now use state 3 to pin down the number of units of
S2 to hold: 176(S2) + 1.1(200) = 44 ⇒ S2 = -1. Thus, the replicating portfolio is (1S1, –1S2, 200S3) for
a cost today of 220.
b. Let q = (q1, q2, q3) denote the risk-neutral probability vector. Obviously R = 1.1. Discounted
expectation using q and R applied to S2 implies that (1/1.1)176q3 = 80 ⇒ q3 = 0.5. Thus, q1 + q2 = 0.5.
Discounted expectation using q and R applied to S1 implies that (1/1.1)[200q1 + 240q2] = 100 ⇒ q1 =q2 =
0.25. Risk-neutral valuation says that (1/R)Eq[V] = (1/R) qTV = p for any vector V. Thus, the value of V is
(1/1.1)[0.25(420) + 0.25(460) + 0.5(44)] = 220, which coincides with the answer in part (a), as it should.
102
16. a. We can use the first four assets to determine the state-prices.
The equations are:
125y1 + 80y2 = 60. 110y1 + 110y2 = 60. These equations imply that y1 = 4/11, y2 = 2/11.
Now we can use these state-prices to determine the no-arbitrage value of asset 5 as:
(4/11)22 + (2/11)11 + (4/21)21 + (4/21)42 = 22.
Since this IS the price of asset 5, this market does NOT exhibit arbitrage.
b. Recall that the reciprocal of the sum of the state-prices equals R = 1 + risk-free rate.
Thus, R = 1/(4/11 + 2/11 + 4/21 + 4/21) = 231/214 = 1.0794. r = 7.94%.
Alternatively, one can easily combine assets 3 and 4 to obtain a constant payoff vector.
For example, a purchase of 1 unit of asset 3 and 110/105 units of asset 4 yields a constant
payoff of 110. The cost of this portfolio is 60(1) + 40(110/105) = 101.905. Thus, the
total return on the risk-free security is 110/101.905 = 1.0794, same as above, as it should.
17. a. The equations are:

b. 80 = 68y1 + Zy2 = 68(10/21) + Z(10/21). So, Z = 100.
c. R = 1/(y1 + y2) = 1.05. So risk-free rate is 5% in this market.
103
18. a. E[S(0.25)] = S(0)exp(0.20*0.25) = 105.127.
b. υ = 0.20 – (0.40)2/2 = 0.12.

ln[S(0.25)/S(0)] ~ Normal with mean = 0.12(0.25) and variance = (0.40)2(0.25). The mean
and median values are the same for a normally distributed random variable, and so the
median value of ln[S(0.25)/S(0)] is 0.03, which implies the median value for S(0.25) is
100*exp(0.03) = 103.045.
c. ln [S(t)/S(0)] := X(t) ~ N(υt, σ2t), where υ = µ - 0.5*σ2 = 0.12.

S(t) = S(0)exp[X(t)].
E[S(t)] = S(0)E[exp(X(t))] = S(0)exp[υt + 0.5σ2t]
= 100exp[0.12(0.25) + 0.5(0.16)(0.25)] (when t = 0.25)
= 100exp(0.05) = 105.127. (Same answer as part a.)
E[S(t)2] = S(0)2E[exp(2X(t))] = S(0)2exp[2υt + 2σ2t]
= 10000exp[0.06+0.08] = 11502.74 (when t = 0.25).
Var[S(0.25)] = 11502.74 – (105.127)2 = 451.05.
Stdev[S(0.25)] = 21.24.
d. p = 0.5(1 + (0.12/0.40)(1/12)1/2) = 0.5433.

For a simulated stock price at the end of the 12th month to have a value of 100, there must have
been exactly 6 “up” and 6 “down” transitions. The probability of this occurrence is
therefore (12C 6)*(0.5433)6(0.4567)6 = 0.2156.
19. a. E[S(0.50)] = S(0)exp(0.12*0.50) = 106.184.
b. υ = 0.12 – (0.60)2/2 = -0.06.

ln[S(0.50)/S(0)] ~ Normal with mean = (-0.06)(0.50) and variance = (0.60)2(0.50). The mean
and median values are the same for a normally distributed random variable, and so the
median value of ln[S(0.50)/S(0)] is -0.06, which implies the median value for S(0.50) is
100*exp(-0.06) = 94.176.
c. ln [S(t)/S(0)] := X(t) ~ N(υt, σ2t), where υ = µ - 0.5*σ2 = -0.06.

S(t) = S(0)exp[X(t)].
E[S(t)] = S(0)E[exp(X(t))] = S(0)exp[υt + 0.5σ2t]
= 100exp[-0.06(0.50) + 0.5(0.36)(0.50)] (when t = 0.50)
= 100exp(0.06) = 106.184. (Same answer as part a.)
E[S(t)2] = S(0)2E[exp(2X(t))] = S(0)2exp[2υt + 2σ2t]
= 10000exp[-0.06+0.36] = 13498.59 (when t = 0.50).
Var[S(0.50)] = 13498.59 – (106.184)2 = 2223.55.
Stdev[S(0.50)] = 47.15.
d. p = 0.5(1 + (-0.06/0.60)(2/12)1/2) = 0.4796.

For a simulated stock price at the end of the 12th month to have a value of 100, there must have
been exactly 3 “up” and 3 “down” transitions. (Period length = 2 months.) The probability of this
occurrence is therefore (6C3)*(0.4796)3(0.5204)3 = 0.3109.
e. d1 = [ln(100/105) + (0.025 + 0.62/2)(0.50)]/[0.60(0.50)1/2] = 0.1266.

d2 = 0.1266 – 0.60(0.50)1/2 = -0.2977.
Kexp(-rT) = 105exp(-0.025(0.50)) = 103.696.
C = 100Φ(0.1266) – 103.696Φ(-0.2977).
104
REAL OPTIONS ANALYSIS
HANDOUTS
105
106
REAL OPTION ANALYSIS EXAMPLE 1
A company is considering investing in a project. The present value (PV) of future discounted expected
cash flows is either 3000 if the market goes up or 500 if the market goes down next year. The objective
probability the market will go up is 20%. The appropriate risk-adjusted rate of return (cost of capital) is
25%. The initial capital investment required at time 0 is 1200. The risk-free rate is 10% per year.
a. Determine the PV of the project at time 0.
b. Determine the NPV of the project at time 0.
c. Should the company invest in this project?
d. Upon closer inspection the CFO realizes the company actually has some flexibility in managing this
project. Specifically, if the market goes down, the company can abandon the project, and liquidate its
original capital investment for 75% of its original value. If, however, the market should go up, the
company could expand operations, which would result in twice the original PV. To expand the company
will have to make an additional capital expenditure of 800. The CFO wants to know if the company should
now proceed with the project with the added flexibilities, and asks for you advice. Use the original project
without flexibility as the traded underlying security.
107
cash flows is either 8000 if the market goes up or 3000 if the market goes down next year. The objective
25%. The initial capital investment required at time 0 is 4000. The risk-free rate is 5% per year.
a. Determine the PV of the project without flexibility at time 0.
b. Determine the NPV of the project without flexibility at time 0.
c. Should the company invest in this project without flexibility?
d. Suppose the company has some flexibility in managing this project. Specifically, if the market goes
down, the company can abandon the project, and liquidate its original capital investment (at time 0) for
50% of its original value. If, however, the market should go up, the company could expand operations.
With expansion the PV (as seen at the end of next year) will be 50% larger than the original PV forecast.
To expand the company will have to make an additional capital expenditure of 1000. Using the original
project without flexibility as the traded underlying security, determine the ROA value of this project with
flexibility.
108
cash flows is either 10,000 if the market goes up or 5,000 if the market goes down next year. The objective
25%. The initial capital investment required at time 0 is 8,000. The risk-free rate is 10% per year.
d. The company has some flexibility in managing this project. Specifically, if the market goes down, the
company can abandon the project, and liquidate its original capital investment for 50% of its original value.
If, however, the market should go up, the company could expand operations, which would result in twice
the original PV. To expand the company will have to make an additional capital expenditure of 4,000.
Determine the ROA value of this project with flexibility. Use the original project without flexibility as the
traded underlying security.
e. What is the cost of capital that will yield the correct value if the objective probabilities are used?
109
110
A DELAY OPTION EXAMPLE
The real-estate price for a one-unit condominium, P, is currently $100 thousand. Next year the price
will, with equal probability, rise to either $150 thousand, if the market moves favorably, or decline to $90
thousand, if the market moves unfavorably.
The construction cost (both now and next year) for a 6-unit building is $80 thousand per unit, and $90
thousand for a 9-unit building. Construction is instantaneous, and rent covers operating expenses, so no
free cash flow is generated now or next year. The risk-free rate is 10%.
Questions:
1. Should the company invest in this real estate construction project?
2. What is the value of this real estate construction project?
3. Let St denote the price of a non-dividend paying stock. The price process of S follows a binomial
lattice with U = 1.5 and D = 0.90. S0 = 100 and R = 1.1. Let C(T, K) denote a European call option on S
with a maturity of T years and strike price of K.
a. Determine the time 0 price of C(1, 80).
b. Determine the time 0 price of C(1, 110).
c. Determine the cost of the portfolio of 6C(1, 80) +3C(1, 110).
d. Compare the answers to questions 2 and 3(c).
e. Let V1(P1) denote the final payoffs of this real estate construction project. Write a formula for V1(P1).
Here, we consider the general case P1 ≥ 0.
f. Graphically depict the function V1( · ). (Label the x-axis P1 and the y-axis V1(P1).)
g. Use (f) to explain (d).
4. What is the value of this real estate construction project if the delay option last for two years?
111
112
A REDEVELOPMENT OPTION EXAMPLE
A real estate developer has the opportunity to redevelop a parcel of land over the next 5 years. Here is
the relevant information:
The project is valued today at 12.5 million.
The project’s (yearly) value follows a binomial lattice with U = 1.5 and D = 2/3.
The project pays no dividends.
The cost to develop the land today is 10 million. The development cost increases 10% each year.
At the beginning of each year it costs 0.5 million to maintain the land if it is not developed for the
upcoming year. If the land is developed, then there is no maintenance cost.
During any year the developer may abandon the project and receive 1.2 million.
The objective probability of the market going up is 70%.
The risk-free rate is 10%.
The real estate developer sees this redevelopment project as a great opportunity. In fact, she is ready to
develop the land today, as she has calculated its NPV at 2.5 million. She asks your consulting company for
advice on what to do.
113
114
REDEVELOPMENT OPTION SOLUTION
0 1 2 3 4 5
12.50 18.75 28.13 42.19 63.28 94.92
8.33 12.50 18.75 28.13 42.19
5.56 8.33 12.50 18.75
3.70 5.56 8.33
Project Value Event Tree Without Options 2.47 3.70
1.65
Capital Investment
10.00 11.00 12.10 13.31 14.64 16.11
Maintenance Cost
0.50 0.50 0.50 0.50 0.50
0 1 2 3 4 5
4 2 1
4.12 8.41 16.03 28.88 48.64 78.81
5
1.47 3.06 6.43 13.49 26.08
3
1.20 1.20 1.27 2.64
1.20 1.20 1.20
Project NPV Event Tree With Options 1.20 1.20
1.20
The numbers in bold signify the development project should be undertaken. Since the developer could
begin development today for an NPV of 2.5 million, and since the value of the development when the delay
option exists is 4.12 million, the developer would be willing to pay up to 1.62 million to acquire these
options.
q = (R – D)/(U – D) = (1.1 – 2/3)/(1.5 – 2/3) = 0.52.

