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Question 1a

Talam Co, a listed company, aims to manufacture innovative engineering products which are environmentally friendly and sustainable. These products have been highly marketable because of their affordability. Talam Co’s mission statement also states its desire to operate to the highest ethical standards. These commitments have meant that Talam Co has a very high reputation and a high share price compared to its competitors.

Talam Co is considering a new project, the Uwa Project, to manufacture drones for use in the agricultural industry, which are at least 50% biodegradable, at competitive prices. The drones will enable farmers to increase crop yields and reduce crop damage. Manufacture of drones is a new business area for Talam Co. The project is expected to last for four years.

Talam Co will also work on the Jigu Project (a follow-on project to the Uwa Project) to make 95%+ biodegradable drones. It is expected that the Jigu Project will last for a further five years after the Uwa Project has finished. If the Uwa Project is discontinued or sold sooner than four years, the Jigu Project could still be undertaken after four years.

Uwa Project
The following number of drones are expected to be produced and sold:

Year 1 2 3 4
Number of drones produced and sold 4,300 19,200 35,600 25,400

In the first year, for each drone, it is expected that the selling price will be $1,200 and the variable costs will be $480.

The total annual direct fixed costs will be $2,700,000. After the first year, the selling price is expected to increase by 8% annually, the variable costs by 4% annually and the fixed costs by 10% annually, for the next three years. Training costs are expected to be 200% of the variable costs in year 1, 60% in year 2, and 10% in each of years 3 and 4. There is substantial uncertainty about the drones produced and sold, and Talam Co estimates the project to have a standard deviation of 30%.

At the start of every year, the Uwa Project will need working capital. In the first year, this will be 20% of sales revenue.

In subsequent years, the project will require additional or a reduction in working capital of 10% for every $1 increase or decrease in sales revenue respectively. The working capital is expected to be fully recovered when the Uwa Project ceases.

The Uwa Project will need $35,000,000 of machinery to produce the drones at the start of the project. Tax allowable depreciation is available on the machinery at 15% per year on a straight-line basis. The machinery is expected to be sold for $7,000,000 (post-inflation) at the end of the project. Talam Co makes sufficient profits from its other activities to take advantage of any tax loss relief. Tax is paid in the year it falls due.

Jigu Project as a real option
Talam Co estimates that Jigu Project’s cash flows are highly uncertain and its standard deviation is 50%. It is estimated that $60,000,000 will be required at the start of the project in four years’ time. Using conventional net present value, Talam Co’s best estimate is that net present value of the project will be $10,000,000 at the start of the project.

The following figures were estimated for the Jigu Project using the real options method.

Asset value (Pa) = $46,100,000 (to nearest 100,000)
Exercise price (Pe) = $60,000,000
Exercise date (t) = 4 years
Risk-free rate (r) = 2·30%
Volatility (s) = 50%

d1 = 0·329 d2 = –0·671 N(d1) = 0·6288 N(d2) = 0·2510

Call option value: $15,258,399
It can be assumed that the call option value is accurate.
Talam Co’s finance director wants to know how the asset value of $46,100,000 has been estimated.

Honua Co’s offer
Honua Co, whose main business is drone production, has approached Talam Co with an offer to buy the Uwa Project in its entirety from Talam Co, for $30,000,000 at the start of the third year of the project’s life.

Talam Co has calculated some figures to assess the value of Honua Co’s offer using the real options method, as follows:

d1 = 0·779 d2 = 0·355 N(d1) = 0·7821 N(d2) = 0·6387

Talam Co’s finance director has requested that the value of Honua Co’s offer is estimated using the real options method.

She has also requested to know the amounts of the initial variables which would have been used to calculate the d1, d2, N(d1) and N(d2) figures.

It can be assumed that the d1, d2, N(d1) and N(d2) figures are accurate.

Additional information
Both Honua Co and Talam Co pay corporation tax at an annual rate of 20%. Talam Co has estimated Uwa Project’s and Jigu Project’s risk-adjusted cost of capital at 11%, based on Honua Co’s asset beta. Talam Co believes that LIBOR, which is currently 2·30%, provides a good estimate of the risk-free rate of interest.

(a) Discuss how incorporating real options into net present value decisions may help Talam Co with its investment appraisal decisions. (5 marks)