Chapter 22 - Real Optiobs Flashcards
What is the most important use of options in corporate finance?
Capital budgeting decisionsWh
What are real options
Real options are choices that a firm gives themselves the right to make. Real options are not traded in a competitive market, but is rather a framework that conceptualize a way of thinking that use the well established theory on options valuation to make investment decisions.
elaborate on decisions trees
two types of nodes:
1) Square: represent decision
2) Circle: represent point of uncertainty
Costs are associated with the edges of the decisions.
in terms of a decision tree, what is the real option?
Every point where we can wait ofr information before we make a deicison, we call it a real option.
Specifically: A decision node after an information part is called a real option.
elaborate on delaying for new information
Delaying has the advantage of providing more information so that the decision is better made later.
However, delaying has costs associated with it. For instance, competitors can enter, and we can loose interim profits.
Considering real options, if we loose cash flow by waiting, what is the analogy of this cash flow?
Lost dividends from owning the stock. It is exactly like holding the call option, and not being able to receive the dividends.
if we have the option to wait, what can happen to NPV of project?
A project that has NPV negative if we were to initialize it now, can have positive NPV if we choose to wait.
What determine the benefit of waiting?
Every factor that influence the call option will also make it more valuable to wait.
For instance, higher volatility.
we can also add the fact that dividends make it more costly to wait. In other words, the costs of waiting in terms of lost cash flow etc makes it more undesirable to wait.
Say we choose to wait, and a competitor enters the scene i nthe mean time. How do we model this using real options?
It is a cost in terms of lost cash flow. We model this as a dividend.
What is a growth option?
A real option that regards a scenario where we can achieve expansion.
On the other hand, we have abandonment options, which is the opposite. In such cases, we are looking at a case where the choice is between waiting/continuing or giving it up.
When is risk neutral probability and regular probability the same+
If the risk is idiosyncratic
Elaborate on abandonment
Abandonment is something that is often ignored. It is about recognizing how it sometiems is more value added if we consider the option of abandoning a project after some time, rather than pursuing only new ventures.
We use it like an option here as well.
