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Unformatted text preview: 19. Real options Generically, an option gives the holder the right but not the obligation to take some action. We have discussed put and call options on financial assets . A real option is an option involving real assets . Uncertainty The main drawback to NPV is that it is not entirely satis- factory in how it addresses uncertainty : cash flows are treated as if known with certainty , and all investment decisions are treated as if they are made at the outset . 2 Real options Scenario, sensitivity, simulation , and break-even analysis are useful tools for addressing uncertainty. Real options provide another tool: Provide a means for addressing uncertainty that is diffi- cult to handle using standard capital budgeting decision criteria Address the fact that future decisions may be based on information which is not yet available (possibly only determined after project has been started). 3 Real Options: Another Way to Value Internet Initiatives, Dan Latimore, Financial Executive, May/June 2000 Few would argue with the difficulties encountered in valuing In- ternet investments. Dan Latimore discusses the problems of using traditional discounted cash flow methods such as net present value or return on investment measures to value these stocks. In this essay, he offers up an alternative valuation method using real op- tions. 4 Example Investment timing decision Standard discounted cash flow analysis says that if a project has a positive NPV then we should do it....
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slides19 - 19. Real options Generically, an option gives...

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