# (solution) E. Solution Legend = Value given in problem =

Thanks,

E. Solution Legend
= Value given in problem
= Formula/Calculation/Analysis required
= Qualitative analysis or Short answer required The following information is for pedagogical purposes only and unlike earlier questions does not deal with real situation.
There are rumors that Netflix is negotiating a three year agreement with Pivotal, according to which Netflix will have a right to
series of options. Also you might find the following option pricing formulas useful (r is the risk-free rate, p is the risk-neutral
probability, Cn is the option payoff in node n) Part E Risk-neutral probability formula Given
AWS current price (in \$ millions)
Price increase (%), u
Price decrease (%), d
Risk free Interest rate, r
Spinnaker's Price (in \$ millions) \$ \$ 400.00
20%
-10%
3%
450.00 Option values formulas with1 period C0 r pC 1 pCd tree
e
u exp( rt ) S d
exp rt (1 d )
p Su Sd
u d with3 period C0 3r
tree
e Risk-neutral probability
One-period discount factor (exp(-risk free rate))
Solution
Today Year One Year Two
1 Year Three
2 Option 2 3
\$691.2
\$450.0 Attention – this is not a binomial option tree!!!
Option 1 \$576.0
\$450.0
\$480.0
\$450.0 AWS Price
Spinnaker Price
Price Netflix pays
Product used \$518.4
\$450.0 \$400
\$450 \$432.0
\$450.0
\$360.0
\$450.0 \$388.8
\$450.0
\$324.0
\$450.0 Value of option 1 (year 1)
Value of option 2 (year 2)
Value of option 3 (year 3)
Total value \$291.6
\$450.0 Option 3 Your recommendation p C with 2 period C0 2r p2Cuu 2p1 pCud 1 p Cdd
tree
e
3 uuu 2 3p2 1 pCuud 3p1 p Cudd 1 p Cddd
2 3 The terminal period growth rates were estimated such that the intrinsic valuation of the firm's equity would equal the current
market capitalization of the firm using the &quot;Goal Seek&quot; function. 