Zeta Airlines Co's Exciting New Flight Route Option Value Calculation

What is the value of the option for Zeta Airlines Co?

Calculate the value of Zeta Airlines Co's option to abandon the new flight route if the demand is low.

Answer:

Through the calculation of expected Net Present Value (NPV) with a discount rate of 15%, the value of Zeta Airline's option to abandon the new flight route if the demand is low is found to be $6.91 million.

Explanation:

This question pertains to the field of finance, specifically the concept of real options and its connection with investment decisions and business strategy. In this case, we evaluate Zeta Airline's option to abandon the route if demand is low. The problem can be solved through expected Net Present Value calculation (NPV) on a perpetuity formula PV = C / r where C is Cash Inflow and r is the discount rate.

Let's firstly calculate the present value of $5 million and $1 million cash inflows. From the data provided, the cash inflow for high demand is $5 million and for low demand is $1 million, with a discount rate of 15%. So, the Net Present Value (NPV) of cash inflows under high and low demand conditions are: NPV (High Demand) = $5 million / 0.15 = $33.33 million; NPV (Low Demand) = $1 million / 0.15 = $6.67 million.

Next, we calculate the present value of the option to abandon. The option value is worth $10 million after 3 years, so the present value (PV) equals: PV (Option) = $10 million / (1 + 0.15)^3 = $6.91 million.

Finally, we compute the expected value of the operation. The expected value equals: NPV (Operation) = (0.40 x $33.33 million) + (0.60 x the greater of $6.67 million or $6.91 million) = $21.64 million.

Therefore, the value of Zeta Airline's option is the greater number between the present value when demand is low ($6.67 million) and the present value of the option itself ($6.91 million), which is $6.91 million.