lecture6-realoptions_1 - Real Options October 10, 2005...

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Unformatted text preview: Real Options October 10, 2005 Corporate Finance 2 DCFs failures Standard DCF assumes a static view of the world: Either you invest or you dont. 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? 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 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 Corporate Finance 5 Value of waiting Suppose you can postpone the decision to invest, at a cost of 5 Then if liberals lose, you dont 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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lecture6-realoptions_1 - Real Options October 10, 2005...

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