1
78.81 = 94.92 – 16.11.
2
48.64 = max{ Develop: 63.28 – 14.64, Continue: [0.52(78.81) + 0.48(26.08)]/1.1 – 0.50, Abandon: 1.20}.
3
4
5
115
116
A GROWTH OPTION EXAMPLE
A biotech project involves a pioneer venture stage to first prove the new technology in order to
establish its viability for future commercial development of spin-off products. The pioneer venture
involves high initial costs and insufficient projected cash inflows. If the technology proves successful,
subsequent product commercialization can be many times the size of the pioneer venture.
Consider the following data for a particular biotech project.
• The pioneer venture requires an initial investment outlay of I0 = $100 million, and expected cash
inflows over two years of C1 = $54 million and C2 = $36 million.
• The follow-on product commercialization stage will become available at the end of year two, and
its expected cash flows are 10 times the size of the pioneer venture. That is, I2 = $1,000 million,
and the expected cash inflows over the subsequent two years are C3 = $540 million and C4 = $360
million.
• The cost of capital is 20% and the risk-free rate is 2.5%. (All rates are compounded annually.)
Questions:
1. Should the company invest in the pioneer venture?
2. Should the company invest in the follow-on product commercialization stage?
3. Should the company invest in this biotech project?
117
118
A TREE FARM EXAMPLE
You are considering an investment in a tree farm. Here are the relevant data:
• Trees grow each year by the following factors:
Year 1 2 3 4 5 6 7 8 9 10
Growth 1.6 1.5 1.4 1.3 1.2 1.15 1.1 1.05 1.02 1.01
• Thus, if the initial number of trees is X, then at the end of one year there would be 1.6X trees, at
the end of 2 years there would be 2.4X, etc.
• The price of lumber follows a binomial lattice with U = 1.20 and D = 0.90.
• The risk-free rate is 10%.
• 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 down the trees at the beginning of any year, collect the proceeds and not have to pay
rent after that.
What is the real options value of this investment opportunity? [ROA_TreeFarmExample.hava]
119
120
A GOLD MINE EXAMPLE
A company has the option to acquire a ten-year lease to extract gold from a gold mine. The
lease should be acquired if its cost is less than the value of the lease.
• The mine capacity is 50,000 ounces.
• When the begin-of-year mine inventory is I, the cost to mine Q ounces for the
upcoming year is 500*Q2/I.
• Production occurs instantaneously.
• Profits each year accrue at the beginning of the year.
• The price of gold follows a binomial lattice with parameters U = 1.25 and D = 0.80.
• The risk-free rate is 2.5%.
Determine the real options value of the gold mine lease.
[NRA_StochasticAnalysis.01.hava and NRA_StochasticAnalysis.02.hava]
121
122
REAL OPTIONS CASE STUDY
ExpectedCashFlows
Period 0 1 2 3 4 5 6 7
Price 30 27.67 25.51 23.53 21.7 20.01
Quantity 200 230 264 303 349 401
UnitCost 9 8.6 8.1 7.7 7.4 7
Revenue 6000 6364 6735 7130 7573 8024
Cost 1800 1978 2138 2333 2583 2807
GrossIncome 4200 4386 4597 4797 4990 5217
Rent 200 200 200 200 200 200
SGA 600 637 676 718 763 810
EBITDA 3400 3549 3721 3879 4027 4207
Depr 3500 3500 3500 3500 3500 3500
EBIT -100 49 221 379 527 707
Taxes 0 20 88 152 211 283
NetIncome -100 29 133 227 316 424
Depr 3500 3500 3500 3500 3500 3500
Investment 35000 0 0 0 0 0 0
FreeCashFlow -35000 3400 3529 3633 3727 3816 3924
ContinueValue 51012
PresentValue 34707 36125 37611 39199 40914 42778 44793
NetPresentValue -293 39525 41140 42832 44641 46594 48717
FCFPercentage 0.086 0.0858 0.0848 0.0835 0.0819 0.0805
OPTIONS:
• Expand: Increases future cash flow by 30% at a cost of 10500
• Abandon: Liquidate hardware investment for 15000
ASSUMPTIONS:
• Price and Quantity independent stochastic processes
• 95% lower confidence interval value for price is 15
• 95% lower confidence interval value for quantity is 190
• Risk-free rate = 2.5%
• Free cash flow percentage is 8.5% each year
CALCULATIONS:
• 51,012 = 3924(1.04)/(0.12 – 0.04)

• ln P ~ N(-0.081, 0.06432) [30e(-0.081*5) = 20. -2 = (ln Pα/P1 - 5νP)/√5νP.]
• ln Q ~ N(0.139, 0.16652) [200e(0.139*5) = 400. -2 = (ln Qα/Q1 - 5νQ)/√5νQ.]
• Simulated standard deviation of first period ln Return is 0.36
• U = 1.433330, D = 0.697676
• q = 0.445371
123
ROA Binomial Lattice
0 1 2 3 4 5 6
193021
16407
235505
147176
12510
177076
112220 93953
9539 7986
132524 109243
85566 71638
7273 6089
98544 80803
65243 54623 45732
5547 4643 3887
72652 59117 47785
49747 41649 34870
4228 3540 2964
54750 41616 35762
34707 31757 26588 22260
0 2699 2260 1892
39308 35057 28464 22260
Inv 35000 24214 20273 16973
ROA 4308 2058 1723 1443
OV 4601 28703 23991 19724
15458 12942 10836
1314 1100 921
21106 18309 15921
9868 8261
839 702
17324 15974
6299 5274
535 448
15773 15448
4021
342
15342
2567
218
15218
First value = project value without flexibility. Second value = free cash flow.
Third value = project value with flexibility. Bold means Expand. Italic means Abandon
CALCULATIONS:
• U*(1 – div) = 1.3115. D*(1 – div) = 0.6384.
• [1.3*(0.915*V) – 10,500] + 0.085*V = 1.2745*V – 10,500.
[ROCS_Analysis.hava]
124
Real Options Analysis
In these notes we show how to apply Real Options Analysis (ROA). We will develop the
ideas by examining five “classic” Real Options problems. We will also illustrate the potential
pitfalls of applying Decision Tree Analysis (DTA), a close companion of ROA.
1 The Delay Option
1.1 Background information
Relevant information pertaining to a project under consideration is as follows:
1. In year 1, the project’s present value (of discounted expected subsequent future) cash flow
will be 1500 if the market goes up next year and will be 666.6̄ if the market goes down
next year. The project’s present value cash flow in year 2 will be as follows: if the market
goes up two consecutive years, then it will be 2250; if the market goes up and then down
or down and then up, then it will be 1000; if the market goes down two consecutive years,
then it will be 444.4̄.
2. The project pays no dividends.
3. The probability of the market going up each year is 0.70.
4. The project’s initial investment I0 (at time 0) is 1050.
5. It is possible to delay the project one year. To do so will cost the company 175 today,
and the required investment next year will increase by 10%.
6. In year 1 the company can spend an additional 25 (at time 1) to delay the project one
more year. The required investment will increase by another 10%.
7. There is a tradable (non-dividend) security S whose current price is 100. Its price process
follows a binomial lattice with U = 1.5 and D = U −1 = 0.6̄.
8. The risk-free rate is 5%.
1.2 Analysis of the project without the delay option
The first step is to determine the project’s value today. The project’s payoffs P are perfectly
correlated with the tradable security, i.e., P = 10S. Thus, the market value of P today must
be 1000. This is the present value of the project.
125
The project’s initial investment I0 (at time 0) is 1050. The project’s Net Present Value
(N P V ) is given by
N P V = P V − I0 = 1000 − 1050 = −50 < 0. (1)
Since the NPV is negative, the project without the delay option should be rejected.
1.3 Analysis of the one year delay option
Consider the project with the one year delay option. Its value next year is determined, as
follows. If the market goes up, the company should make the investment, and its value is
1500 − (1.1)(1050) = 345; (2)
if, however, the market goes down, then its value is zero since the company would not make
the investment.
What is the value today for such a risky payoff? We examine two approaches.
DTA analysis
Let’s first examine how traditional DT A would analyze this opportunity. The project’s cost of
capital is 25% since
0.7(1500) + 0.3(666.6̄)
= 1000. (3)
1.25
Accordingly, using DT A the NPV would be determined as follows:
(0.7)(345) + (0.3)(0)
NPV = − 175 = 18.2 > 0. (4)
1.25
Since the NPV is positive, traditional DTA says the project with the one year delay option
should be undertaken and implemented next year only if the market goes up.
ROA analysis
The use of DT A is not correct given the present setup. Let’s use Real Options Analysis (ROA)
to see why. The risk-neutral probability of the market going up is 0.46, since
0.46(150) + 0.54(66.6̄)
= 100. (5)
1.05
126
Therefore, the correct value of the project today is computed as
0.46(345) + 0.54(0)
− 175 = −23.86 < 0, (6)
1.05
and so the correct N P V says the delay option and the project should be rejected.
How can we verify/explain this? The P V of the project is 151.14 since
151.14 − 175 = −23.86. (7)
Since
∆P 345 − 0
= = 4.14, (8)
∆S 150 − 66.6̄
the replicating portfolio of S and the money market M is
(4.14S, −262.86M ), (9)
which, not surprisingly, costs 151.14 to purchase. This portfolio’s value next year will either be
345 if the market goes up or 0 if the market goes down, which exactly matches the value of the
project with the delay option.
If someone insists the correct PV is 193.2 (193.2 = 18.2 + 175), then, in principle, you
sell this person a “similar” project for 193.2 and buy the replicating portfolio for 151.14. The
replicating portfolio will fully hedge your position and you will make 193.2 − 151.14 = 42.06
today, risk-free.
Remark. Using DT A can work, but only if the cost of capital is properly adjusted. The
expected value of next year’s project value using the objective probabilities is (0.7)(345) = 241.5.
Consequently, if one uses a cost of capital of 59.79%, then the P V will be 151.14, as required.
As we have remarked in class, it is often difficult to arrive at correct values for the cost of
capital at each project state since the project’s risk characteristics typically change over the
life of the project. Recall there is another way to arrive at the cost of capital of 59.79%. The
replicating portfolio weights are
wS = 4.14(100)/151.14 = 2.739 (10)

wM = −262.86/151.14 = −1.739, (11)
respectively. Since rS = 25% and rM = 5%, the replicating portfolio’s expected return is
2.739(25) − 1.739(5) = 59.79. (12)
127
Table 1: Project value event tree without flexibility
t=0 t=1 t=2

1000 1500.00 2250.00
666.66 1000.00
444.44
Sensitivity analysis
Let ρ denote the “premium” cost today to delay the project, and let 100γ% denote the percent-
age increase in the required investment. As a function of ρ and γ, it is possible to determine
the acceptance region for the project.
In what follows we assume that γ > 0 and (1 + θ)(1050) < 1500. As a function of ρ and γ,
the project’s correct N P V is
0.46[1500 − (1 + γ)1050]
− ρ, (13)
1.05
which must be positive if the project with the delay option is to be accepted. The acceptance
region is therefore
{(γ, ρ) : 197.14 ≥ 460γ + ρ}. (14)
1.4 Analysis of the two year delay option
Project value event tree without flexibility
Table 1 records the “Project value event tree without flexibility,” which we take as our under-
lying tradable security or the “twin security.”
Project value event tree with flexibility
The project with flexibility may be viewed as a collection of options on the underlying security.
Table 2 records the “Project NPV event tree with flexibility” according to ROA. Here is how
these numbers were obtained.
The project will not be undertaken next year if the market goes down. We need to assess
the correct project value (with the delay options) if the market goes up. If the project is not
delayed one more year, then the project’s value is 345, as before. However, the company does
128
Table 2: Project NPV event tree with flexibility (* = delay)
t=0 t=1 t=2

*2.04 *404.11 979.50
0.00 0.00
0.00
have the option to delay one more year, and this option must be considered at this point in
time. If the company chooses to delay one more year, the discounted expected project value
using the risk-neutral probability is
0.46[1.5(1500) − (1.1)2 (1050)]

= 429.11. (15)
1.05
After subtracting the cost of 25 the value in this state is 404.11. Since 404.11 > 345 it is
optimal to delay the project 1 more year should the market go up next year. We conclude that
the project’s value next year is thus 404.11 if the market goes up and 0 if the market goes down.
The correct N P V for this project (with the delay options) is therefore equal to
0.46(404.11)
− 175 = 2.04 > 0, (16)
1.05
and so the project with the two year delay option should be accepted.
129
2 Option to Contract Operations
A company is considering investing two projects. Relevant information is as follows:
1. Each project requires an initial investment of 80 million.
2. Each project has a present value without flexibility of 100 million.
3. Each project pays no dividends.
4. The annual volatility for the present value of project 1 is 40% (i.e. σ = 0.40) whereas the
annual volatility for the present value of project 2 is 20%.
5. The appropriate cost of capital for each project is 12%.
6. The company has only 80 million to spend on new investment, so only one project may
be selected.
7. With each project it is possible to contract operations by 40% at any time during the
next two years. If operations are contracted, the salvage value (cash received) for project
1 is 33 million and 42 million for project 2.
2.2 Analysis of the projects without the option to contract
Tables 3 and 4 record the respective project value event trees without flexibility. For project 1
1/2 1/2
the value for U = eσ(∆t) = e0.40(1) = 1.4918 (and so D = 1/U = 0.6703) and for project 2
1/2 1/2
the value for U = eσ(∆t) = e0.20(1) = 1.2214 (and so D = 1/U = 0.8187).
With an initial investment of 80 million, each project has an NPV of 20 million, which is
positive. Therefore, the company should invest in one of the projects.
For subsequent reference the value event tree for each project has 6 “nodes”, which we shall
label, respectively, as {0, u, d, uu, ud = du, dd}.
130
Table 3: Project 1 value event tree without flexibility
t=0 t=1 t=2

100 149.18 222.55
67.03 100.00
44.93
Table 4: Project 2 value event tree without flexibility
t=0 t=1 t=2

