FM11 Ch 12 Show

FM11 Ch 12 Show - 12 - 1 Real options Decision trees...

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Unformatted text preview: 12 - 1 Real options Decision trees Application of financial options to real options CHAPTER 12 Real Options 12 - 2 What is a real option? Real options exist when managers can influence the size and risk of a projects cash flows by taking different actions during the projects life in response to changing market conditions. Alert managers always look for real options in projects. Smarter managers try to create real options. 12 - 3 It does not obligate its owner to take any action. It merely gives the owner the right to buy or sell an asset. What is the single most important characteristic of an option? 12 - 4 How are real options different from financial options? Financial options have an underlying asset that is traded--usually a security like a stock. A real option has an underlying asset that is not a security--for example a project or a growth opportunity, and it isnt traded. (More...) 12 - 5 How are real options different from financial options? The payoffs for financial options are specified in the contract. Real options are found or created inside of projects. Their payoffs can be varied. 12 - 6 What are some types of real options? Investment timing options Growth options Expansion of existing product line New products New geographic markets 12 - 7 Types of real options (Continued) Abandonment options Contraction Temporary suspension Flexibility options 12 - 8 Five Procedures for Valuing Real Options 1. DCF analysis of expected cash flows, ignoring the option. 2. Qualitative assessment of the real options value. 3. Decision tree analysis. 4. Standard model for a corresponding financial option. 5. Financial engineering techniques. 12 - 9 Analysis of a Real Option: Basic Project Initial cost = $70 million, Cost of Capital = 10%, risk-free rate = 6%, cash flows occur for 3 years. Annual Demand Probability Cash Flow High 30% $45 Average 40% $30 Low 30% $15 12 - 10 Approach 1: DCF Analysis E(CF)=.3($45)+.4($30)+.3($15) = $30. PV of expected CFs = ($30/1.1) + ($30/1.1 2 ) + ($30/1/1 3 ) = $74.61 million. Expected NPV = $74.61 - $70 = $4.61 million 12 - 11 Investment Timing Option If we immediately proceed with the project, its expected NPV is $4.61 million. However, the project is very risky: If demand is high, NPV = $41.91 million.* If demand is low, NPV = -$32.70 million.* _______________________________________ * See FM11 Ch 12 Mini Case.xls for calculations. 12 - 12 Investment Timing (Continued) If we wait one year, we will gain additional information regarding demand. If demand is low, we wont implement project....
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This note was uploaded on 04/24/2008 for the course FNCE 3010 taught by Professor Donchez,ro during the Spring '07 term at Colorado.

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FM11 Ch 12 Show - 12 - 1 Real options Decision trees...

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