Describe each of the following situations in the language of options:
a. Drilling rights to undeveloped heavy crude oil in Northern Alberta. Development and production of the oil is a negative-NPV endeavor. (The break-even oil price is C$70 per barrel, versus a spot price of C$60.) However, the decision to develop can be put off for up to five years. Development costs are expected to increase by 5% per year.
b. A restaurant is producing net cash flows, after all out-of-pocket expenses, of $700,000 per year. There is no upward or downward trend in the cash flows, but they fluctuate as a random walk, with an annual standard deviation of 15%. The real estate occupied by the restaurant is owned, not leased, and could be sold for $5 million. Ignore taxes.
c. A variation on part (b): Assume the restaurant faces known fixed costs of $300,000 per year, incurred as long as the restaurant is operating. Thus,
Net cash flow =revenue less variable costs- fixed costs
$700,000 = 1,000, XXXXXXXXXX,000
The annual standard deviation of the forecast error of revenue less variable costs is 10.5%. The interest rate is 10%. Ignore taxes.
d. A paper mill can be shut down in periods of low demand and restarted if demand improves sufficiently. The costs of closing and reopening the mill are fixed.
e. A real estate developer uses a parcel of urban land as a parking lot, although construction of either a hotel or an apartment building on the land would be a positive-NPV investment.
f. Air France negotiates a purchase option for 10 Boeing 787s. Air France must confirm the order by 2010. Otherwise Boeing will be free to sell the aircraft to other airlines.