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Lecture Intermediate corporate finance – Chapter 14: Real options

Lecture Intermediate corporate finance – Chapter 14: Real options. This chapter presents the following content: Real options, decision trees, application of financial options to real options. | CHAPTER 14 Real Options Topics in Chapter Real options Decision trees Application of financial options to real options What is a real option? Real options exist when managers can influence the size and risk of a project’s cash flows by taking different actions during the project’s life in response to changing market conditions. Alert managers always look for real options in projects. Smarter managers try to create real options. What is the single most important characteristic of an option? It does not obligate its owner to take any action. It merely gives the owner the right to buy or sell an asset. (More.) How are real options different from financial options? Financial options have an underlying asset that is traded--usually a security like a stock. A real option has an underlying asset that is not a security--for example a project or a growth opportunity, and it isn’t traded. How are real options different from financial options? The payoffs for financial options are specified in the contract. Real options are “found” or created inside of projects. Their payoffs can be varied. What are some types of real options? Investment timing options Growth options Expansion of existing product line New products New geographic markets Types of real options (Continued) Abandonment options Contraction Temporary suspension Flexibility options Five Procedures for Valuing Real Options 1.DCF analysis of expected cash flows, ignoring the option. 2.Qualitative assessment of the real option’s value. 3.Decision tree analysis. 4.Standard model for a corresponding financial option. 5.Financial engineering techniques. Analysis of a Real Option: Basic Project Initial cost = $70 million, Cost of Capital = 10%, risk-free rate = 6%, cash flows occur for 3 years. Demand Probability Annual cash flow High 30% $45 Average 40% $30 Low 30% $15 Approach 1: DCF Analysis E(CF) =.3($45)+.4($30)+.3($15) = $30. PV of expected CFs = ($30/1.1) + ($30/1.12) + . | CHAPTER 14 Real Options Topics in Chapter Real options Decision trees Application of financial options to real options What is a real option? Real options exist when managers can influence the size and risk of a project’s cash flows by taking different actions during the project’s life in response to changing market conditions. Alert managers always look for real options in projects. Smarter managers try to create real options. What is the single most important characteristic of an option? It does not obligate its owner to take any action. It merely gives the owner the right to buy or sell an asset. (More.) How are real options different from financial options? Financial options have an underlying asset that is traded--usually a security like a stock. A real option has an underlying asset that is not a security--for example a project or a growth opportunity, and it isn’t traded. How are real options different from financial options? The payoffs for financial options