ECO 359 Practice Problems 3
1. Ross et al.s Corporate Finance text has a number of questions on real options at the end of
Chapter 9 (5th edition). To familiarize yourself with the concept I advise you to try a few of
2. An independent Toronto movie company has hired you as a consultant. They have just
finished filming their first blockbuster-to-be and are trying to determine the best strategy for
The company is well-known and respected among the local movie-goers, and the movie is
guaranteed to make $10,000 in revenues if released in Toronto only (without any additional
The outcome of the world-wide release is uncertain. The launch will require additional
expenses of $550,000 -- mainly for the marketing campaign, without it the company will
make zero profits outside Toronto. This promotion campaign can backfire, as it will reveal the
(possibly very low) movie quality to everybody, including the loyal Toronto audience. If the
campaign is successful (the revealed movie quality is high), the movie will yield $1,120,000
total (including Toronto audience) in revenues. If the movie ‘tanks’, it'll make zero revenues.
The probability of success is 50% (that is, 50-50 chance that the movie is good). Assume that
the company is risk neutral and cares about expected profits only.
(a) Should they release the movie world-wide?
Now suppose that one has an option to conduct 100% informative preview: based on the
audience response, the company will know for sure whether the movie succeeds of tanks
world-wide. The preview will be confidential, and will not reveal the movie quality to the
loyal Toronto audience.
(b) Assume for subparts (b) and (c) only that conducting such preview is free. Should the
company go ahead with it?
(c) What is the option value of conducting the preview (assuming conducting it is free)?
(d) Will the company be willing to pay for such a preview? If so, what is the maximum
amount that the company would be willing to pay for such a preview?
3. Ross et al’s Corporate Finance text has a number of questions at the end of Chapter 16 (5th
edition). If you need additional practice, I advise you to try (some of –not all!) of the
following questions from the 5th edition: 16.1, 16.2, 16.3, 16.7, 16.10, 16.11. You may ignore