SECTION B- ADVANCED INVESTMENT APRAISAL
PART 1 (Each 25 marks)
QUSESTION 01: CHARLIE CO.
The Chief Executive Officer (CEO) of Charlie Co has just returned from a discussion at a leading university on the ‘application of options to investment decisions and corporate value’. She wants to understand how some of the ideas which were discussed can be applied to decisions made at Charlie Co. She is still a little unclear about some of the discussion on options and their application, and wants further clarification on the following:
Charlie Co is involved in the exploration and extraction of oil and gas. Recently there have been indications that there could be significant deposits of oil and gas just off the shores of the Republic of Ireland. The Government of the Republic of Ireland has invited companies to submit bids for the rights to commence the initial exploration of the area to assess the likelihood and amount of oil and gas deposits, with further extraction rights to follow. Charlie Co is considering putting in a bid for the rights. The speaker leading the discussion suggested that using options as an investment assessment tool would be particularly useful to Charlie Co in this respect.
The speaker further suggested that options were useful in determining the value of equity and default risk, and suggested that this was why companies facing severe financial distress could still have a positive equity value.
Towards the end of the discussion, the speaker suggested that changes in the values of options can be measured in terms of a number of risk factors known as the ‘Greeks’, such as the ‘Vega’. The CEO is unclear why option values are affected by so many different risk factors.
a. With regard to (i) above, discuss how Charlie Co may use the idea of options to help with the investment decision in bidding for the exploration rights, and explain the assumptions made when using the idea of options in making investment decisions.