Question 1

SECTION B: ADVISORY REPORT

This question is worth 25 marks.

OrbitLink Communications ('OrbitLink') is a North American startup specializing in low-earth orbit (LEO) satellite technology. The company is evaluating a massive capital investment to launch a regional satellite constellation ('Project Alpha').

The traditional Net Present Value (NPV) analysis for Project Alpha shows a negative base-case NPV of $15.5 million. However, OrbitLink's CEO argues that launching Project Alpha provides the company with a crucial strategic advantage: the option to expand the network globally in Year 3 ('Project Omega'). Without launching Project Alpha now, the global expansion in Year 3 would be impossible.

EXHIBIT 1: Real Option Parameters for Project Omega (Expansion)
OrbitLink's financial analysts have gathered the following data to value the option to expand using the Black-Scholes Option Pricing (BSOP) model:
- The present value of the expected cash flows from the global expansion (Project Omega), discounted to today (Year 0), is estimated at $180 million.
- The capital expenditure required to launch Project Omega in exactly 3 years is estimated at $220 million.
- The risk-free rate of interest is 4% per annum (continuously compounded).
- The volatility (standard deviation) of the present value of the cash flows for satellite projects is estimated at 35% per annum.

EXHIBIT 2: Black-Scholes Formula Variables
d1 = [ln(Pa / Pe) + (r + 0.5 * s^2) * t] / (s * sqrt(t))
d2 = d1 - s * sqrt(t)
Call Value = Pa * N(d1) - Pe * e^(-rt) * N(d2)

REQUIREMENTS:

(a) Using the Black-Scholes Option Pricing model, calculate the value of the real option to expand (Project Omega). (12 marks)

(b) Calculate the Adjusted Present Value (APV) / Strategic NPV of the overall investment decision (combining Project Alpha and the real option). Conclude whether OrbitLink should proceed with Project Alpha. (4 marks)

(c) The CEO has also suggested that if Project Alpha fails, the satellite technology could be sold to the military in Year 2. Identify what type of real option this represents and explain how its existence would impact the overall project valuation. (No calculations required). (4 marks)

(d) Discuss the practical limitations and assumptions of using the Black-Scholes model to value real options in a highly volatile, technology-driven startup environment like OrbitLink. (5 marks)

Accepted Answer

1. For part (a), carefully extract the 5 variables needed for the Black-Scholes formula. Calculate d1 and d2 step-by-step, showing your workings. Look up the normal distribution values for N(d1) and N(d2), remembering that N(-x) = 1 - N(x). Plug these into the final call value formula. 2. For part (b), simply add the option value to the base NPV and conclude based on whether the sum is positive. 3. For part (c), identify it as an abandonment/put option and explain that it adds value by limiting downside risk. 4. For part (d), critique the assumptions of the BSOP model (constant volatility, European exercise, tradable underlying asset) against the reality of a physical, illiquid satellite project.

Question 2

What mistakes do candidates make on this ACCA question?

Accepted Answer

Mathematical errors in calculating d1 and d2 are very common, particularly with the natural logarithm (ln) and the square root of time. Another frequent mistake is misinterpreting the normal distribution table for negative values of d1 or d2. In part (d), students often give generic NPV limitations rather than specific BSOP limitations.

How to approach this question

Full Answer

Common mistakes

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