100 122.14 149.18
81.87 100.00
67.03
2.3 DTA Analysis
DTA uses the objective probabilities and the cost of capital for the project without flexibility.
Let pi denote the probability for the “up” state for project i, i = 1, 2. Since the cost of capital
for each project is 12%, it follows that
149.18p1 + 67.03(1 − p1 )
= 100 =⇒ p1 = 0.547, (17)
1.12
122.14p2 + 81.87(1 − p2 )
= 100 =⇒ p2 = 0.748. (18)
1.12
Analysis of project 1
Table 5 records the NPV event tree with flexibility using DTA. Here is how these numbers were
obtained.
Table 5: Project 1 NPV event tree with flexibility using DTA (* = contract)
t=0 t=1 t=2

22.47 149.18 222.55
*73.22 100.00
*59.96
131
Table 6: Project 2 NPV event tree with flexibility using DTA (* = contract)
t=0 t=1 t=2

22.36 122.58 149.18
*91.09 *102.00
*82.22
We must work backwards through the value event tree. Assume the company has reached
year 2 and has not yet exercised its option to contract. It does not pay to contract in states
uu and ud, and so their respective values remain the same at 222.55 and 100, respectively. In
state dd it does pay to contact since
0.6(44.93) + 33 = 59.96 > 44.93, (19)
and so the value here is 59.96.
Now let’s move back to year 1, and suppose the company has not yet exercised its option
to contract. In state u it would not pay to contract. Now consider state d. If the company
chooses to contract now, then the value would be
0.6(67.03) + 33 = 73.22. (20)
The company can, however, choose not to contract, and then the value would be
0.547(100) + 0.453(59.96)
= 73.09. (21)
1.12
The best choice at state d is therefore to contract, and the associated value is 73.22.
Now let’s move back to year 0. Its value is
0.547(149.18) + 0.453(73.22)
= 102.47, (22)
1.12
which gives an N P V of 102.47 − 80 = 22.47.
According to DT A the option to contract is worth 2.47. Moreover, according to DT A the

option to contract should be exercised in year 1 if state d occurs.
Table 6 records the NPV event tree with flexibility using DTA. Here is how these numbers are
obtained.
132
year 2 and has not yet exercised its option to contract. It does not pay to contract in state uu,
and so its value remains the same at 149.18. In state ud it does pay to contact since
0.6(100) + 42 = 102 > 100, (23)
and so the value in state ud is 102. In state dd it also pays to contact since
0.6(67.03) + 42 = 82.22 > 67.03, (24)
and so the value in state dd is 82.22.
to contract. In state u it would not pay to contract. Its (new) P V is
0.748(149.18) + 0.252(102)
= 122.58. (25)
1.12
Now consider state d. If the company chose to contract now, then the value would be
0.6(81.87) + 42 = 91.09. (26)
The company can, however, choose not to contract, and then the value would be
0.748(102) + 0.252(82.22)
= 85.29. (27)
1.12
The best choice is therefore to contract in state d, and the associated value is 91.09.
Now let’s move back to year 0. Its value according to DT A is

0.748(122.58) + 0.252(91.09)
= 102.36, (28)
1.12
which gives an N P V of 102.36 − 80 = 22.36.
According to DT A the option to contract for project 2 is worth 2.36. Moreover, according
to DT A the option to contract should be exercised in year 1 if state d occurs or in year 2 if
state ud occurs.
Since the NPV for project 1 (2.47) is higher than that for project 2 (2.36), the company
should invest in project 1 according to DTA.
2.4 ROA Analysis
ROA uses the risk-neutral probabilities and the risk-free rate to perform the discounted ex-
pectation for valuation purposes when working backwards through the P V tree. Using ROA
requires that an underlying marketable security be identified that can be used to construct the
replicating portfolio; here, we take the project without flexibility as such a security. The project
and the money complete the market, i.e., span all possible valuations on the event tree, which
then implies risk-neutral valuation will work and provide the correct valuation.
133
Table 7: Project 1 NPV event tree with flexibility using ROA (* = contract)
t=0 t=1 t=2

23.92 149.18 222.55
74.72 100.00
*59.96
Table 7 records the Project 1 NPV event tree with flexibility using ROA. Here is how these
numbers are obtained.
For project 1 the risk-neutral probability q1 must satisfy
149.18q1 + 67.03(1 − q1 )
= 100 =⇒ q1 = 0.462. (29)
1.05
We now proceed, as before.
Assume the company has reached year 2 and has yet to have exercised its option to contract.
The terminal values in year 2 are unaffected here by the change in probabilities and discount
rate. The values for states {uu, ud, dd} are, respectively, {222.55, 100, 59.96}. (If the operations
have not been contracted by year 2, then the company should contract them in state dd.)
to contract. In state u it would not pay the company to contract. In this state the value will
still be
0.462(222.55) + 0.538(100)
149.18 = . (30)
1.05
Now consider state d. If the company chooses to contract now, then the value would be
0.6(67.03) + 33 = 73.22, (31)
which has not changed. The company can, however, choose not to contract, and then the value
according to ROA would be
0.462(100) + 0.538(59.96)
= 74.72. (32)
1.05
The best choice is therefore not to contract, and the associated value is 74.72. (Here is an
example of a difference between recommendations using DT A and ROA.)
134
Table 8: Project 2 NPV event tree with flexibility using ROA (* = contract)
t=0 t=1 t=2

24.16 122.93 149.18
*91.09 *102.00
*82.22
Now let’s move back to year 0. Its value according to ROA is
0.462(149.18) + 0.538(74.72)
= 103.92, (33)
1.05
which gives an N P V of 103.92 − 80 = 23.92. The correct value of the option to contract is 3.92
for Project 1. The company should only contract operations if it reaches state dd in year 2.
numbers are obtained.
For project 2 the risk-neutral probability q2 must satisfy
122.14q2 + 81.87(1 − q2 )
= 100 =⇒ q2 = 0.574. (34)
1.05
We now proceed, as before.
Assume the company has reached year 2 and has not yet exercised its option to contract.
The terminal values in year 2 are unaffected here by the change in probabilities and discount
rate. The values for states {uu, ud, dd} are, respectively, {149.18, 102, 82.22}. (If the company
has not contacted operations by year 2, then it should contract them if either state ud or dd.)
Now let’s move back to year 1, and suppose the company has not yet exercised its option to
contract. In state u it would not pay the company to contract. In this state the value will be
0.574(149.18) + 0.426(102)
= 122.93. (35)
1.05
(This value will change since the value for state ud changed.) Now consider state d. If the
company chooses to contract now, then the value would be
0.6(81.87) + 42 = 91.09, (36)
135
which has not changed. The company can, however, choose not to contract, and then the value
according to ROA would be
0.574(102) + 0.426(82.22)
= 89.12. (37)
1.05
The best choice is therefore to contract, and the associated value is still 91.09.
Now let’s move back to year 0. Its value according to ROA is
0.574(122.93) + 0.426(91.09)
= 104.16, (38)
1.05
which gives an N P V of 104.16 − 80 = 24.16. The correct value of the option to contract is 4.16
for Project 2. The company should contract operations if it reaches state d in year 1.
2.5 Comparison of DTA to ROA
DT A recommends Project 1 since 22.47 > 22.36, whereas ROA recommends Project 2 since
24.16 > 23.92. (They are close.) The optimal contract policy changes, too.
136
t=0 t=1 t=2 t=3

100 134.99 182.21 245.96
74.08 100.00 134.99
54.88 74.08
40.66
3 Option to Abandon Operations
A company is considering investing in a project. Relevant information is as follows:
1. The project’s present value without flexibility is 100 million.
2. The project pays no dividends.
3. The project’s present value without flexibility has an annual volatility of 30%.
4. The project requires an initial investment of 108 million.
5. The appropriate cost of capital for the project is 15%.
6. The company has the option to abandon operations at any time during the next 3 years,
and receive an after-tax cash flow (salvage value) of 90 million.
3.2 Analysis of project without flexibility
The project’s NPV is 100 − 108 = −8 < 0, and so this the company should not invest in the
project without flexibility.
For subsequent reference Table 9 records the Project value event tree for the project with-
out flexibility. It has 10 “nodes”, which we shall label, respectively, as {0, u, d, uu, ud =
du, dd, uuu, uud = udu = duu, udd = dud = ddu, ddd}. The value for U is e0.30 = 1.3499
and D is e−0.30 = 0.7408.
137
Table 10: Project NPV event tree with flexibility using DTA (* = abandon)
t=0 t=1 t=2 t=3

-2.69 136.29 182.21 245.96
*90.00 104.55 134.99
*90.00 *90.00
*90.00
3.3 DTA analysis
DT A uses the objective probabilities and the cost of capital of the project without flexibility.
Let p denote the probability for the “up” state for the project. We must have
134.99p + 74.08(1 − p)
= 100 =⇒ p = 0.672. (39)
1.15
Table 10 records the NPV event tree with flexibility using DT A. Here is how these numbers
were obtained.
We work backwards through the value event tree. Suppose it is year 3 and the company has
yet to exercise its option to abandon. This option will not be executed in states uuu and uud,
and so their values remain the same. In states udd and ddd it does pay to execute the option,
and the values in both states are 90.
Now let’s go back to year 2. In state uu it does not pay to execute the option, and its value
will remain the same. It also does not pay to execute the option in state ud; its value is
0.672(134.99) + 0.328(90)
= 104.55. (40)
1.15
In state dd it should be clear that the option should be executed, as it is better to receive the
90 now instead of next year. (In both future states from state dd the value is 90.)
Now let’s go back to year 1. In state u the option will not be executed; its value is
0.672(182.21) + 0.328(104.55)
= 136.29. (41)
1.15
Now consider state d. If the option to abandon is executed the company receives 90. However,
the company can choose not to abandon now; the value if the company choose not to abandon
is
0.672(104.55) + 0.328(90)
= 86.76. (42)
1.15
Thus, the option to abandon should be executed in state d, and its value in this state is 90.
138
Table 11: Project NPV event tree with flexibility using ROA (* = abandon)
t=0 t=1 t=2 t=3

3.14 138.52 182.21 245.96
94.17 107.88 134.99
*90.00 *90.00
*90.00
Now let’s go back to year 0. The value is

0.672(136.29) + 0.328(90)
= 105.31. (43)
1.15
The N P V of the project is therefore 105.31 − 108 = −2.69 < 0, and so the project should be
rejected.
According to DT A the value of the option to abandon is worth 5.31 since the change in
N P V is −2.69 − (−8) = 5.31.
3.4 ROA analysis
For this project the risk-neutral probability q must satisfy

134.99p + 74.08(1 − p)
= 100 =⇒ q = 0.508. (44)
1.05
Table 11 records the NPV event tree with flexibility using ROA. Here is how these numbers
were obtained.
We work backwards through the value event tree. Assume the company has reached year 3
and has not yet exercise its option to abandon. The terminal values in year 3 are unaffected here
by the change in probabilities and discount rate. The values for states {uuu, uud, udd, ddd} are,
respectively, {245.96, 134.99, 90, 90}. (If the company has not abandoned operations by year 3
it should abandon them if it reaches state udd or ddd.)
Now let’s go back to year 2, and suppose the company has not yet exercised its option to
abandon. In state uu it does not pay to abandon, and its value will remain the same. It also
does not pay to abandon in state ud; its value is
0.508(134.99) + 0.492(90)
= 107.48. (45)
1.05
In state dd it should be clear that the company should abandon, as it is better to receive the
90 now instead of next year. (In both future states from state dd the value is 90.)
139
Now let’s go back to year 1. In state u the option will not be executed; its value is
0.508(182.21) + 0.492(107.48)
= 138.52. (46)
1.15
Now consider state d. If the company abandons it receives 90. However, the company can
choose not to abandon now; the value if the company continues the project is
0.508(107.48) + 0.492(90)
= 94.17. (47)
1.05
Thus, the option to abandon should not be executed in state d, and its value in this state is
94.17.
Now let’s go back to year 0. The value is
0.508(138.52) + 0.492(94.17)
= 111.14. (48)
1.05
The N P V of the project is therefore 111.14 − 108 = 3.14 > 0, and so the project should be
accepted.
It may be seen that the abandonment option here is equivalent to a three year American
put option with strike price equal to 90.
3.5 Comparison of DTA to ROA
ROA accepts the project; DT A rejects the project. ROA would not abandon the project if
state d is reached in year 1, whereas DT A would.
140
4 The Installment Option
A company is considering investing in two projects. Background information is as follows.
1. The present value of each project without flexibility is 100 million.
2. Each project pays no dividends.
3. The project value for each project without flexibility has an annual volatility of 80%.
5. The present value (at the risk-free rate) of the required investment for each project is 102
million.
6. The required investment for project 1 is staged over time, as follows: 52 million at time
0, 21 million at time 1 and 33.075 million at time 2. The required investment for project
2 is staged over time, too, as follows: 22 million at time 0, 31.5 million at time 1 and
55.125 million at time 2.
7. For both projects their respective investments must be made to continue the project for
the upcoming year. These investments may be viewed as planned. However, at any time
the company has the option to “default” on its planned investment at which point the
project is terminated.
8. The appropriate cost of capital for the project (without flexibility) is 20%.
4.2 Analysis of the projects without flexibility
Both projects have an NPV of 100 − 102 = −2 < 0, and so the company should not invest in
either project.
Table 12 records the project value event tree for both projects. Here, U = e0.80 = 2.2255
and D = 1/U = 0.4493.
141
t=0 t=1 t=2

