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ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
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:
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
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.
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.