Mitch Plc, a UK-based smart phone manufacturer, is considering adding a new model of smart phones to its current production line. The success of the new model depends on general market conditions. Mitch’s current share price is £100.
If the conditions are good, the revenues from the project are estimated to be £30 million a year for 5 years, starting a year from now, and the share price will be £150. On the other hand, if the conditions are bad, the revenues are expected to be £5 million a year for the first 3 years, and £2 million for the remaining 2 years of the project, and the share price will be £50. The initial cost of the project is £50 million. The risk-free rate is 10%.
Required
a) Calculate the Net Present Value (NPV) of the project.
b) Mitch’s CEO thinks that the project is too risky and wants to wait for a year and only
invest in the project if the conditions are good. Assume that, if the decision is delayed, the project’s cash flows and its time duration will not change but the positive cash flows will start in 2 years’ time. Also, assume that Mitch’s competitors are not ready to produce a similar smart phone model within the next 12 months.
Calculate
the NPV of the project if the CEO’s proposal is accepted
the value of the option to delay the project.
c) Calculate the price of a call option on Mitch’s stock that expires in one year’s time, with an exercise price of £100, and show all your workings, using.
i. Risk-neutral binomial valuation approach and
ii. Tracking portfolio approach.
