corp_Ch23_09

corp_Ch23_09 - CLASS NOTES WEEK X BMA Ch.23 Real options...

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IRPGEN424 Corporate Finance Alex Kane 1 CLASS NOTES WEEK X BMA Ch.23 Real options
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IRPGEN424 Corporate Finance Alex Kane 2 Real vs. financial valuation DCF in capital budgeting invokes the opportunity cost of capital. To price an option embedded in a project, it is difficult to use DCF. The required rate for this type of CF constantly changes We use the same principle: The opportunity cost includes the price of the option, if traded in capital markets The fact that a firm’s project (the underlying) doesn’t trade is of no consequence when we price an option on it
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IRPGEN424 Corporate Finance Alex Kane 3 Real and financial options The wide array of traded options may look to uninformed observers as a casino for speculators. While it is that, too, albeit with a positive expected return (!), it provides an externality The rich array of real options that need to be priced to ensure financing of worthwhile projects (including public/non profit), give traded options another use: confirm prices of real options and create desired hedges for various risks
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IRPGEN424 Corporate Finance Alex Kane 4 A project comes with a real option to wait A business idea rarely comes with a fixed date. Access to the opportunity is a call option on it, you strike on a date that maximizes NPV NPV = PV(future CF) – I = P – I Since uncertainty about I and P is continuously resolved, waiting may rescue investors from investing in negative NPV projects (1) If investment is fixed, I=X = strike price of the (American) call. Underlying = PV(project CF) (2) If I is significantly random, we hold an option to exchange P for I. Pricing this option is not a problem
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IRPGEN424 Corporate Finance Alex Kane 5 Malted Herring The text solves the Malted Herring example with a binomial tree In the excel file the B-S formula is used. The foregone CF is akin to dividends, which reduces the value of the stock by PV of these dividends The dividend rate reduces the capital gains rate of the project, its rate of increase is less than cost of capital The (close) B-S solution is equivalent to what you would get if you expanded the one-stage tree to (large) n stages The one-stage tree overstates the value of the call by 7%
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IRPGEN424 Corporate Finance Alex Kane 6 Malted Herring CF=25/year D=25, P=250 Build now: NPV=70 C=70 CF=16/year D=16, P=160 Build now: NPV= –20 C=0 I = –180 Build now: P=PV(CF)=200 NPV=20 rf = 0.05 u = (25+250)/200 = 1.375
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corp_Ch23_09 - CLASS NOTES WEEK X BMA Ch.23 Real options...

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