option characteristics, i.e., presence of an underlying asset, limited downside risk and significant upside potential, and a fixed life. 2.Philosophical Basis: Proponents believe that firms may hold option-like real assets and the market incorporates the values of these assets into the stock price. Any difference between the value arrived at by the model and the market price is indicative of mispricing and will be corrected over time. 3.Input Requirement: The same inputs as those needed by the option pricing model
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FINS3641 SAV Week 1: The Role and Approaches to Valuation 9 Third Approach – Contingency Claim (Real Option) Valuation Models 4.Applicability: best for Equity in deeply troubled firm with negative earnings and high leverage (a call option on the assets of the firm) The stock of a small, bio-technology firm with no revenues and profits, but patents on products that have not reached the marketing and production stages (a call option on the underlying product) Reserves owned by natural resource firms (a call option on the underlying resource) Rights possessed by a firm to expand an existing investment / technology into new markets or new products (a call option on the underlying product) assets with an uncertain future when DCF models may underestimate the expected future cash flows and/or overestimate the discount rate 5.Limitations: The underlying asset is not traded making it hard to estimate the value of a real option the underlying asset