100 222.55 495.30
44.93 100.00
20.19
Table 13: Project 1 NPV event tree with flexibility using ROA (* = default)
t=0 t=1 t=2

3.06 169.98 462.22
0.54 66.92
*0.00
4.3 ROA analysis
Let q denote the risk-neutral probability for the “up” state. We must have
222.55q + 44.93(1 − q)
= 1.05 =⇒ q = 0.338. (49)
100
numbers were obtained.
year 2 and has not yet defaulted on its planned investments. In states uu and ud it pays
the company to make its final planned investment, and so their values in these states become,
respectively, 462.22 and 66.92. It does not pay to make the final investment in state dd, and so
its value becomes 0.
Now let’s move back to year 1, and suppose the company has not yet defaulted on its
planned investments. In state u it pays the company to make the investment. Its (new) value
would be
0.338(462.22) + 0.662(66.92)
− 21 = 169.98. (50)
1.05
Now consider state d. If the company chooses to continue with the project now, then the value
at this state would be
0.338(66.92) + 0.662(0)
− 21 = 0.54. (51)
1.05
142
Table 14: Project 2 NPV event tree with flexibility using ROA (* = default)
t=0 t=1 t=2

22.58 138.48 440.17
*0.00 44.87
*0.00
Since this value is positive, the company should continue the project in state d.

0.338(169.98) + 0.662(0.54)
= 55.06, (52)
1.05
which gives an N P V of 55.06 − 52 = 3.06. As the N P V is positive, the project is accepted.
The value of the default option is 3.06 − (−2) = 5.06. If state dd is reached, then the final
investment should not be made.
numbers were obtained.
year 2 and has not yet defaulted on its planned investments. In states uu and ud it pays the
company to make the final planned investment, and so their values in these states become,
respectively, 440.17 and 44.87. It does not pay to make the final investment in state dd, and so
its value becomes 0.
Now let’s move back to year 1, and suppose the company has not yet defaulted on its
planned investments. In state u it would pay the company to make the investment. Its (new)
value would be
0.338(440.17) + 0.662(44.87)
− 31.5 = 138.48. (53)
1.05
Now consider state d. If the company chooses to continue with the project now, then the value
at this state would be
0.338(44.87) + 0.662(0)
− 31.5 = −16.61. (54)
1.05
Since this value is negative, the company should not make the planned investment in state d.
143
0.338(138.48) + 0.662(0)
= 44.58, (55)
1.05
which gives an N P V of 44.58 − 22 = 22.58. As the N P V is positive, the project should be
accepted. The value of the default option is 22.58 − (−2) = 24.58. If state d is reached, then
the project should be terminated.
Remark. Project 2 has a much higher value than project 1 when the default option is
in place. This is because its planned investments are “back loaded” as opposed to the first
project’s planned investments, which are “front loaded”. If it is possible to delay investment
while learning about the project’s value, then this will create extra value, as this example
illustrates.
144
5 Switch Use Option
A chemical company currently uses technology X to manufacture its final product, which has
recently experienced an increase in demand. The company wants to build a new factory to
satisfy demand for the next two years. It is considering using technology X again. It is also
considering adopting two other technologies, Y and Z.
1. Technology X. If the company adopts technology X the current net cash flow is 100 with
an annual volatility of 33.65%. The objective probability of going “up” from each node
is 0.5. The appropriate cost of capital for this type of risky cash flows is 9%. The initial
investment required to build the factory with technology X is 100.
2. Technology Y. The cost of material inputs used in Y are less volatile than those used
in X, but the quality of the final good is less, and so it commands a lower (albeit less
volatile) price. If technology Y is adopted, its current net cash flow would also be 100,
but its annual volatility would only be 9.53%. The initial investment required to build
the factory would also be 100 if technology Y were adopted.
3. Technology Z. Should it pay to do so, the chemical company also has the opportunity
to acquire “flexible” technology Z, which can switch (at a cost) back and forth between
technologies X and Y . The changeover cost from X to Y is 15, whereas it only costs 10
to switch from Y to X. The initial investment required to build the factory would be 110
if the flexible technology Z were adopted.
5.2 ROA Analysis
Technology X
Since technology X has been in use for some time we can use it to model the underlying security.
But, we have to be careful in what we model here.
The first step here is to determine the cash flow event tree. The values in this tree are
recorded in Table 15. Here, U = e0.3365 = 1.4000 and D = 1/U = 0.7142.
The cash flow event tree is not the value event tree. The value event tree at each node
represents the present values of future discounted expected cash flows. We shall use the “Running
PV” approach. We shall also use the objective probabilities with the appropriate cost of capital,
145
Table 15: Technology X cash flow event tree
t=0 t=1 t=2

100 140.00 196.00
71.42 100.00
51.02
Table 16: Technology X value event tree
t=0 t=1 t=2

291.05 275.78 196.00
140.70 100.00
51.02
since the cash flows with technology X are assumed to be marketed. (We cannot use risk-neutral
probabilities here as there is no other underlying security from which to make this calculation.)
Table 16 records the value event tree. Here is how these numbers were obtained. The
P V ’s at states {uu, ud, dd} in year 2 correspond to their net cash flows, namely, they are
{196, 100, 51.02}, respectively. Now consider state u in year 1. Its value is
0.5(196) + 0.5(100)
+ 140 = 275.78. (56)
1.09
Similarly, the value in state d in year 2 is
0.5(100) + 0.5(51.02)
+ 71.42 = 140.70. (57)
1.09
In year 0 the P V is
0.5(275.78) + 0.5(140.70)
+ 100 = 291.05. (58)
1.09
To perform ROA one needs an underlying marketable security. We shall use the value event
tree for X as our marketed security (along with the money market) upon which to build a
replicating portfolio.
Constructing portfolios with X and the associated calculation of the risk-neutral probability
is different here because the value event tree for X pays dividends. For example, one cannot
meaningfully represent the value at time 0, 291.05, as a discounted expectation of the respective
146
Table 17: Technology Y cash flow event tree
t=0 t=1 t=2

100 110.00 121.00
90.91 100.00
82.64
future values 275.78 and 140.70 at time 1. Examining the calculation of 291.05 in (58), it could
just as easily been determined via
q(275.78) + (1 − q)(140.70)
+ 100 = 291.05 =⇒ q = 0.443. (59)
1.05
The cash flow at time 0, 100, does not figure into the calculation of the risk-neutral probability.
(It did not figure into the discounted expectation when we used the objective probabilities with
the cost of capital.) When constructing a portfolio with X, one assumes it is being valued
ex-dividend ; that is, after the dividend payout of 100. The ex-dividend cost of X at time 0 is
191.05. The number 291.05 is called the cum-dividend value.
You may verify that the risk-neutral probability of 0.443 will be the same at every node.
For example,
0.443(196.00) + 0.557(100.00)
+ 140 = 275.78 (60)
1.05
0.443(100.00) + 0.557(51.02)
+ 71.42 = 140.70. (61)
1.05
For the specific type of cash flow event tree here this fact will always be true. Note that the
risk-neutral probability that would be calculated using the cash flow event tree directly is
105 − 71.42
= 0.4896, (62)
140 − 71.42
which is definitely not equal to the correct value 0.443. One must always calculate the risk-
neutral probability on the event tree coinciding with the tradable/marketable security.
Technology Y
Once again to determine the value event tree we first must determine the cash flow event tree.
Table 17 records the cash flow event tree. Here, U = e0.0953 = 1.1000 and D = 1/U = 0.9091.
It is tempting at this point to proceed as we did for technology X; however, the cash flow
stream for Y is clearly less volatile than that for X so the cost of capital should be lower. In lieu
147
Table 18: Technology Y value event tree
t=0 t=1 t=2

284.19 214.10 121.00
176.94 100.00
82.64
of estimating the cost of capital for Y , we will use the value event tree for X as our marketed
security (along with the money market) upon which to build a replicating portfolio.
Now we are in position to properly value the present values of future discounted expected
cash flows for technology Y . We use the “Running PV” approach using the risk-neutral prob-
abilities. Table 18 records the value event tree. Here is how these numbers were obtained.
The P V ’s at states {uu, ud, dd} in year 2 correspond to their net cash flows, namely, they
are {121, 100, 82.64}, respectively. Now consider state u in year 1. Its value is
0.443(121) + 0.557(100)
+ 110 = 214.10. (63)
1.05
Similarly, the value in state d in year 2 is
0.443(100) + 0.557(82.64)
+ 90.91 = 176.94. (64)
1.05
In year 0 the P V is
0.443(214.10) + 0.557(176.94)
+ 100 = 284.19. (65)
1.05
Remark. To determine the appropriate cost of capital kY for technology Y we use the
objective probabilities; that is, kY satisfies
0.5(214.10) + 0.5(176.94)
= 184.19 =⇒ kY = 6.15%. (66)
1 + kY
It will be the same at any node along the tree. (If one uses the risk-neutral probabilities, the
cost of capital would be simply 5%.)
Technology Z
Table 19 records the value event tree corresponding to technology Z assuming the switching
costs are zero. (Assume the value event trees for X and Y correspond to the same states of
nature.) Here is how these numbers were calculated.
148
Table 19: Technology Z value event tree with no switching costs. The letter(s) in parentheses
indicate the optimal technology to employ at each state.
t=0 t=1 t=2

(X/Y) 310.22 (X) 275.78 (X) 196.00
(Y) 176.94 (X/Y) 100.00
(Y) 82.64
Table 20: Technology Z value event tree with switching costs (* = switch)
t=0 t=1 t=2

X Y X Y X Y
302.26 306.00 275.78 *265.78 196.00 *186.00
*161.94 176.94 100.00 100.00
*67.64 82.64
With no changeover costs it is clearly optimal to use the technology with the highest net
cash flow each period depending on the state of nature. In year 2 the P V ’s corresponding to
states {uu, ud, dd} are, respectively, {196, 100, 82.64}. Now consider state u in year 1. Its value
is
0.443(196) + 0.557(100)
+ 140 = 275.78. (67)
1.05
The value value for state d in year 1 is
0.443(100) + 0.557(82.64)
+ 90.91 = 176.94. (68)
1.05
In year 0 the P V value is
0.443(275.78) + 0.557(176.94)
+ 100 = 310.22. (69)
1.05
When there are changeover costs the calculations become more involved, as it is necessary
to know what technology is currently in operation in order to decide if it is optimal to switch
use. Table 20 records the value event tree with switching costs. Here is how these numbers
were obtained.
Let VtX (·), resp. VtY (·), denote the value function in year t given the company enters year
t using technology X (resp. Y ). In state uu in year 2 it pays the company to switch from Y to
X, and in state dd in year 2 it pays the company to switch from X to Y ; otherwise, it does not
149
pay to switch use. Thus, V2X (uu) = 196; V2X (ud) = 100; V2X (dd) = 67.64, and V2Y (uu) = 186;
V2Y (ud) = 100; V2Y (dd) = 82.64.
Now consider year 1. In each state u or d the company must decide whether to switch
assuming that it entered each state using either technology X or Y . That is, four separate
calculations must be performed, as follows:
0.443V2X (uu) + 0.557V2X (ud) 0.443V2Y (uu) + 0.557V2Y (ud)

V1X (u) = Max{140 + ; (110 − 15) + }
1.05 1.05
= 275.78; (70)
0.443V2Y (uu) + 0.557V2Y (ud) 0.443V2X (uu) + 0.557V2X (ud)

V1Y (u) = Max{110 + ; (140 − 10) + }
1.05 1.05
= ∗265.78; (71)
0.443V2X (du) + 0.557V2X (dd) 0.443V2Y (du) + 0.557V2Y (dd)

V1X (d) = Max{71.42 + ; (90.91 − 15) + }
1.05 1.05
= ∗161.94; (72)
0.443V2Y (du) + 0.557V2Y (dd) 0.443V2X (du) + 0.557V2X (dd)

