78106_25_Web_Ch25B_p01-02 - WEB EXTENSION Risk-Neutral...

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WEB EXTENSION 25B Risk-Neutral Valuation T his extension provides an introduction to a financial engineering technique known as risk-neutral valuation. As we discussed in the chapter, decision trees will almost always give an inaccurate estimate of a real option s value because it is impossible to estimate the appropriate discount rate. In many cases there is an existing model for a financial option that cor- responds to the real option in question. Sometimes, however, there isn t such a model, and then financial engineering techniques must be used. Many financial engi- neering methods are extremely complicated and are best left for an advanced finance course. However, one method is reasonably easy to implement with simulation anal- ysis. This method is risk-neutral valuation , and it is similar to the certainty equiva- lent method (discussed in Chapter 11) in that a risky variable is replaced with one that can be discounted at the risk-free rate. We show how to apply this method to the investment timing option presented in the chapter. Recall that Murphy Software is considering a project with uncertain future cash flows. Discounting these cash flows at a 14% cost of capital gives a present value of $51.08 million. The cost of the project is $50 million, so it has an expected NPV of $1.08 million. Given the uncertain market demand for the software, the resulting NPV could be much higher or much lower. However, Murphy has certain software licenses that allow it to defer the project
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This note was uploaded on 05/03/2010 for the course FRR 3032 taught by Professor Mr.wroshr during the Spring '10 term at Crafton Hills College.

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78106_25_Web_Ch25B_p01-02 - WEB EXTENSION Risk-Neutral...

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