CHAPTER TWENTY-TWO REAL OPTIONS When you use discounted cash flow (DCF) to value a project, you implicitly assume that your firm will hold the project passively. In other words, you are ignoring the real options attached to the project options that sophisticated managers can take advantage of. | 22. Real Options CHAPTER TWENTY-TWO R E A L O P T I O N 616 Brealey-Meyers Principles of Corporate Finance Seventh Edition VI. Options 22. Real Options The McGraw-Hill Companies 2003 WHEN YOU USE discounted cash flow DCF to value a project you implicitly assume that your firm will hold the project passively. In other words you are ignoring the real options attached to the project options that sophisticated managers can take advantage of. You could say that DCF does not reflect the value of management. Managers who hold real options do not have to be passive they can make decisions to capitalize on good fortune or to mitigate loss. The opportunity to make such decisions clearly adds value whenever project outcomes are uncertain. Chapter 10 introduced the four main types of real options The option to expand if the immediate investment project succeeds. The option to wait and learn before investing. The option to shrink or abandon a project. The option to vary the mix of output or the firm s production methods. Chapter 10 gave several simple examples of real options. We also showed you how to use decision trees to set out possible future outcomes and decisions. But we did not show you how to value real options. That is our task in this chapter. We will apply the concepts and valuation principles you learned in Chapter 21. For the most part we will work with simple numerical examples. The art and science of valuing real options are illustrated just as well with simple calculations as complex ones. But we will also show you results for several more complex examples including A strategic investment in the computer business. The valuation of an aircraft purchase option. The option to develop commercial real estate. The decision to operate or mothball an oil tanker. These examples show how financial managers value real options in real life. THE VALUE OF FOLLOW-ON INVESTMENT OPPORTUNITIES It is 1982. You are assistant to the chief financial officer CFO of Blitzen .