V1Y (d) = Max{90.91 + ; (71.42 − 10) + }
1.05 1.05
= 176.94. (73)
The asterisk symbol denotes the decision to switch use.
Now in year 0 one computes:
0.443V1X (u) + 0.557V1X (d) 0.443V1Y (u) + 0.557V1Y (d)

V0X = Max{100 + ; (100 − 15) + } = 302.26; (74)
1.05 1.05
0.443V1Y (u) + 0.557V1Y (d) 0.443V1X (u) + 0.557V1X (d)

V0Y = Max{100 + ; (100 − 10) + } = 306.00. (75)
1.05 1.05
At time 0 the value of technology Z is 302.26 if its initial state is technology X or 306.00 if
its initial state is technology Y . Obviously, if one has a choice, it would be preferable to begin
in technology Y .
The N P V for technology X is 191.05, the N P V for technology Y is 184.19, and the N P V
for technology Z is either 192.26 or 196.00. In any case, technology X is preferred to technology
Y , and technology Z is preferred to X regardless of its initial state.
150
REAL OPTIONS ANALYSIS SAMPLE PROBLEMS
I. Single-period
1. A company is considering investing in a project. The present value (PV) of future discounted expected
25%. The initial capital investment required at time 0 is 8,000. The risk-free rate is 2.5% per year.

d. The company has some flexibility in managing this project. Specifically, it can abandon the project
and liquidate its original capital investment for 50% of its original value. It can also expand operations,
which will result in twice the original PV. To expand the company will have to make an additional capital
expenditure of 4,000. Determine the ROA value of this project with flexibility.
f. Show how your answer to (e) can be obtained using the replicating portfolio’s weights and the
expected returns on the underlying assets under the objective probabilities.
2. A company is considering investing in a project. The present value (PV) of future discounted expected
20%. The initial capital investment required at time 0 is 8,500. The risk-free rate is 5% per year
(compounded annually).

d. The company has some flexibility in managing this project next year. Specifically, it can abandon the
project and liquidate its original capital investment for 50% of its original value. It can also expand
operations, which will result in twice the original PV. To expand the company will have to make an
additional capital expenditure of 10,000. Determine the ROA value of this project with flexibility.
f. Show how your answer to (e) can be obtained using the replicating portfolio’s weights and the
expected returns on the underlying assets under the objective probabilities.
151
II. Growth Option
3. Consider another biotech project, which involves a pioneer venture stage to first prove the new
technology in order to establish its viability for future commercial development of spin-off products. The
pioneer venture requires an initial investment outlay of I0 = $15 million, and expected cash inflows over 2
years of C1 = $5 million, C2 = $10 million. The follow-on product commercialization stage will become
available in year 2. It will require an additional investment of I2 = $150 million. The expected cash
inflows over the subsequent 2 years are C3 = $50 million, C4 = $100 million. The cost of capital for both
the pioneer project and the follow-on commercialization project is 20%. The risk-free rate is 5%. (All
rates are continuously compounded.) The log-volatility σ of the follow-up commercialization project’s
value is 60%.
4. Consider the following data for this biotech project. The pioneer venture requires an initial investment
outlay of I0 = $2800, and expected cash inflows over 2 years of C1 = $1200 and C2 = $1440. The follow-on
product commercialization stage will become available in year 3. The present value of the future expected
cash flows as seen at time t = 3 is 17,280, and the required investment at time t = 3 is 15,552. The
company’s cost of capital is 20%. The risk-free rate is 2.5%. The follow-on product commercialization
stage’s project value (without flexibility) follows a binomial lattice with U = 1.5 and D = 1/1.5.
a. Determine the value of biotech project if the company commits to both stages at time 0.
b. Determine the ROA value of this biotech project assuming the company does not have to commit at
the outset to invest in the follow-on commercialization project. Use annual compounding and round to the
nearest dollar.
5. Consider another biotech project. The pioneer venture requires an initial investment outlay of I0 = $30
million, and expected cash inflows over 2 years of C1 = $11 million, C2 = $18.15 million. The follow-on
product commercialization stage will become available in year 2. It will require an additional investment
of I2 = $75 million. The expected cash inflows over the subsequent 2 years are C3 = $26.62 million, C4 =
$58.564 million. The cost of capital for both the pioneer project and the follow-on commercialization
project is 10%. (Interest is compounded annually.) Explain how Real Options Analysis would characterize
this project with flexibility using the language of Financial Options Analysis. Be specific with numbers.
(You cannot calculate an ROA value since data are missing.)
152
III. Installment Option
6. The present value of a project without flexibility is 50 million. The project pays no dividends. The
project without flexibility follows a binomial lattice with u = 1.35 and d = 1/1.35. The risk-free rate is 5%
(compounded annually). The required investment for this project is staged over time, as follows: 5 million
at time 0, 20 million at time 1 and 30 million at time 2. Investments must be made to continue the project
for the upcoming year. At any time the company has the option to default on these planned investments at
which point the project is terminated.
a. Determine the ROA value of this project.

b. Describe the optimal stopping policy in words.
c. Determine the value of the installment option.
project without flexibility follows a binomial lattice with U = 2 and D = 0.5. The risk-free rate is 2.5%.
The required investment for this project is staged over time, as follows: 10 million at time 0, 40 million at
time 1 and 60 million at time 2. Investments must be made to continue the project for the upcoming year.
At any time the company has the option to default on these planned investments at which point the project
is terminated.
a. Determine the ROA value of this project with flexibility and describe the optimal policy.
b. Suppose the objective probability p = 0.5. What are the appropriate cost of capitals (to the nearest
percent) to use so that DTA will produce the same answer as ROA?
project without flexibility follows a binomial lattice with U = 1.5 and D = 1/1.5. The risk-free rate is 5%
(compounded annually). The required investment for this project is staged over time, as follows: 5 million
at time 0, 10 million at time 1 and 30 million at time 2. Investments must be made to continue the project
for the upcoming year. At any time the company has the option to default on these planned investments at
which point the project is terminated.
a. Determine the ROA value of this project.

b. Describe the optimal stopping policy in words.
c. Determine the value of the installment option.
153
IV. Delay Option
9. A company owns a parcel of land on which it can build either an 8-unit or a 16-unit condominium.
The current real-estate price for a one-unit condominium is $200 thousand. Next year the price will rise to
either $260 thousand, if the market moves favorably, or decline to $150 thousand, if the market moves
unfavorably. The chance the market will move favorably is 60%. The construction cost (both now and
next year) is $140 thousand per unit for an 8-unit building or $180 thousand for a 16-unit building.
Assume construction is instantaneous. Rent covers operating expenses, so no free cash flow is generated.
Risk-free rate is 2.5%. What is the value of the land if the company has a one year delay option?
10. A one unit condominium price follows a binomial lattice with U = 1.5 and D = 0.9. The current price
for a one-unit condominium is $100 thousand. The construction cost (both now and next year) for a 6-unit
building is $80 thousand per unit, and $90 thousand for a 9-unit building. Construction is instantaneous,
and rent covers operating expenses, so no free cash flow is generated now or next year. The risk-free rate
is 10% (compounded annually). The company has the option to develop at any time over the next two
years. If it chooses to delay construction, it must pay $80 thousand at the beginning of the year for
maintenance and security. Determine the ROA value of this development project with the two-year
embedded (American) delay option.
11. Solve the tree farm example for a three year horizon. [See ROA_TreeFarmExample.hava. ]
154
REAL OPTIONS ANALYSIS SAMPLE PROBLEM SOLUTIONS
1. a. [0.6(10,000) + 0.4(5,000)]/(1.25) = 6,400.

b. 6,400 – 8,000 = -1,600.
c. No.
d. Risk-neutral probability q = 0.312 since [0.312(10,000) + 0.688(5,000)]/(1.025) = 6,400.
The value of the project if the market goes up is 2(10,000) – 4,000 = 16,000.
The value of the project if the market goes down is
max[5,000, 0.5(8,000), 2(5,000) – 4,000] = 6,000.
The ROA value is therefore
[0.312(16,000) + 0.688(6,000)]/(1.025) – 8,000 = 8,897.56 – 8,000 = 897.56.
e. The correct cost of capital is 34.87% since 8,897.56 = [0.6(16,000) + 0.4(6,000)]/(1.3487).
f. The RP is (2P, -3902.44M). The portfolio weights are wP = 1.4386, wM = -0.4386. Expected
percentage return of the project with flexibility under the objective probabilities is 1.4386(25) –
(0.4386)(2.5) = 34.87, as it should.
2. a. [0.6(12,000) + 0.4(6,000)]/(1.20) = 8,000.

b. 8,000 – 8,500 = -500.
c. No.
d. Risk-neutral probability q = 0.4 since [0.4(12,000) + 0.6(6,000)]/(1.05) = 8,000.
The value of the project if the market goes up is 2(12,000) – 10,000 = 14,000.
The value of the project if the market goes down is
max[6,000, 0.5(8,000), 2(6,000) – 10,000] = 6,000.
The ROA value is therefore
[0.4(14,000) + 0.6(6,000)]/(1.025) – 8,500 = 8,761.90 – 8,500 = 261.90.
e. The correct cost of capital is 23.26% since 8,761.90 = [0.6(14,000) + 0.4(6,000)]/(1.2326).
f. The RP is (4/3P, -1904.77M). The portfolio weights are wP = 1.2174, wM = -0.2174. Expected
percentage return of the project with flexibility under the objective probabilities is 1.2174(20) –
(0.2174)(5) = 23.26, as it should.
3. The present value at time 0 of the follow-on project is 50*exp(-0.6) + 100*exp(-0.8) = 72.37. ROA
value of the follow-on project is the same as a European call option on a non-dividend stock whose
current price is 72.37 with two years to maturity and a strike price of 150.
As a quick estimate of this value, consider a binomial lattice with one-year periods. The value of the U
parameter is exp(0.6) = 1.8221. (The value of the D parameter is 0.5488 and R = 1.0513.) The risk-
neutral probability q is 0.3946. The only state after two years in which this option would be exercised
would be if there were two successive “UP” moves, in which case the option would be exercised for a
net value of 72.37(1.8221)2 – 150 = 90.27. This state will be reached with probability (0.3946)2 =
0.156. Hence, the crude estimate of this call option is therefore 0.156(90.27)/[exp(0.1)] = 12.75. The
NPV of the pioneer project is -15 + 5*exp(-0.20) + 10*exp(-0.40) = -4.20, which is this growth option
premium. Since 4.20 is well less than the option value of 12.75, the company should invest in the
project. (The Black-Scholes value of the call option is 10.6384.)
4. The present value at time 0 of the follow-on project is 17,280/(1.2)3 = 10,000. ROA value of the
follow-on project is the same as a European call option on a non-dividend stock whose current price is
10,000 with three years to maturity and a strike price of 15,552. The risk-neutral probability q is 0.43.
The only state after three years in which this option would be exercised would be if there were three
successive “UP” moves, in which case the option would be exercised for a net value of 10,000(1.5)3 –
15,552 = 18,198. This state will be reached with probability (0.43)3 = 0.0795. Hence, its value is
0.0795(18,198)/(1.025)3 = 1,343. The NPV of the pioneer project is -2,800 + 1,200/1.2 + 1,440/(1.2)2
= -800. Thus, the ROA value is 1,343-800 = 543, and the company should invest in the project.
155
5. Follow-on project is viewed as a European call option on a non-dividend paying stock whose current
price is 60 with two years to maturity and a strike price of 75. Option premium is 5 (the cost of the
pioneer project).
6.
0 1 2
P0 = 50 P1(u) = 67.500 P2(uu) = 91.125
ROA = 8.438 = 13.438-5 27.135 = 47.135-20 61.125
P1(d) = 37.037 P2(ud) = P2(du) = 67.500

*0 37.500
q = 0.5076
* default P2(dd) = 27.435
*0
7.
0 1 2
P0 = 100 P1(u) = 200 P2(uu) = 400
ROA = 24.646 = 34.646-10 101.463 = 141.463-40 340
46.4% since 0.464 = 34.3% since 0.343 =
[0.5(101.463)+0.5(0)]/34.646 - 1 [0.5(340)+0.5(40)]/141.463 - 1
P1(d) = 50 P2(ud) = P2(du) = 100

*0 40
q = 0.35
* default P2(dd) = 25
*0
8.
0 1 2
P0 = 36 P1(u) = 54 P2(uu) = 81
ROA = 1.759 = 6.759-5 15.429 = 25.429-10 51
P1(d) = 24 P2(ud) = P2(du) = 36

*0 6
q = 0.46
* default P2(dd) = 16
Only default if the market is down next year *0
9. q = 0.50. In the up state it is best to build a 16-unit condo for an NPV of 1280. In the down state it is
best to build an 8-unit condo for an NPV of 80. The ROA value is [0.5(1280) + 0.5(80)]/1.025 =
663.415. The RP is (10.909P, -1518.4M). The value without the delay option is 480.
10.
0 1 2
P0 = 100 P1(u) = 150 P2(uu) = 225
ROA = 120 *540 1215
6(100 – 80) =
540 > 533.636 = 613.636 - 80
[1/3(540)+2/3(60)]/1.1 – 80
P1(d) = 90 P2(ud) = P2(du) = 135
*60 405
q = 1/3 60 > [1/3(405)+2/3(60]/1.1 - 80
P2(dd) = 81
* build 6
156
MARKET SURVEY ANALYSIS
HANDOUTS
157
158
EXAMPLE 1
The value of a project depends on the as-yet realized market state, which can either be “LOW,”
“MEDIUM,” or “HIGH.” There is an initial assessment of the likelihood of these market states.
State Value Probability

LOW -80.0 0.30
MEDIUM 25.0 0.50
HIGH 30.0 0.20
It is possible to undertake a market survey to gain more information. The market survey result will
indicate a particular market state. However, the test result outcome is not completely reliable. It could, for
example, indicate a HIGH market state when, in fact, the true market state is LOW. Based on historical
data, an assessment of the survey’s reliability is known.
State
Test Result LOW MEDIUM HIGH
LOW 0.60 0.25 0.10
MEDIUM 0.30 0.50 0.30
HIGH 0.10 0.25 0.60
QUESTIONS:
1. Should the test be undertaken?

