Question

Hi, my teacher posted this question: A ship next year is worth 1100 in up market, 230 in down market. The probability of up-market is 65%. owners can choose to scrap the ship 275 now or 320 in one year. cost of capital = 10%, rf = 5% beta =1. a) what is standard NPV b) what is DTA NPV c) how much is the flexibility worth? the answer is supposed to be: a) 446.2 b) 466.8 and c) 481.7

Answer 1

A. Standard NPV

At t = 1,

Worth in upmarket = 1100, Probablity = 0.65

Worth in downmarket = 230, Probablity = 0.35

Net worth = 1100*0.65 + 230*0.35 = 795.5

At t - 0,

Net Worth = 795.5/1.1 = 723.3

Opportunity Cost = 275

Standard NPV = -275 + 723.3 = 448.2

B. DTA NPV

Tree is attached in the image.

DTA NPV = -275 + ((1100*0.65/1.1)+(230*0.35)/1.1) = 476.8

Note: During downmarket, owner will choose to scrap the ship

C) Flexibility worth -

As we have a definite scrap value at the end of the year 1, therefore we will lower the discount rate required to discount the scrap value to risk free rate

Flexibility = -275 +((1100*0.65/1.1) + (320*0.35/1.05)) = 481.7