¶ … Financial Management
Required: I
Net Present Value (NPV) is a financial technique used in capital budgeting to evaluate the profitability of a project. To determine the viability of investment, it is critical to invest when NPV is positive or greater than zero. Organizations face option to move forward with the investment or to abandon an investment. When an NPV is greater than zero, the investment should be accepted. The decision tree is very critical in the investment analysis. Using NPV could assist in making right investment decision. From fig 1, John could only accept the investment since it is revealed that NPV of an investment is more than 1 which is profitable. However, when the profit is $0. It will not be possible for John to pursue the investment
Fig 1: Decision Tree
Profits
$1,000-$500=$500
In the contemporary business environment, investor should consider volatility of stock before making an investment decision. Typically, the variable behind calculating fair value of stock option is the volatility, and volatility has largest effect on stock price. Typically, the percentage change in stock price is normally being affected by the volatility of the stock price. Volatility of stock measures the uncertainty about the return that stocks will yield. Although, it is essential to pursue with the investment decision when NPV is positive, however, when there is high degree of volatility in the economy, it is better to wait before implementing an investment even when NPV is positive. It should be noted that volatility of the stock is out of control of decision maker. However, using Black-Scholes Model, it is advisable to implement short-term investment under volatility period when NPV is positive.
Moreover, "in the absence of dividends, it is not to exercise call earlier. In the real option context, it is always better to wait unless there is a cost of doing so. The greater the costs, the less attractive, the less attractive the options to delay become." (Hillier, Ross. Westerfield, and Jaffe, 2005). However, the interest rate is the critical factor that determines call premiums. The increase in the interest rates will increase the call premiums which will make the premium to decrease. To understand the effect of interest rates, it needs to compare option position to owing a stock. On the other hand, cash dividends option prices have significant effect on the underlying stock price. The stock price is expected to drop by the amount of dividends at ex-dividend rate. Dividends are very critical when exercise a stock call option. The call options are very critical when determining the cash dividend. Investment decision is based on the whether an investment stands to yield positive NPV. (Brealey, Myers, and Allen 2008).
To value a project; it is necessary to estimate the discount cash flow to determine the opportunity of highest value of a project as being measured by NPV. Given uncertainty inherent in the investment due to volatility, it is essential to assess the sensitivity of an investment using NPV. (Hillier, Ross, Westerfield, and Jaffe, (2005)
Required: II
Using the Black-Scholes Model it is appropriate to start the project today and not to wait for one year before starting the project. To invest today or wait for one year before starting the project, it is essential to invest when NPV is substantially greater than zero. It is critical to invest today if the NPV of today is greater than NPV of waiting. For example, an investment that currently has negative NPV should wait until the NPV is positive. If the NPV is positive today it is better to invest today rather than wait till next year because an investment with positive NPV today is likely to generate positive free cash flow. In the real world, there is always a price to pay by delaying an investment decision. Thus, it is better to invest today if the NPV is positive and exceed the option of waiting. When there is high degree of uncertainty due to volatility, it is better to wait before implementing an investment.
Based on the application of the Black-Scholes model in the present day financial analysis, short-term investment analysis could only be valued using Black-Scholes model because volatility could change at very rapid rate within few days. Typically, Black-Scholes model is not too applicable for medium term or long-term option. As being argued by the Black-Scholes model, hedge is the key behind the derivation where option of buying and selling the underlying asset right away is very critical to eliminate the investment risks. The model calls the hedge the delta hedging which is the basis of complicated hedging strategies. Typically, Black-Scholes require an investor to make investment decision right away to eliminate investment risks...
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