2. What decision should be make given a test result outcome?
3. What is the value of this test?
159
160
/** MarketSurveyAnalysis.01.hava */
/** */
/** DATA */
/** */
/** Market States, Values and Probabilities */
token LOW, MEDIUM, HIGH;

States = (LOW, MEDIUM, HIGH);
// State Values and Probabilities (Objective is maximization)

table marketValue(state) = (-80.0, 25.0, 30.0)[state:States];
table prob(state) = (0.3, 0.5, 0.2)[state:States];
/** */
/** Market Survey Conditional Probabilities of Observation Given State */
// Conditional probability of observation given state (required input)

function pObsGivenState(obs, state) = (
(0.60, 0.25, 0.10), // obs = LOW, state = LOW to HIGH
(0.30, 0.50, 0.30), // obs = MEDIUM, state = LOW to HIGH
(0.10, 0.25, 0.60) // obs = HIGH, state = LOW to HIGH
) [obs:States, state:States];
table marketSurveyProbs(state, obs) = pObsGivenState(obs, state);

private marketSurveyConditionalProbs =
collect(state in States, obs in States) {
marketSurveyProbs(state, obs)
};
/** */
/** BAYESIAN UPDATING */

/** */
// Updated probability of state given observation

function pStateGivenObs(state, obs) =
pObsGivenState(obs, state)*prob(state)/pObs(obs);
/** Probability of Observation */

table pObs(obs) = sum(state in States)
{pObsGivenState(obs, state)*prob(state)};
/** */
/** Updated Probabilities of State Given Observation */

table updatedProbs(obs, state) = pStateGivenObs(state, obs);
private conditionalProbs =
collect(obs in States, state in States) {
updatedProbs(obs, state)
};
/** */
/** MARKET ANALYSIS */

/** */
/** Decision-Maker's Value Function */

value(state) = U(marketValue(state));
function U(x) = x;
/** */
/** Expected Value Analysis */

expValueNoTest = max(expValueFullCommit, 0);
expValueFullCommit =
sum(state in States) {prob(state)*value(state)};
expValuePerfectInfo =
sum(state in States) {prob(state)*max(value(state), 0)};
expValueWithTest =
sum(obs in States){pObs(obs)*max(expValueGivenObs(obs),0)};
table expValueGivenObs(obs) =
sum(state in States){value(state)*pStateGivenObs(state, obs)};
161
MarketSurveyAnalysis.01.hava
DATA
Market States, Values and Probabilities

States (LOW, MEDIUM, HIGH)
marketValue state value
LOW -80.0
MEDIUM 25.0
HIGH 30.0
prob state value
LOW 0.3
MEDIUM 0.5
HIGH 0.2
Market Survey Conditional Probabilities of Observation Given State

marketSurveyProbs state obs value
LOW LOW 0.6
LOW MEDIUM 0.3
LOW HIGH 0.1
MEDIUM LOW 0.25
MEDIUM MEDIUM 0.5
MEDIUM HIGH 0.25
HIGH LOW 0.1
HIGH MEDIUM 0.3
HIGH HIGH 0.6
BAYESIAN UPDATING
Probability of Observation
pObs obs value
LOW 0.325
MEDIUM 0.4
HIGH 0.275
Updated Probabilities of State Given Observation

updatedProbs obs state value
LOW LOW 0.553846
LOW MEDIUM 0.384615
LOW HIGH 0.0615385
MEDIUM LOW 0.225
MEDIUM MEDIUM 0.625
MEDIUM HIGH 0.15
HIGH LOW 0.109091
HIGH MEDIUM 0.454545
HIGH HIGH 0.436364
MARKET ANALYSIS
Decision-Maker's Value Function

value(LOW) -80.0
value(MEDIUM) 25.0
value(HIGH) 30.0
Expected Value Analysis

expValueNoTest 0
expValueFullCommit -5.5
expValuePerfectInfo 18.5
expValueWithTest 5.175
expValueGivenObs obs value
LOW -32.8462
MEDIUM 2.125
HIGH 15.7273
162
EXAMPLE 2
A company is considering expanding its retail store to accommodate recent and projected business
growth. There are two options. The first option (“expand LARGE”) will expand the store by leasing
additional floor space and then remodeling the entire store. The second option (“expand SMALL”) is far
less costly. It will expand the store by redoing the layout and making a small addition.
The incremental revenues critically depend on two factors: (i) the type of option taken, and (ii) the
future business condition (either LOW, MEDIUM or HIGH).
State
Action Taken LOW MEDIUM HIGH
NONE 0 0 0
SMALL -9887 30339 50452
LARGE -54089 26362 76645
There is an initial assessment of the likelihood of these market states.
State Probability
LOW 0.15
MEDIUM 0.60
HIGH 0.25
It is possible to undertake a market survey to gain more information. The market survey result will
indicate a particular market state. However, the test result outcome is not completely reliable. It could, for
example, indicate a HIGH market state when, in fact, the true market state is LOW. Based on historical
data, an assessment of the survey’s reliability is known.
State
LOW 0.70 0.30 0.10
MEDIUM 0.20 0.40 0.10
HIGH 0.10 0.30 0.80
QUESTIONS:
1. Should the test be undertaken?

2. What decision should be make given a test result outcome?
3. What is the value of this test?
163
164
/** MarketSurveyAnalysis.02.hava */
/** */
/** DATA */
/** */
/** Market States, Actions, Values and Probabilities */

token LOW, MEDIUM, HIGH;
token NONE, SMALL, LARGE;
States = (LOW, MEDIUM, HIGH);
Actions = (NONE, SMALL, LARGE);
table marketValue(action, state) = (

( 0, 0, 0),
( -9887, 30339, 50452),
(-54089, 26362, 76645)
)[action:Actions, state:States];
table prob(state) = (0.15, 0.60, 0.25)[state:States];
token MIN, MAX;

OBJECTIVE = MAX;
/** */
/** Market Survey Conditional Probabilities of Observation Given State */
// Conditional probabilitiy of observation given state (required input)

function pObsGivenState(obs, state) = (
(0.70, 0.30, 0.10), // obs = LOW, state = LOW to HIGH
(0.20, 0.40, 0.10), // obs = MEDIUM, state = LOW to HIGH
(0.10, 0.30, 0.80) // obs = HIGH, state = LOW to HIGH
) [obs:States, state:States];
table marketSurveyProbs(state, obs) = pObsGivenState(obs, state);

private marketSurveyConditionalProbs =
collect(state in States, obs in States) {
marketSurveyProbs(state, obs)
};
/** */
/** BAYESIAN UPDATING */

/** */
function pStateGivenObs(state, obs) =

pObsGivenState(obs, state)*prob(state)/pObs(obs);
/** Probability of Observation */

table pObs(obs) = sum(state in States)
{pObsGivenState(obs, state)*prob(state)};
/** */
/** Updated Probabilities of State Given Observation */

table conditionalProbs(obs, state) = pStateGivenObs(state, obs);
private conditionalProbs =
collect(obs in States, state in States) {
conditionalProbs(obs, state)
};
/** */
/** MARKET ANALYSIS */

/** */
/** Decision-Maker's Value Function */

value(state, action) = U(marketValue(state, action));
function U(x) = x;
/** */
165
/** Expected Value Analysis */
table expValueWithTest(obs) =
expActionValueGivenObs(obs, optActionWithTest(obs));
table optActionWithTest(obs) =
if (OBJECTIVE == MAX) {
argmax(action in Actions) {
expActionValueGivenObs(obs, action)
}
}
else {
argmin(action in Actions) {
expActionValueGivenObs(obs, action)
}
};
table expActionValueGivenObs(obs, action) =

sum(state in States){
pStateGivenObs(state, obs)*value(action, state)
};
expValueWithTest =
sum(obs in States) {
pObs(obs)*expValueWithTest(obs)
};
table expValueNoTest(action) =
sum(state in States) {
prob(state)*value(action, state)
};
expValueNoTest =
max(action in Actions) {expValueNoTest(action)}
}
else {
min(action in Actions) {expValueNoTest(action)}
};
expValuePerfectInfo =
prob(state)*max(action in Actions) {value(action, state)}
}
}
else {
prob(state)*min(action in Actions) {value(action, state)}
}
};
/** */
/** Policy Variables */
maxValueOfAnyTest =
absoluteValue(expValuePerfectInfo - expValueNoTest);
valueOfThisTest =
absoluteValue(expValueWithTest - expValueNoTest);
/* Service Functions */
function absoluteValue(x) =
if (x >= 0) {x} else {-x};
166
DATA
Market States, Actions, Values and Probabilities

Actions (NONE, SMALL, LARGE)
marketValue action state value
NONE LOW 0
NONE MEDIUM 0
NONE HIGH 0
SMALL LOW -9887
SMALL MEDIUM 30339
SMALL HIGH 50452
LARGE LOW -54089
LARGE MEDIUM 26362
LARGE HIGH 76645
prob state value
LOW 0.15
MEDIUM 0.6
HIGH 0.25
OBJECTIVE MAX

LOW LOW 0.7
LOW MEDIUM 0.2
LOW HIGH 0.1
MEDIUM LOW 0.3
MEDIUM MEDIUM 0.4
MEDIUM HIGH 0.3
HIGH LOW 0.1
HIGH MEDIUM 0.1
HIGH HIGH 0.8
BAYESIAN UPDATING
pObs obs value
LOW 0.31
MEDIUM 0.295
HIGH 0.395

conditionalProbs obs state value
LOW LOW 0.33871
LOW MEDIUM 0.580645
LOW HIGH 0.0806452
MEDIUM LOW 0.101695
MEDIUM MEDIUM 0.813559
MEDIUM HIGH 0.0847458
HIGH LOW 0.0379747
HIGH HIGH 0.506329
167
MARKET ANALYSIS

value(NONE, LOW) 0
value(NONE, MEDIUM) 0
value(NONE, HIGH) 0
value(SMALL, LOW) -9887
value(SMALL, MEDIUM) 30339
value(SMALL, HIGH) 50452
value(LARGE, LOW) -54089
value(LARGE, MEDIUM) 26362
value(LARGE, HIGH) 76645

expValueWithTest obs value
LOW 18336.1
MEDIUM 27952.7
HIGH 48766.6
optActionWithTest obs value
LOW SMALL
MEDIUM SMALL
HIGH LARGE
expActionValueGivenObs obs action value
LOW NONE 0.0
LOW SMALL 18336.1
LOW LARGE 3167.55
MEDIUM NONE 0.0
MEDIUM SMALL 27952.7
MEDIUM LARGE 22441.8
HIGH NONE 0.0
HIGH SMALL 38995.2
HIGH LARGE 48766.6
expValueNoTest action value
NONE 0.0
SMALL 29333.4
LARGE 26865.1
expValueNoTest 29333.4
Policy Variables
maxValueOfAnyTest 8031.3
valueOfThisTest 3859.71
168
MarketSurveyAnalysis.02b.hava
DATA

Actions (NONE, SMALL, LARGE)
NONE LOW 0
NONE MEDIUM 0
NONE HIGH 0
SMALL LOW -9887
SMALL MEDIUM 30339
SMALL HIGH 50452
LARGE LOW -54089
LARGE MEDIUM 26362
LARGE HIGH 76645
prob state value
LOW 0.15
MEDIUM 0.6
HIGH 0.25
OBJECTIVE MAX

