Chapter 22 - Real Options V2 Flashcards
What is the most important part about options in corporate finance?
The most important application of option in corporate finance is its use case in capital budgeting decisions
why is capital budgeting so important?
Firms typically end up having hundreds and thousands of differnet projects that pull income. In order to navigate it, we need to understand their value.
How can R&D be a regarded as an option?
Call option. We commit a small amount of cash to start the project. If it turns out to be a success, we “exercise” the option and go hard into it. If not, we discard it. This is exactly the dynamics of a financial option.
The question we ask when faced with R&D projects is essentially “what is this test project actually worth when considering the fact that the R&D project supply us information we would not get otherwise”
Are there rules that guide us in the real option methods?
No, not really. It can often be very application specific.
however, we have certain rules that aid us.
There are 3 common options that occur in real options. Which?
1) The option of waiting to invest
2) The option to grow in the future
3) The option to abandon a poorly performing project.
What is a real option?
A real option is a tool we use (not traded on a market) to make capital budgeting decisions.
A real option is the right to make a specific business decision
Regarding the 2 movie decisions, what is the outcome in terms of principle?
The option to wait turned out to be valuable. In other words, the expected payoff from one choice was better than doing all at once. this means that the information received later is important, regardless of what the information is.
How do we solve a decision tree?
We start at the leaves. Like always, we find the intrinsic value at the different outcomes.
at each decision node, we register the optimal choice by selecting the one with the largest payoff.
At each information node, compute expected payoff.
Always compute present values.
What discounting rate do we use to compute the present values when considering real options?
We need to be careful here. If the cost or profit is guaranteed, then we need to use the risk free rate.
If the money is a cash flow that has uncertainty or is the result of funding, we need to discount with the appropriate cost of capital.
This most likely apply to cases where we can choose to pay for instance 5 million now or in a year. in a year, the 5 million should be discounted using the risk free rate.
BS require volatility. How do we deal with this?
Typically by finding a comparable and select its volatility.
elaborate on the general theory behind real options in regards to waiting to invest
In short, it is a trade off between the uncertainty of the project/industry and the immediate and close-term cash flows that we would sacrifice should we wait.
Keyword: Uncertainty. Volatility.
if we wait, this is akin to reducing the uncertainty. we end up observing the state. If we do not wait, we have more uncertainty.
In addition, if the uncertainty is very large to begin with, it represent a large ability of the project to be a bust or to be a success. Investing now would be risky.
The general case is that high volatility and low immediate sacrifice point in the direction of waiting.
however, one must be very aware of how waiting introduce risk in regards to seeing other players enter the scenery.
What is an interesting outcome of real options in regards to the option to wait?
We can have singificantly negative NPV project that become positive NPV projects when considering the option to wait.
what abstract concept is used in real options to represent cash flows we sacrifice etc?
Dividends
elaborate on the distinction between the “deciding when to invest” option, and the “growth option”
Two entirely different things.
Deciding when to invest is about reducing uncertainty by observing market evolving. Based on the added informaiton, we can make a decision.
Growth options also reduce uncertainty by waiting, but not be observing from the outside. Instead, we make a project initially, and then use the results of this project to decide on the option to grow further.
what happens if risk is idiosyncratic?
investors do not require premium for it, and therefore the return is equal to the risk free rate. This means that we can use the risk neutral probabilities as the actual probabilities.
What is the option in this image?
There is no option. This is a standard NPV deicison problem.
