Chapter14 - Chapter 14 Real Options ANSWERS TO...

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Mini Case: 14 - 1 Chapter 14 Real Options ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS 14-1 Financial options deal with securities like stocks and debt instruments, whereas real options deal with physical assets like capital budgeting projects. There are many different types of real options, ranging from those related to whole plants to options on commodities such as oil, electricity, gas, and copper. We focused primarily on real options as they relate to capital budgeting, and we specifically considered (a) timing options, under which investment decisions can be delayed, (b) abandonment options, under which an operation can be closed down if it is more profitable to do so than to continue with it, (c) growth options, under which companies can expand operations if things work out especially well, and (d) flexibility options, under which inputs and/or outputs can be changed if market conditions change. The text discusses several approaches to dealing with real options: Ignore them. Just use traditional DCF approaches to capital budgeting. Recognize them and deal with them in a qualitative, judgmental manner. Take a decision tree, or scenario analysis, approach, and find the NPV of a project with and without considering the real option or options. The difference between the with and without cases represents the value of the option. Employ an option pricing model, especially the Black-Scholes model, to determine the value of the real option. If the option has a positive value, then this will lead to a specific decision. For example, in the timing option analysis, if the timing option is positive, then the project should be delayed so as to avoid “killing off” an option with a positive value. Go into “financial engineering,” wherein specialized option models are developed to deal with specific issues. Financial engineering literally employs “rocket scientists” who develop complex mathematical models, and it goes beyond the scope of the text. In the chapter BOC spreadsheet model, we analyze a project’s timing option using the first 4 procedures. The Tool Kit for the chapter extends the analysis to growth, flexibility, and abandonment options. Some real options are inherent in capital budgeting, but others can be created. For example, abandonment and timing option may be inherent in a given asset decision, but the plant might have to be designed to provide for input and output flexibility options. Even timing and abandonment options might not be inherent—management might have to take actions to make them possible. It is important to both identify and create real options, as they can greatly reduce risk and increase expected profitability.
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Mini Case: 14 - 2 14-2 See the BOC model for an example of a scenario analysis and a Black-Scholes analysis for an investment timing option. Similar analyses for growth and abandonment options are contained the chapter Tool Kit. Some controversy exists regarding the use of decision trees versus formal option
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This note was uploaded on 04/27/2008 for the course FINC 3333 taught by Professor Melissawilliams during the Spring '08 term at UH Clear Lake.

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Chapter14 - Chapter 14 Real Options ANSWERS TO...

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