LOW LOW 0.7
LOW MEDIUM 0.2
LOW HIGH 0.1
MEDIUM LOW 0.3
MEDIUM MEDIUM 0.4
MEDIUM HIGH 0.3
HIGH LOW 0.1
HIGH MEDIUM 0.1
HIGH HIGH 0.8
BAYESIAN UPDATING
pObs obs value
LOW 0.31
MEDIUM 0.295
HIGH 0.395

LOW LOW 0.33871
LOW MEDIUM 0.580645
LOW HIGH 0.0806452
MEDIUM LOW 0.101695
MEDIUM MEDIUM 0.813559
MEDIUM HIGH 0.0847458
HIGH LOW 0.0379747
HIGH HIGH 0.506329
MARKET ANALYSIS
Decision-Maker's Value Function U(x) = 1 - exp(-x/30000)

value(NONE, LOW) 0.0
value(NONE, MEDIUM) 0.0
value(NONE, HIGH) 0.0
value(SMALL, LOW) -0.390366
value(SMALL, MEDIUM) 0.636254
value(SMALL, HIGH) 0.813949
value(LARGE, LOW) -5.06762
value(LARGE, MEDIUM) 0.584691
value(LARGE, HIGH) 0.922295
169
LOW 0.302858
MEDIUM 0.546911
HIGH 0.687241
LOW SMALL
MEDIUM SMALL
HIGH SMALL
LOW NONE 0.0
LOW SMALL 0.302858
LOW LARGE -1.30258
MEDIUM NONE 0.0
MEDIUM SMALL 0.546911
MEDIUM LARGE 0.0384904
HIGH NONE 0.0
HIGH SMALL 0.687241
HIGH LARGE 0.540985
NONE 0.0
SMALL 0.526685
LARGE -0.178755
Policy Variables
valueOfThisTest 0.0
170
EXAMPLE 3
You must decide whether to buy or lease a car. You have gathered some data on the costs of buying,
operating and leasing a vehicle for three months under two circumstances.
State
Action Taken LIGHT HEAVY
BUY 1200 1600
LEASE 950 1700
These figures include all quantifiable costs. The unknown factor is whether the car will have light or heavy
use. This factor is beyond your control, but you estimate a 0.4 probability of light use and 0.6 probability
of heavy use.
You can determine with 95% accuracy whether your car will be subject to light or heavy use. This will
require about 4 hours of work on your part. You value your time at $200 per 8-hour working day.
QUESTIONS:
1. Should you spend more time investigating the matter?

2. What actions do you recommend and why?
171
172
DATA

States (LIGHT, HEAVY)
Actions (BUY, LEASE)
BUY LIGHT 1200
BUY HEAVY 1600
LEASE LIGHT 950
LEASE HEAVY 1700
prob state value
LIGHT 0.4
HEAVY 0.6
OBJECTIVE MIN

LIGHT LIGHT 0.95
LIGHT HEAVY 0.05
HEAVY LIGHT 0.05
HEAVY HEAVY 0.95
BAYESIAN UPDATING
pObs obs value
LIGHT 0.41
HEAVY 0.59

LIGHT LIGHT 0.926829
LIGHT HEAVY 0.0731707
HEAVY LIGHT 0.0338983
HEAVY HEAVY 0.966102
MARKET ANALYSIS

value(BUY, LIGHT) 1200
value(BUY, HEAVY) 1600
value(LEASE, LIGHT) 950
value(LEASE, HEAVY) 1700

LIGHT 1004.88
HEAVY 1586.44
LIGHT BUY
HEAVY LEASE
LIGHT BUY 1229.27
LIGHT LEASE 1004.88
HEAVY BUY 1586.44
HEAVY LEASE 1674.58
BUY 1440.0
LEASE 1400.0
Policy Variables
173
174
Example 3 Solution
Survey Forecast Prob. B/L Actual Prob. Payoff Expected Best Expected
Decision Decision Use Payoff Decision Payoff
Light .40 1200
Buy 1440
Heavy .60 1600
No survey Lease 1400
Light .40 950
Lease 1400
Heavy .60 1700
Light .38/.41 1200

Buy 1229.27
Heavy .03/.41 1600
Light 0.41 Lease
Light .38/.41 950
Lease 1004.88
Heavy .03/.41 1700
Survey 1348
Light .02/.59 1200
Buy 1586.44
Heavy .57/.59 1600
Heavy 0.59 Buy
Light .02/.59 950
Lease 1674.58
Heavy .57/.59 1700
Expected cost given that you buy = 0.40(1200) + 0.60(1600) = 1440.

Expected cost given that you lease = 0.40(950) + 0.60(1700) = 1400.
Expected cost with perfect information = 0.40(950) + 0.60(1600) = 1340.
Expected value of perfect information = 1400 - 1340 = 60.
Expected benefit of obtaining information = 1400 – 1348 = 52.
Cost to obtain information = 100, which means we already knew it couldn’t be worth it.
175
176
EXAMPLE 4
You are evaluating the development of an information system (IS) to forecast sales volumes. You will
decide the staffing of a manufacturing line on the basis of this forecasted volume. The system may forecast
sales as either POOR, STABLE or GOOD. You will either staff with a SINGLE shift or DOUBLE shift.
Here are the projected payoffs as a function of the action taken and the realized state of nature.
State
Action Taken POOR STABLE GOOD
SINGLE 2000 10000 11000
DOUBLE -3000 8000 18000
If an IS is used, it provides a sales volume forecast (prediction). The manager then chooses a staff
level (action), and finally an actual sales level (state of nature) is realized yielding its associated payoff.
States of nature are uncontrollable, but occur with a probability based on historical data.
State Probability
POOR 0.25
STABLE 0.45
GOOD 0.30
The manager must estimate the accuracy of the IS in forecasting sales levels. If the IS is infallible, it is
called a perfect information system. Most IS’s are imperfect, and the reliabilities are estimated, as follows.
State
Predicted Sales POOR STABLE GOOD
POOR 0.75 0.10 0.15
STABLE 0.15 0.80 0.20
GOOD 0.10 0.10 0.65
QUESTIONS:
1. Is it worth using the IS system?

2. What actions do you recommend and why?
177
178
DATA

States (POOR, STABLE, GOOD)
Actions (SINGLE, DOUBLE)
SINGLE POOR 2000
SINGLE STABLE 10000
SINGLE GOOD 11000
DOUBLE POOR -3000
DOUBLE STABLE 8000
DOUBLE GOOD 18000
prob state value
POOR 0.25
STABLE 0.45
GOOD 0.3
OBJECTIVE MAX

POOR POOR 0.75
POOR STABLE 0.15
POOR GOOD 0.1
STABLE POOR 0.1
STABLE STABLE 0.8
STABLE GOOD 0.1
GOOD POOR 0.15
GOOD STABLE 0.2
GOOD GOOD 0.65
BAYESIAN UPDATING
pObs obs value
POOR 0.2775
STABLE 0.4575
GOOD 0.265

POOR POOR 0.675676
POOR STABLE 0.162162
POOR GOOD 0.162162
STABLE POOR 0.0819672
STABLE STABLE 0.786885
STABLE GOOD 0.131148
GOOD POOR 0.0943396
GOOD STABLE 0.169811
GOOD GOOD 0.735849
MARKET ANALYSIS

value(SINGLE, POOR) 2000
value(SINGLE, STABLE) 10000
value(SINGLE, GOOD) 11000
value(DOUBLE, POOR) -3000
value(DOUBLE, STABLE) 8000
value(DOUBLE, GOOD) 18000
179
POOR 4756.76
STABLE 9475.41
GOOD 14320.8
POOR SINGLE
STABLE SINGLE
GOOD DOUBLE
POOR SINGLE 4756.76
POOR DOUBLE 2189.19
STABLE SINGLE 9475.41
STABLE DOUBLE 8409.84
GOOD SINGLE 9981.13
GOOD DOUBLE 14320.8
SINGLE 8300.0
DOUBLE 8250.0
Policy Variables
180
Example 4 Solution
IS Forecast Prob. Shift Actual Prob. Payoff Expected Best Expected

Decision Decision Sales Payoff Decision Payoff
GOOD .30 11,000
Single STABLE .45 10,000 8,300
POOR .25 2,000

No IS Single 8,300
GOOD .30 18,000
Double STABLE .45 8,000 8,250
POOR .25 -3,000
GOOD .195/.265 11,000
Single STABLE .045/.265 10,000 9,981
POOR .025/.265 2,000

GOOD .2650 Double
GOOD .736 18,000
Double STABLE .170 8,000 14,321
POOR .094 -3,000
GOOD .06/.4575 11,000
Single STABLE .36/.4575 10,000 9,475
POOR .0375/.4575 2,000

Use IS STABLE .4575 Single 9,450
GOOD .131 18,000
POOR .082 -3,000
GOOD .045/.2775 11,000
Single STABLE .045/.2775 10,000 4,757
POOR .1875/.2775 2,000

POOR .2775 Single
GOOD .162 18,000
POOR .676 -3000
Expected value of perfect information without IS = 10,400 – 8,300 = 2,100.

Expected value of perfect information with IS = 10,400 – 9,450 = 950.
Expected benefit of obtaining IS = 9,450 – 8,300 = 1,150 = 2,100 – 950.
181
182
Market Survey Analysis Homework Problem
1. A company is considering expanding its retail store to accommodate recent and projected business growth.
There are two options. The first option (“expand LARGE”) will expand the store by leasing additional floor space
and then remodeling the entire store. The second option (“expand SMALL”) is far less costly. It will expand the
store by redoing the layout and making a small addition. The incremental revenues critically depend on two factors:
(i) the type of option taken, and (ii) the future business condition (either LOW, MEDIUM or HIGH).
State
Action Taken LOW MEDIUM HIGH
NONE 0 0 0
SMALL -10000 30000 50000
LARGE -60000 20000 100000
There is an initial assessment of the likelihood of these market states.
LOW MEDIUM HIGH

Probability 0.20 0.30 0.50
It is possible to undertake a market survey to gain more information. The market survey result will indicate a
particular market state. However, the test result outcome is not completely reliable. Based on historical data, an
assessment of the survey’s reliability is known.
State
LOW 0.60 0.20 0.10
MEDIUM 0.30 0.60 0.30
HIGH 0.10 0.20 0.60
a. What is the value of this project if no test is taken?

b. What is the maximum value of any test?
c. What is the value of this test and what decision should be make given a test result outcome?
183
184
UTILITY ANALYSIS
HANDOUTS
185
186
Utility Homework Problems
I. Lotteries and Certainty Equivalents
1. Consider an individual with zero initial wealth and a utility function U(W) = 1 – exp[-0.0001W]. Find
the certainty equivalent for each of the alternatives below.
Alternative -10,000 0 10,000 20,000 30,000

1 0.1 0.2 0.4 0.2 0.1
2 0.1 0.2 0.3 0.3 0.1
3 0.0 0.3 0.4 0 0.3
4 0.0 0.15 0.65 0 0.2
5 0.5 0 0 0 0.5
2. Consider an individual with zero initial wealth and a utility function U(W) = 1 – exp[-0.0001W]. The
individual is choosing between a certain 20,000 and a lottery with probability p of winning 30,000 or
probability (1-p) of winning 10,000. There is no cost for either alternative.
a. Find the probability p so that the individual is indifferent if the initial wealth is 10,000.
b. Find the probability p so that the individual is indifferent if the initial wealth is 20,000.
3. Consider an individual with initial wealth of 20,000 and a quadratic utility U(W) = W – W2/100,000.
The individual faces a lottery with probability 0.50 of winning 10,000 and a probability of 0.50 of winning
20,000. Find the certainty equivalent of the lottery.
4. Smith has an initial wealth of $125,000 and a utility function U(W) = 3ln (W) + 10. Smith has the
option of playing the following lottery: There is a 5% chance of losing 100,000, a 75% chance of winning
10,000, and a 20% chance of winning 500,000. There is no cost for the lottery. Determine the minimum
amount of money Smith would have to be offered so that Smith would prefer to take this money and not
play lottery A.
5. Smith has an initial wealth of $50,000 and a utility function U(W) = ln (W). Smith has the option of
playing the following lottery A: { (0.10, -$40,000), (0.70,$10,000), (0.20, $100,000) }. There is no cost
for the lottery.
a. What is the minimum amount of money you would have to offer Smith so that Smith would prefer to
take this money and not play lottery A?
b. Smith also has the option of playing lottery B: with probability 0.50 Smith will win $M and with
probability 0.50 Smith will win nothing. There is no cost for the lottery. Determine the smallest value of
M for which Smith would prefer lottery B to lottery A.
187
II. Insurance Analysis
6. Consider a homeowner with utility function U(W) = 1 – exp[-0.00001W] who is deciding on whether
or not to buy fire insurance. There is a 1% chance of a fire in which case it will cost the homeowner
60,000. The insurance premium is 700 per year, and the deductible amount on the loss is D. (In the case
of a fire the homeowner will pay D in addition to the already paid premium of 700.) Determine the
deductible amount that would make the homeowner indifferent between buying and not buying insurance.
The homeowner’s initial wealth is 80,000.
7. Consider a homeowner with utility function U(W) = ln(W) who is deciding on whether or not to buy
fire insurance. There is a 1% chance of a fire in which case it will cost her 75,000. The homeowner’s
initial wealth W0 = 100,000. If she chooses to purchase an insurance policy, she will pay an insurance
premium P up front, i.e., the cost of the policy, and she will pay an additional deductible amount D should
a fire occur. She has spoken with two insurance companies, and each company has offered her a policy, as
follows:
Company 1: Premium P = 3000. Deductible D = 3,000.

