Chapter14 - CHAPTER 14 Real Options 1 Topics in Chapter...

Info iconThis preview shows pages 1–14. Sign up to view the full content.

View Full Document Right Arrow Icon
  1 CHAPTER 14 Real Options
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
  2 Topics in Chapter Real options Decision trees Application of financial options to real  options
Background image of page 2
  3 What is a real option?   Real options exist when managers can  influence the size and risk of a project’s cash  flows by taking different actions during the  project’s life in response to changing market  conditions. Alert managers always look for real options in  projects. Smarter managers try to create real options.
Background image of page 3

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
  4 What is the single most important characteristic of an option? It does not obligate its owner to take  any action.  It merely gives the owner  the right to buy or sell an asset.
Background image of page 4
  5 (More. ..) 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  isn’t traded. 
Background image of page 5

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
  6 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.
Background image of page 6
  7 What are some types of  real options? Investment timing options Growth options  Expansion of existing product line New products New geographic markets
Background image of page 7

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
  8 Types of real options  (Continued) Abandonment options Contraction Temporary suspension Flexibility options
Background image of page 8
  9 Five Procedures for  Valuing Real Options 1.DCF analysis of expected cash flows,  ignoring the option.  2.Qualitative assessment of the real  option’s value. 3.Decision tree analysis. 4.Standard model for a corresponding  financial option. 5.Financial engineering techniques.
Background image of page 9

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
  10 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. Demand Probability Annual  cash flow High 30% $45 Average 40% $30 Low 30% $15
Background image of page 10
  11 Approach 1: DCF Analysis E(CF) =.3($45)+.4($30)+.3($15)  = $30. PV of expected CFs = ($30/1.1) +  ($30/1.12) + ($30/1/13)  = $74.61 million. Expected NPV = $74.61 - $70   = $4.61 million.
Background image of page 11

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
  12 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 IFM9 Ch 14 Mini Case.xls for  calculations.
Background image of page 12
  13 Investment Timing  (Continued) If we wait one year, we will gain  additional information regarding 
Background image of page 13

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Image of page 14
This is the end of the preview. Sign up to access the rest of the document.

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.

Page1 / 61

Chapter14 - CHAPTER 14 Real Options 1 Topics in Chapter...

This preview shows document pages 1 - 14. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online