MGMT332 Financee

2

>Prob.

1

+

growth

%

%

(% of sales):

1 2

5 6

Sales

%

Cost of Goods Sold

Advert., Prom., & Selling

General & Administrative

Income before Tax

(incl.

)

TV

.0

																																																																																																																																																																																																																																																																																																																																																																																																																																		JRA Inc.
Yrs. 1-			6				7
	Sales	2.		8	2.			5	Cash Flows
	Costs			3			4
	Cost of Goods Sold	52%	66.0
	Advert., Prom., & Selling		23
	General & Administrative	5%
	Rates:
Tax rate	21%		Net
	Discount rate	6.6%	Taxes
Results	Net Income after Tax
			PV of NCF	TV	Cash flow adjustments:
+ Cash	3.3	Working Capital	1.4	1.3	1.2	1.1	1.0	0.		9
– Debt			3.5	Capital Expenditures			2.0	1.9	1.8	1.7	1.6	1.5
Total Equity (M$)	Net Cash Flows
– # of shares outstanding (M)			14
– Price/share ($)

alfonso canella:
The perpetuity formula is the present value of all cash flows from years 7 and on. It is a significant portion of the firm’s value and the assumed growth rate should be carefully considered.
alfonso canella:
This calculation is the value of the firm. To get the value of the equity, add cash and subtract interest bearing debt. The equity value is then divided by the number of shares outstanding to get the price per share.
Note that many firms buy back their shares to boost their stock price!
alfonso canella:
This is the long term or steady state growth rate for the firm. It is crucial for the firm’ stock price. The higher it is, the more valuable the firm is.
alfonso canella:
The discount rate is the firm’s weighed average cost of capital – that is, the weighed cost of debt and equity. To invest, the firm should get a return higher than the discount rate. This number can go up or down depending on the perceived risk of each investment – up for higher risk and and down for lower risk.

Prob. 2

Rates:
Discount rate
1 2 3 4 5 6 7 8 9

14

8.0

2.0

3.5

5.0

5.6

PV of NCF
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Cash from Operations 5.0 5.6 6.2 6.8 7.4 8.0 8.6 9.2 9.8 10.4 11.0 11.6 12.2 12.8 13.4

5.0

minus: Capital Expenditures 2.0 2.3 2.6 2.9 3.2 3.5 3.8 4.1 4.4 4.7 5.0 5.3 5.6 PV of NCF
= Net Cash Flow

Terminal Value 55.0

PV of NCF

PV of Cap. Ex. (Yrs. 1-2)

– 0

– 0

– 0

– 0

	JTM Airlines
Risk-free rate
Scenario: No Real Options
	10		11		12		13		15
	Cash from Operations					5.0				5.6		6.2		6.8		7.4			8.0		8.6		9.2		9.8		10.4		11.0		11.6		12.2		12.8		13.4
	minus: Capital Expenditures	9.0		2.3		2.6		2.9		3.2		3.8		4.1		4.4		4.7		5.3
	= Net Cash Flow
	Terminal Value		55.0
Scenario: Real Options	Option Pricing:
	PV of Cap. Ex. (Yrs. 1-2)
Maturity
Risk free rate
Volatility			55%
BS calculations:
d1										– 0
N(d1)
d2
N(d2)
Price of call
Difference:
– Value of Option over PV
– % of PV
Text answer here.

alfonso canella:
The NPV function of Excel makes quick work of the yearly cash flows by present valuing them according to when they happen. The terminal value must also be included. It can be put in as a year 16 and included in the NPV function or as a year 15 cash flow, as done here.
alfonso canella:
The largest cash outflows in the project are considered to be the cost of doing the project. The smaller cash outflows are seen to be operating costs. So, the two large Cap Ex are discounted using the risk free rate as these investments will be made no matter what. Because they will be made no matter what, they are not risky, so the risk free rate is used.
alfonso canella:
This is the option pricing formula. It is called the Black-Scholes formula as it was devised by Fisher Black and Myron Scholes. It has five inputs: time to maturity (in years), risk free rate (the alternative investment), the volatility of prices for the specific project (so if this were an oil industry project, the volatility would be the price volatility of crude oil), the strike price (that is, the PV of the Cap Ex necessary to do the project), and the present value of the cash flows that accrue from doing the project.
alfonso canella:
The NPV function of Excel makes quick work of the yearly cash flows by present valuing them according to when they happen. The terminal value must also be included. It can be put in as a year 16 and included in the NPV function or as a year 15 cash flow, as done here.

Prob. 3

JTM Airlines

Costs Net

0

55%

%

– 0

20

Success

55%

%

Failure – 0

45%

Success

30 Success

23

Start Failure – 0

7

Failure – 0

33

Failure – 0

40

Airport Expansion
	Start	Phase I	Phase II	Phase III	PV of Revenues	Probability	Expected Value
			Success		30
25
East Coast
	20	34
				Failure
	45%
180
29
West Coast
	33		40
22
66%	410
70%
Caribbean
25%	43
32	30%
22%
34%

v. MAR 2021

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MGMT 332
Corporate Finance I

Module 3: Risk Analysis, Real Options, and Capital Budgeting

Problem Set 3 – Risk Analysis, Real Options, and Capital Budgeting

1. Company Valuation
Your manager has asked you to value Ted Enterprises, a potential acquisition. To make
your life easier, your manager gave you some of the numbers in the Excel template file
provided. Note that your manager wants the dollar price per share, so you must
calculate the dollar value of the equity and then divide by the number of shares
outstanding.

2. Real Options

a. JTM Airlines, where you work, is looking at potentially buying more gates at their
home airport. If it pays the airport $1M, JTM will hold exclusive rights to buy
those gates for $17M (at the start) and $17.5M (one year later) at any time in the
next 4 years. The option expires at the end of year 4. JTM’s discount rate is 10%.
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 your ERAU
corporate finance class’s coverage of real options. You know that the 4-year
option has value, so you decide to calculate it by:

1. Present valuing the purchase price of the gates 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. Using the Black-Scholes Option Pricing formula to come up with option’s
price assuming a 4-year maturity and a 10% price volatility for gate
prices.

4. Compare the price of the call option as calculated using the BSO formula
with the NPV in the No Real Options scenario. With this, you can decide
whether or not the $1M option is worth it or not. Is it?

3. 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. Upon purchase of the new gates, start a marketing program to promote JTM’s
routes to the East Coast, West Coast, and the Caribbean. If all goes well and the
market is receptive, they will go on to phase 2.

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b. Phase 2 has JTM invest in new routes to the three sets of destinations listed. If at
any time, JTM finds that this is not going to work, they will pull the plug on phase
2 and scratch the project.

c. Phase 3 has JTM start the new routes to the destinations listed. If things don’t go
well on any of the three destinations, they will pull the plug on phase 3 and
scratch that destination out.

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 in the building, and you lose part of your work. You have to go back and
complete it so you can present it to your manager. Please use the Excel template
provided to complete problem 3.

Module 3: Risk Analysis, Real Options, and Capital Budgeting