Mini Case:
13  17
We explain how to calculate P and
σ
2
below.
Just as the price of a stock is the present value of all the stock’s future cash flows, the
“price” of the real option is the present value of all the project’s cash flows that occur
beyond the exercise date.
Notice that the exercise cost of an option does not affect
the stock price.
Similarly, the cost to implement the real option does not affect the
current value of the underlying asset (which is the PV of the project’s cash flows).
It
will be helpful in later steps if we break the calculation into two parts.
First, we find
the value of all cash flows beyond the exercise date discounted back to the exercise
date.
Then we find the expected present value of those values.
Step 1: Find the value of all cash flows beyond the exercise date discounted back to
the exercise date.
Here is the time line.
The exercise date is year 1, so we discount
all future cash flows back to year 1.
0
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 Spring '08
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 exercise date

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