real_options_20073_2per

real_options_20073_2per - Real options Applying Derivative...

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Real options Applying Derivative Valuation Techniques to Capital Applying Derivative Valuation Techniques to Capital Budgeting Financial Policy and Corporate Control - Callahan 1 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? | Should you invest in the project? Financial Policy and Corporate Control - Callahan 2
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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 consultant? Financial Policy and Corporate Control - Callahan 3 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 Following the study results you can choose whether or not to pursue the project. | Now what is the value of the project? Financial Policy and Corporate Control - Callahan 4
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Decision trees vs real options | The previous is an example of a decision tree. | Applying decision trees in a standard NPV DCF valuation requires: Knowledge of the major decision points z z Likelihood of the possible outcomes z Appropriate discount rates for the various stages / 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 Financial Policy and Corporate Control - Callahan 5 sometimes is better, sometimes not) Real Options | Throughout the life of a project managers make adjustments in response to unexpected developments 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 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 only when it is valuable to do so, and stay the course otherwise. | From this perspective, almost any project contains options. Financial Policy and Corporate Control - Callahan 6
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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 an ad hoc way by, e.g., using a lower or higher discount rate.
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real_options_20073_2per - Real options Applying Derivative...

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