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opt4 - CORPORATE FINANCE Thomas E Copeland and Philip T...

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38 THE McKINSEY QUARTERLY 1998 NUMBER 2 CORPORATE FINANCE A lot, if uncertainty is high But discounting cashflows is the wrong way to calculate it Instead, use options theory to value management’s flexibility to act in the future Thomas E. Copeland and Philip T. Keenan
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THE McKINSEY QUARTERLY 1998 NUMBER 2 39 H AVE YOU EVER BEEN INVOLVED in a capital investment decision where the net present value calculations proved negative, but the manage- ment team decided to go ahead anyway? Or been confronted with a positive NPV project where your intuition warned you not to proceed? Oƒten, it is not your intuition that is wrong, but your time-honored NPV decision- making tools. But there is another way. Managers can use a diƒferent tool: real option value. When a situation involves great uncertainty and managers need flexibility to respond, ROV comes into its own. If the decision you face involves low uncertainty, or you have no scope to change course when you acquire new information later on, then NPV works fine. If not, you will want to know more about what real options are and how to value them. Below, we compare the main decision-making tools and show why traditional techniques such as NPV, economic profit (EP),* and decision trees are incomplete, oƒten misleading, and sometimes dead wrong. We also look at how real options have been used in several practical situations, drawing on simple examples for illustrative purposes rather than going into the mechanics of valuing complicated real options.† Real options began to be properly understood in 1973, when Fischer Black, Myron Scholes, and Robert Merton devised rigorous “arbitrage-free” solutions to value them. Applications have proliferated, particularly in securities markets, where the theory held up remarkably well when tested against actual prices. However, from our point of view 25 years later, the assumptions of the Black–Scholes model seem somewhat restrictive when applied to real options. Tom Copeland is a former principal in McKinsey’s New York oƒfice and Phil Keenan is a consultant in the Cleveland oƒfice. Copyright © 1998 McKinsey & Company. All rights reserved. ≠ Defined as the return on invested capital minus the weighted average cost of capital, multiplied by the invested capital; sometimes known as economic value added. ≤ For a detailed account of this sort, see L. Trigeorgis, Real Options: Managerial flexibility and strategy in resource allocation, MIT Press, Cambridge, Mass., 1996. The authors wish to acknowledge the contributions of Sam Blyakher, Cem Inal, Max Michaels, Yiannos Pierides, and Dan Rosner.
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Put simply, “arbitrage-free” means that securities with exactly the same risk/return profiles should be identically priced. If you can describe the payouts on one risky security and then build a portfolio of other securities with exactly the same payout, the price of both must be the same. If the prices were not identical, arbitrage, or buying the underpriced security and selling the other, would be possible. This simple idea is at the heart of option pricing.
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