Question

Real options problems 2. You just finished a week of heli-skiing and had such a good time that you want to go again next year. Plus, the heli-ski outfit is offering the following deal: If you pay for your vacation now, you can get a week of heli-skiing for $2,500. However, if you cannot ski because the helicopters cannot fly due to bad weather, there is no snow or you get sick, you do not get a refund. There is a 20% probability that you will not be able to ski. Your other option is to wait and book the trip one week before you go. The heli-ski company requires a minimum of one week advanced booking. In this case, your cost is $5,000, but you can be much more certain about the conditions, your health and the weather. Now, the probability that you will not be able to ski is only 5%. In either case, you estimate the pleasure you get from heli-skiing is worth $6,000. If your cost of capital is 8% per year, should you book ahead or wait? (pay now benefit = $1,944.44, wait benefit = $648.15), so better to pay now.

Answer 1

THERE ARE THREE DIFFERENT QUESTIONS , HENCE ONLY FIRST ANSWERED

Ans-1

Booking Now

Present Value of Gain = 6000/(1+8%) = 5555.56...(A)

Cost Today of Booking = 2500......(B)

Gain = A - B = 1944.44

But there is a 80% chance of this gain hence doscounting for probability Gain = 1944.44*80% = 1555.56

Booking Later:

Present Value of Gain = 5555.56

Present Value of Cost = (5000)/(1+8%) = 4629.63

Net Gain = 5555.56 - 4629.63 = 925.93

Discounting for success probability = 925.93*95% = 879.63

Decision:

Better to Book now