Passage of time brings deviation from forecasts and new information

# Passage of time brings deviation from forecasts and

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Passage of time brings deviation from forecasts and new information Opportunities to abandon, expand, or redirect the venture: real options Select strategy with the highest expected value, given the venture’s real options 90
Option Basics The right, but not the obligation, to make a decision and take an action in the future Option value depends on Market price of the underlying asset Volatility of the price of the underlying asset Time to option expiration Time value of money Option premium: cost to acquire an option 91
Call Option 92
Put Option 93
Real vs. Financial Options Real options are similar to financial options Important differences Real option markets are not complete Real options often are interdependent Real option premium May bear little relation to the value of the option 94
Real Options: Example A building supply store is considering expanding its capacity. The alternatives are to build a new store, expand the existing store, or do nothing. The following NPV estimates (\$ millions) based on economic conditions have been provided: 95 Market Upturn (p=0.20) Stable Market (p=0.60) Market Downtur n (p=0.20) Build new store 1.9 0.3 -0.5 Expand old store 1.5 0.5 -0.3 Do nothing 0.5 0.0 -0.1
Real Options and Rival Reactions Decisions of competing firms can be highly interdependent Decision trees may not reflect all possible reactions from rivals Game theory & Nash equilibrium apply 96
Chapter 5 Developing Business Strategy Using Simulation
Learning Objectives Understand the advantages of using simulation to describe the risks underlying new ventures Understand the steps involved in developing a simulation model for a new venture Be able to make better strategic decisions by using and evaluating the statistical information produced by a simulation model Apply simulation techniques to evaluate common real options that face new ventures 98
Simulation Decision trees are limited to a few discrete outcomes and probabilities Simulation models the behavior of a complex system through the use of another system Simulation can incorporate uncertainty about Venture Business environment (industry, macroeconomy, etc.) Rival reactions 99
Who Relies on Simulation? 70% of Fortune 500 companies Professional sports teams Simulation tools (Excel Add-ins): Venture .SIM™ @Risk ® Crystal Ball ® 100
Uses of Simulation in New Venture Finance Strategy formulation Deal structuring Risk allocation Contingent claims evaluation Cash needs assessment Staging investments Valuation 101
Describing Risk: Probability Distributions Discrete distributions Finite number of potential outcomes Uniform discrete: events have equal probabilities Probabilities need not be equal 102
Describing Risk: Probability Distributions Continuous distributions Normal: symmetrical Lognormal: non-zero problem Triangular: prevents extreme outliers Exponential: decay rate – mean is half-life Binomial: yes-no processes 103
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Simulating the Value of a Stock Option