real_options_20073_3per

real_options_20073_3per - Real options Applying Derivative...

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1 Real options Financial Policy and Corporate Control - Cal ahan 1 Applying Derivative Valuation Techniques to Capital Budgeting Simple project | A project costs $1M today and is equally likely to generate either $100,000 or $300,000 of after-tax expected cash flows for 10 years. The appropriate discount rate is 12% | What is the NPV of the project? Financial Policy and Corporate Control - Cal ahan 2 | Should you invest in the project? Simple project continued | Suppose you could hire a consultant today, who could tell you today whether the future expected project cash flows will low ($100,000) or high ($300,000). | How much would you be willing to pay the Financial Policy and Corporate Control - Cal ahan 3 consultant?
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2 Simple project continued | Suppose no consultant is available, but you can for a cost of $100,000 perform a 1-year feasibility and marketing study that will yield the same information. | Following the study results you can choose whether or not to pursue the project. Financial Policy and Corporate Control - Cal ahan 4 | Now what is the value of the project? Decision trees vs real options | The previous is an example of a decision tree. | Applying decision trees in a standard NPV DCF valuation requires: z Knowledge of the major decision points z Likelihood of the possible outcomes Financial Policy and Corporate Control - Cal ahan 5 z Appropriate discount rates for the various stages / branches | An alternative valuation approach that tackles the same issues is real options z Real options uses a different set of inputs (which sometimes is better, sometimes not) Real Options | Throughout the life of a project managers make adjustments in response to unexpected developments. | Having flexibility to adapt a project to a changing environment is clearly valuable. | The goal is to be able to quantify the value if feasible. These types of flexibility are often referred to as “strategic Financial Policy and Corporate Control - Cal ahan 6 | These types of flexibility are often referred to as “strategic options” as they allow managers to respond strategically to changes in the firm’s operating environment. | Option-like payoffs arise because managers will alter course only when it is valuable to do so, and stay the course otherwise. | From this perspective, almost any project contains options.
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3 Real option valuation | Sometimes managers ignore, or overrule, the results of a discounted cash flow (i.e., NPV) analysis on “strategic grounds” because they don’t feel that NPV captures the “strategic value” of a project. | Other times, the NPV analysis might be “fudged” in Financial Policy and Corporate Control - Cal ahan 7 an ad hoc way by, e.g., using a lower or higher discount rate. | We will try to develop a more disciplined approach to valuing these strategic options – but it can be difficult!
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real_options_20073_3per - Real options Applying Derivative...

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