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lecture6-realoptions_1 - Real Options DCFs failures...

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Real Options October 10, 2005
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Corporate Finance 2 DCF’s failures Standard DCF assumes a “static view” of the world: Either you invest or you don’t. If you do, you know what the expected cash flows are However, in many investments: There is leeway about the timing of the investment There are choices one can make in the future The question: how to introduce these in capital budgeting?
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Corporate Finance 3 The Value to Wait Option pricing is a useful method to account for timing and irreversibility Example: An investment project: » If the next government is liberal, NPV = 100 » If conservative, NPV = - 100 The next gov. is going to be liberal with probability .50 NPV of the project is .5 x 100 - .5 x 100 = 0
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Corporate Finance 4 Uncertainty Suppose there are local elections between now and the general elections If the local elections are won by liberals, the prob that they will also win the next general election is .8 » NPV = - 100 x .20 + 100 x .80 = 60 If not, the prob is .20: » NPV = - 100 x . 80 + 100 x .20 = – 60
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Corporate Finance 5 Value of waiting Suppose you can postpone the decision to invest, at a cost of 5 Then if liberals lose, you don’t invest If the prob of liberals winning the local election is .50, NPV = .5 x 60 + .5 x 0 – 5 = 25 So the value of the project is 25 when the option to wait is considered.
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