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Unformatted text preview: Real Options October 10, 2005 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? 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 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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This note was uploaded on 11/22/2010 for the course FINANCE 100104 taught by Professor Pfofessorking during the Spring '10 term at Erusmus University Rotterdam .
 Spring '10
 PfofessorKing
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