Topic_11_E2 - It is well suited when deciding whether or...

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Topic 11, Exercise 2 Using Real Options for a Risk Management Framework Real Options is a risk management technique that uses an options framework to evaluate investments in nonfinancial assets. Many firms are using options analysis to analyze risks involved in capital budgeting. While some firms have actually moved to full blown options analysis, other firms have used the techniques to modify more traditional analyses of risk. The concepts are particularly suited to assessing risks on projects that will have additional decision points over their duration. A recent article entitled, “Thinking in Real (Options) Time,” describes how the concepts can be used to analyze risk. After reading this article, address the following questions: 1. How does the real options approach differ from traditional NPV analysis with respect to analyzing a project over time? One of the advantages of the “real options” approach over more traditional approaches is in analyzing strategic projects.
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Unformatted text preview: It is well suited when deciding whether or not to continue a project or abandon a project after receiving results from initial investment. You can analyze a project over time using this framework whereas traditional NPV analysis is better suited to the analysis of a single-period decision. 2. Explain how a firm may have to change its performance evaluation and compensation formulas for managers if it adopts a “real options” approach. Performance evaluation and compensation must be consistent with the outcomes of real options analysis. One of the potential, and indeed likely, outcomes from a real options analysis is the decision to abandon a project. You do not want to penalize a manager for making a decision to abandon a project. Some performance measures may be tied to short-run profitability and assets under management as measured by some growth statistic. The performance measures must be consistent with the decision to abandon an investment....
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This note was uploaded on 09/13/2011 for the course FIN 6301 taught by Professor El-asmawanti during the Fall '09 term at University of Texas at Dallas, Richardson.

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