What is the embedded real option in the project

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Reference no: EM131977109

Question: Fox Searchlight Pictures recently purchased a script for a new movie about a poker player. It will cost $40 million to produce the movie (which is fixed regardless of when it is produced). Following the production of the movie today, the cash flow to be generated from the movie in year 1 will be $40 million with 25% chance or $10 million with 75% chance. From year 2, the movie will generate $5 million, which will decline by 5% per year forever. Given the growing popularity of the poker game, the producer believes that it may be better to delay the decision of movie production for a year. In year 1, the uncertainty about the first cash flow to be generated from the movie one year after production ($40 million or $10 million) will be resolved. The remaining cash flows will be the same as above (that is, the second cash flow will be $5 million, which will decline by 5% per year forever). The firm requires at least 15% on the project. Do not consider any other factors.

(a) What is the NPV of the project if the firm needs to decide today whether to invest in the project?

(b) What is the embedded real option in this project? Can the real option be regarded as a call option or a put option? Identify the underlying asset and the exercise price of the option.

(d) Should the firm need to produce the movie now or wait a year?

Reference no: EM131977109

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