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Ch15 - Chapter 15 Real Options Road Map Part A Introduction...

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Chapter 15 Real Options Road Map Part A Introduction to finance. Part B Valuation of financial assets, given discount rates. Part C Determination of discount rates. Part D Introduction to corporate finance. Efficient Market Hypothesis (EMH). Capital budgeting. Real options. Financing decisions. Main Issues Strategic Options Valuation of Real Options and Capital Budgeting
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15-2 Real Options Chapter 15 Contents 1 Strategic Options . . . . . . . . . . . . . . . . . . . . . . . . 15-3 1.1 Value of Strategic Options: An Example . . . . . . . . . . . . . . 15-4 1.2 Option of Waiting . . . . . . . . . . . . . . . . . . . . . . . . . . 15-9 1.3 Options to Undertake Follow-up Projects . . . . . . . . . . . . . . 15-10 1.4 Comments on Strategic Options . . . . . . . . . . . . . . . . . . 15-13 2 Homework . . . . . . . . . . . . . . . . . . . . . . . . . . . 15-15 15.407 Lecture Notes Fall 2003 c Jiang Wang
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Chapter 15 Real Options 15-3 1 Strategic Options In investment decisions, we often face situations involving strategic options. Common and important options in capital investments include: The option to wait before investing The option to make follow-on investments The option to abandon a project The option to vary output or production methods. Two key elements in strategic options and their valuation: 1. New information arrives over time 2. Decisions can be made after receiving new information. In the previous example of optimal timing with changing demand, the decision is made today based on information today about fu- ture cash flows. It does not take into account (1) new information arriving later and (2) flexibility to adjust investment decisions in response to the new information. In this section, we focus on the impact of strategic options with these two elements on capital investment decisions. c Jiang Wang Fall 2003 15.407 Lecture Notes
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15-4 Real Options Chapter 15 1.1 Value of Strategic Options: An Example Example 1. UW Inc. is deciding whether or not to buy a copper mine: The mine can produce one million kilograms (kg) of copper, but only for one year, and it becomes useless after that. It takes one year to extract the copper, and the extraction cost is $1.8 per kilogram paid up-front, which is increasing at 10% per year. The copper price is now S 0 = $2 per kilogram. The next year, it may either increase by the factor u = 1 . 3 to $2.6, or decrease by the factor d = 0 . 8 to $1.6 with equal probability, p = 0 . 5 . All uncertainty about copper price is resolved next year.
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