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78106_25_Web_Ch25B_p01-02

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

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W E B E X T E N S I O N 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.

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

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