Week 3 – risk analysis, real options, and capital budgeting

1. Real Options

A. JTMAirlinesislookingatbuyingmoregatesattheirhomeairport.JTM’sdiscountrateis 5.5% and the risk free rate is 2.0%. What is the NPV of the gate purchases if it bought them today? Use the data in the Excel template provided.

B. After you run the numbers for part A, you remember back to the concept of real options, which means that JTM can make investment decisions as time passes:

1. Present valuing the purchase price of the gates (that is, the years 1 and 2 Capital Expenditures) separately using the risk-free rate. Once JTM decides to go ahead with the purchase, there is no risk to that expenditure.

2. Present valuing the Net Cash Flow excluding those purchase prices. This calculation will include Cap. Ex. for years 3-15 as they are part of the normal operation of the gates and are unrelated to the purchase price.

3. Use the Black-Scholes Option Pricing formula to come up with option’s price assuming a 2-year maturity and a 15% price volatility for gate prices.

4. Compare the price of the call option with the NPV in the No Real Options scenario. Is the option worth it?

2. Decision Tree

JTM really liked your work on the option pricing of the gates, so they ask you to look at their 3- phase expansion at their home airport. The three phases are:

A. Uponpurchaseofthenewgates,startamarketingprogramtopromoteJTM’sroutesto the East Coast, West Coast, and the Caribbean. If all goes well and the market is receptive, they will go on to phase 2.

B. Phase2hasJTMinvestinnewroutestothedestinationslisted.Ifatanytime,JTM finds that this is not going to work, they will pull the plug on everything.

C. Phase3hasJTMstartthenewroutestothedestinationslisted.Ifthingsdon’tgowell on any of the three destinations, they will pull the plug on everything.

After much work with other departments, you generate enough data to calculate the NPV of the 3-phase expansion. Before you have a chance to save all your work, there is a power spike and you lose part of your work. You have to complete it for a presentation. Please use the Excel template provided to complete this.

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