a. Determine the best option for her.

b. For the option you recommend in part (a), determine its Certainty Equivalent and associated Risk
Premium.
fire insurance. The homeowner’s initial wealth W0 = 200,000. There is a 1% chance of a fire in which
case it will cost her 150,000. If she chooses to purchase an insurance policy, she will pay an insurance
follows:


b. Determine the Certainty Equivalent and Risk Premium for the option you recommend in part (a).
fire insurance. There is a 1% chance of a fire in which case it will cost her 75,000. The homeowner’s
initial wealth W0 = 100,000. If she chooses to purchase an insurance policy, she will pay an insurance
follows:


b. For the option you recommend in part (a), determine its Certainty Equivalent and associated Risk
Premium.
188
III. Stochastic Dominance
10. Consider the following two mutually exclusive investment opportunities.
PV pdf f pdf g F = cdf f G = cdf g F^ = ∫ F G^ = ∫ G

-10,000 0.20 0.00
0 0.00 0.20
10,000 0.40 0.60
20,000 0.25 0.05
30,000 0.15 0.15
a. Fill out the above table.

b. Which opportunity would you recommend? Explain your reasoning.
11. Consider the following two mutually exclusive investment opportunities.

5,000 0.00 0.70
10,000 0.30 0.00
40,000 0.60 0.00
95,000 0.00 0.30
100,000 0.10 0.00
a. Fill out the above table.

b. Which opportunity would you recommend? Explain your reasoning.
12. For the problems below, we consider two risky alternatives, “X” and “Y”. The probability density
function associated with X is f(x) = 1/6 if 0 ≤ x ≤ 1, f(x) = 1/6 if 4 ≤ x ≤ 9, and f(x) = 0 everywhere else.
The probability density function associated with Y if g(y) = 1/3 if 1 ≤ y ≤ 4 and g(y) = 0 everywhere else.
a. Smith prefers more wealth to less. He has been known to exhibit risky behavior. Can first-order
stochastic dominance be used to know which risky alternative, X or Y, Smith prefers? Explain.
b. Jane’s utility function is U(w) = w 0.5. Which alternative, X or Y, does Jane prefer? (Assume Jane’s
initial wealth is zero.)
c. What is Jane’s certainty equivalent for the risky alternative X?
189
190
Utility Homework Problem Solutions
1. U(W) = 1 - exp[-.0001W].
Cash Amount -10,000 0 10,000 20,000 30,000

Utility -1.718 0 0.632 0.865 0.95
Alternative E[U(W)] CE = U-1[E(U(W))] = 10,000 ln [1/ (1-U)]

1 0.3490 4,292
2 0.3723 4,657
3 0.5378 7,718
4 0.6008 9,183
5 -0.3840 -3,250
2.
a. Initial wealth is 10,000. U(W) = 1 - exp[-.0001W].
Seek the value of p for which U(30,000) = pU(40,000) + (1-p)U(20,000).
Therefore: 0.9502 = 0.8647 + p[0.9817 - 0.8647] ⇒ p = 0.731
b. Initial wealth is now 20,000. U(W) = 1 - exp[-.0001W].

Seek the value of p for which U(40,000) = pU(50,000) + (1-p)U(30,000).
Therefore: 0.9817 = 0.9502 + p[0.9533 - 0.9502] ⇒ p = 0.731 (as before)
NOTE: In general, we seek the value of p for which U(W0 + CE) = U(W0 + X1)p + U(W0 + X2)(1-p).
Let V(W) = 1-U(W). The equality holds with V(W), too. Since V(W) is of the form exp(aW), it follows
that V(x + y) = V(x)*V(y), which means we can divide both sides of the equality by V(W0). We have now
shown that the answer for p must be independent of the value for W0.
3. U(W) = W - W2/100,000. W0 = 20,000.

Begin by finding the value Y for which: 0.50U(30,000) + 0.50U(40,000) = U(Y).
Y satisfies the quadratic equation Y2/100,000 - Y + 22,500 = 0, whose roots are 34,189 and 65,811.
Clearly, Y = 34,189. Now Y = W0 + CE, which means that CE = 14,189.
4. EU(W) = 0.05U(25,000) + 0.75U(135,000) + 0.20U(625,000) = 46.105616. Thus ln(W) = 12.035205,

which implies that W = 168,586.70, the certainty equivalent of the lottery. Since initial wealth W0 =
125,000, Smith would have to be offered 43,586.70 not to play. Note that ln(W) in lieu of 3ln(W) + 10
would have worked just fine, too.
5. a. E[U(A)] = 0.10[ln(10,000)} + 0.70[ln(60,000)] + 0.20[ln(150,000)] = 11.006182 = ln(C).

Thus C = 60,245, which means that break-even point for Smith is 10,245.
b. E[U(B)] = 0.50[ln(50,000)] + 0.50[ln(50,000 + M)] = E(U(A)] = 11.006182.

Thus, the break-even point for Smith is M = 22,590.
6. We seek the deductible D for which the expected utility of not buying insurance equals the expected
utility for buying insurance. U(W) = 1 - exp[-.00001W].
If you do not buy insurance: E[U(W)] = .99U(80,000) + .01U(20,000) = .546977.

If you do buy insurance: E{U(W)] = .99U(79,300) + .01U(79,300 - D)
Therefore D = 11,228
7. Option 1: E[U(W)] = 0.99ln(97,000)+0.01ln(94,000)= 11.4821521.

Option 2: E[U(W)] = 0.99ln(98,000)+0.01ln(90,000)= 11.49187118.
191
No Insurance: E[U(W)] = 0.99ln(100,000)+0.01ln(25,000)= 11.49906252. Best option.
CE of no insurance option = exp(11.49906252) = 98,623.

Expected wealth of no insurance option = 0.99(100,000)+0.01(25,000) = 99,250.
Risk premium = 99,250-98,623 = 627.
8. Option 1: E[U(W)] = 0.99ln(194,000)+0.01ln(188,000)= 12.17529928.

Option 2: E[U(W)] = 0.99ln(196,000)+0.01ln(180,000)= 12.18501836.
CE of no insurance option = exp(12.1922087) = 197,247. Expected wealth of no insurance option =
0.99(200,000)+0.01(50,000) = 198,500. Risk premium = 198,500 – 197,247 = 1253.
9. Option 1: E[U(W)] = 0.99ln(97,000)+0.01ln(94,000)= 11.4821521.

Option 2: E[U(W)] = 0.99ln(98,000)+0.01ln(90,000)= 11.49187118.
CE of no insurance option = exp(11.49906252) = 98,623.

Expected wealth of no insurance option = 0.99(100,000)+0.01(25,000) = 99,250.
Risk premium = 99,250-98,623 = 627.
10.
-10,000 0.20 0.00 0.20 0.00 0 0
0 0.00 0.20 0.20 0.20 2,000 0
10,000 0.40 0.60 0.60 0.80 4,000 2,000
20,000 0.25 0.05 0.85 0.85 10,000 10,000
30,000 0.15 0.15 1.00 1.00 18,500 18,500
A risk-averse investor would select g due to 2nd degree stochastic dominance.

11.
5,000 0.00 0.70 0.00 0.70 0 0
10,000 0.30 0.00 0.30 0.70 0 3,500
40,000 0.60 0.00 0.90 0.70 9,000 24,500
95,000 0.00 0.30 0.90 1.00 58,500 63,000
100,000 0.10 0.00 1.00 1.00 63,500 68,.000
By second-degree stochastic dominance, a risk-averse investor would prefer the density f since G(.) ≥ F(.).
(If the investor is not necessarily risk-averse, then we cannot say.)
12. a. No. The cdfs FX(.) and FY(.) cross.

b. E[U(X)] = ∫ U(x)f(x)dx = 20/9. E[U(Y)] = ∫ U(y)g(y)dy = 14/9. Jane prefers alternative X.
c. (20/9)2 = 4.938.
192

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ECONOMIC DECISION ANALYSIS

Professor: Steve Hackman

1. Course Description and Objectives

6. Projected Topical Outline

A. Cash Flow Analysis.

B. Dynamic Cash Flow Analysis.

C. Financial Options Analysis.

D. Real Options Analysis.

E. Market Survey Analysis.

G. Strategic Decision Analysis.

Scenario Probability I II III IV

Real Estate Investment

Multistage Capital Investment

Natural Resource Investment

**Total payment = 10000[ .10 ÷ {1 – (1 + 0.10)-5} ] = 2637.97.

NPV@10% = 10000-[2238/(1.10)+2303/(1.10)2+2376/(1.10)3+2455/(1.10)4+2542/(1.10)5] = 1021.88.

**Total payment = 10000[ .08 ÷ {1 – (1 + 0.08)-5} ] = 2504.56.

NPV@8% = 10000-[2185/(1.08)+2239/(1.08)2+2298/(1.08)3+2362/(1.08)4+2430/(1.08)5] = 843.41.

NPV@8% = [53/(1.08) + 64/(1.08)2 + 78/(1.08)3 + 93/(1.08)4 + 112/(1.08)5] = 310.70.

NPV@8% = [53/(1.08) + 65/(1.08)2 + 190/(1.08)3] = 255.12.

Discount rate = 12%. Ignore taxes and depreciation.

I. COMPUTE PRESENT VALUE:

The present value cost of option (a) is:

1000 + 300{ [ 1 – (1.12)-10 ] ÷ 0.12} - 100(1.12)-10 = 2662.87.

The present value cost of option (b) is:

1300 + 270{ [ 1 – (1.12)-15 ] ÷ 0.12} - 200(1.12)-15 = 3024.99.

2. COMPUTE ANNUAL EQUIVALENT:

The Annual Equivalent (or Worth) of option (a) is:

2662.87 { 0.12 ÷ [ 1 – (1.12)-10 ] } = 471.28,

and its “lifetime cost” is:

471.28 ÷ 0.12 = 3927.33.

The Annual Equivalent (or Worth) of option (b) is:

3024.99 { 0.12 ÷ [ 1 – (1.12)-15 ] } = 444.14,

and its “lifetime cost” is:

444.14 ÷ 0.12 = 3701.18.

* 46,000 = 40,000 – 0.4(40,000 – 55,000). SV – τ(SV – BV).

PV @ 10% of after-tax cash flow for A = -168,454. AE for 4 years = -53,142.

Process device A is the best option.

* 33,216 = 40,000 – 0.4(40,000 – 23,040). SV – τ(SV – BV).

PV @ 10% of after-tax cash flow for A = -159,758. AE for 4 years = -50,399.

Process device A is the best option.

A. Tax Effect of Depreciation

-(1- τ)[C] = -C + τC = -1000 + (0.40)(1000),

NPV = -1,000 + {[1 – (1.10)-5]/(0.10)} 80 = -1,000 + 3.791(80) = -696.74,

B. Accounting for Depreciation in the Income Statement

Income Statement Approach Flow In – Flow Out Approach

Income Statement Approach: = (1 - τ)[R – C – Dep] + Dep = (1- τ)[R – C] + τ Dep,

Chart 3. Income Inclusion Amount Rates

Page 76 17 Publication 946 (2009)

1 33.33% 20.00% 14.29% 10.00% 5.00% 3.750%

6 5.76 8.92 7.37 6.23 5.285

11 3.28 5.91 4.462

1 58.33% 35.00% 25.00% 17.50% 8.75% 6.563%

6 1.38 8.74 6.76 5.99 5.130

11 0.82 5.90 4.459

Publication 946 (2009) 18 Page 77

1 41.67% 25.00% 17.85% 12.50% 6.25% 4.688%

6 4.26 8.87 7.17 6.15 5.233

11 2.46 5.91 4.463

1 25.00% 15.00% 10.71% 7.50% 3.75% 2.813%

6 7.06 8.85 7.58 6.31 5.336

11 4.10 5.91 4.460

Page 78 19 Publication 946 (2009)