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VC > 2.1 Real Options > Flashcards

2.1 Real Options Flashcards

1
Q
  1. What are the steps in valuating flexibility?
A

1: Identify Options
2: Value the Flexibility

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2
Q
  1. What are the conditions when identifying options?
A

1: News will arrive in the future
2: When it arrives, the news may affect the decision

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3
Q
  1. “Phases”, “Scenarios”, “Strategic Investment” might be clue for ___
A

Real Options

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4
Q
  1. Checklist of frequently encountered options
A
  • Growth option
  • Abandonment option
  • Option to expand or contract scale
  • Timing option
  • Option to switch (inpouts, outputs, processes, etc.)
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5
Q
  1. Timing Options / Option to defer
A

• Flexibility over the timing of the investment. Can wait to invest

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6
Q
  1. Timing Options / Option to defer. Important in:
A

• Real estate, technology

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7
Q
  1. Staged Investment
A

Option to reevaluate and/or abandon project at any time

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8
Q
  1. Staged investment important in
A

R&D, energy, start-up ventures

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9
Q
  1. Option to expand/contract scale
A

If market conditions change, the firm can expand/contract the fraction (for example the production scale)

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10
Q
  1. Option to expand/contract scale important in
A

Natural resources,
fashion, real estate,
consumer goods

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11
Q
  1. Option to abandon
A

If market conditions decline, management sells off assets.

Like a put option. Can, but don’t have to get rid off…..

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12
Q
  1. Option to abandon important in __
A

Capital-intensive industries, new product introduction in uncertain markets

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13
Q
  1. Option to switch
A

Management can change product mix or switch inputs

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14
Q
  1. Option to switch important in
A

Volatile markets with shifting preferences, energy companies

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15
Q
  1. Growth options
A

Allows for follow-up investments if prices or demand changes

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16
Q
  1. Growth options important in
A

High tech; industries with multiple product generations

17
Q
  1. Multiple Interaction Options + important in?
A

Project involve a collection of various options – both put and call types.

Important in many industries

18
Q
  1. Different real options
A

1: Timing option (option to defer)
2: Staged Investment
3: Expand/Contract Scale (alter operating scale)
4: Option to abandon
5: Option to switch
6: Growth options
7: Multiple Interacting Options

19
Q
  1. In what ways can we value an option
A

1: Binomial trees
2: Black-Scholes

20
Q
  1. What strategies can we use when creating binomial trees?
A

1: Replicating portfolio
2: Risk Neutral Valuation

21
Q
  1. Horizon is a new start-up, and plans to enter 9 new markets in year 2. The key uncertainty is the price markup on transport. its a 50% chance that it’s 25% and a 50% chance its 15%. Assume losses of $ 5.9 million per market then. (You want high markups). If the markup is 25%, they will be able to generate 13,7 per market. Cost of Capital is 16%. Show the value:
A

One tree up gives 13,7 * 9 = 123

Tree down gives 0 (Investors are not passive, so they will not enter 9 markets)

Value: [0,5 * (9 * 13,7)] / 1,16^2 = 46

22
Q
  1. When can you use the decision tree approach?
A

When you are sure you are facing a zero-beta project

23
Q
  1. What discount rate are used with decision trees
A

Can use Risk-Free Rate or the firms Cost of Capital

24
Q
  1. How can you simplify a project with two different phases – and how can you value the lower bound?
A

Simplify by separating the DCF-analysis of them.

Add the DCF-values together. This is a benchmark for the lower bound

So you only go with Phase 2 if it has positive NPV

25
Q
  1. What is risk neutral pricing
A
  • Assumption that all investors are risk-neutral
  • This means that all financial instruments yield the same return = risk free
  • Then compute the probability that ensure no arbitrage
26
Q
  1. What are some practical issues with real options?
A

1: What volatility to use
2: Interpretation
3: Which method should be used

27
Q
  1. How to find the volatility?
A

1: Informed Guess
2: Use data available

28
Q
  1. How to interpret
A

Since we use simplified models, results needs to be taken with a grain of salt.

Put complexity back into the model with:

1: Sensitivity analysis
2: Conditioning and qualifying of inferences

29
Q
  1. Consider two firms that could both do the same project. Both can execute the project early, or they could wait. How much is the option worth when there is a competitor?
A

• Check both value of investing immediately and

  • Competitor enters now
  • Competitor enters later

• Do the same calculating the option value of waiting when

  • Competitor enters now
  • Competitor enters later

Then put payoffs in a matrix and view it as a game. Solve for the Nash Equilibrium

30
Q
  1. Under the BS assumptions, the stock price follows a ____
A

Geometric Brownian motion (GBM)

31
Q
  1. How do we get the annual volatility?
A
  • Estimate from daily stock changes

* Ignore days without much trading, i.e. weekends or holidays (concentrate on trading days)

32
Q
  1. What does ARCH/GARCH do?
A

Helps us predict tomorrow’s variance conditional on today’s.

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