Question 2.AeroTech Inc is evaluating an investment in a joint venture to establish a state-of-the -art aircraft maintenance hub that will provide services to leading international airlines. The project is designed to operate for 30 years requiring an initial investment of 90 million and is projected to yield a net present value (NPV) of 10 million for AeroTech Inc. The project lead contends that the reported NPV of 10 million does not fully capture the project's value, as it excludes the embeddec option allowing AeroTech Inc to sell its stake in the venture back to its partner for 40 million at any point within the first ten years. The standard deviation of returns is estimated at 45% per annum, while the risk-free interest rate stands at 5% per annum.

The correct answer is:<br /><br />D. The project lead is correct, and the NPV of the project should be adjusted to reflect the value of the embedded option.<br /><br />Explanation:<br />The project lead is correct in the reported NPV of $10 million does not fully capture the project's value, as it excludes the embedded option allowing AeroTech Inc. to sell its stake in the venture back to its partner for $40 million at any point within the first ten years.<br /><br />The embedded option can be considered as a real option, which is a valuable feature of the project. The real option allows AeroTech Inc. to exercise its right to sell its stake in the venture back to its partner for $40 million at any point within the first ten years.<br /><br />To adjust the NPV to reflect the value of the embedded option, we can use the Black-Scholes model for real options. The Black-Scholes model is a widely used option pricing model that can be used to value real options.<br /><br />The Black-Scholes model requires the following inputs:<br />1. The current price of the underlying asset (in this case, the stake in the venture).<br />2. The strike price of the option (the $40 million option to sell the stake back to the partner).<br />3. The risk-free interest rate (5% per annum).<br />4. The volatility of the returns (45% per annum).<br />5. The time to maturity (10 years).<br /><br />By plugging in these inputs into the Black-Scholes model, we can calculate the present value of the embedded option. This present value can then be added to the reported NPV of $10 million to obtain the adjusted NPV that reflects the value of the embedded option.<br /><br />Therefore, the project lead is correct, and the NPV of the project should be adjusted to reflect the value of the embedded option.