Lecture 4- Risk and uncertainty

Question 1

Why is it difficult to predict the path of diffusion? Which factors can reduce the predictive power?

Answer 1

It’s due to factors that can have an impact on the diffusion process: Learning, cost of adoption, performance, price expectations, first mover, technology expectations, firm characteristics, discount factor, product differentiation.

Question 2

What is conventional investment evaluation?

Answer 2

It is a fixed strategy that can’t adjust to changing conditions and doesn’t consider decision alternatives.

Question 3

What is the real options approach (RO)?

Answer 3

It transfers the option price theory (finance market) to physical investments. Also having real options make it flexible.

Question 4

Summarize financial options (FO) in relation to RO.

Answer 4

take into account financial assets (stocks, bonds, currencies) and trades on the stock exchange or OTC. While RO (Real option) has real assets (land, buildings, plants, or equipment) and these are not traded on financial exchange.

Question 5

What are the pre-conditions for RO modelling?

Answer 5

1. Irreversibility of investment projects.
2. Flexibility (value of flexibility) regarding timing (e.g. delaying of the building of electric power plant).
3. Uncertainty (about future cash flow).

Question 6

Name and explain different types of Real options

Answer 6

• To defer- to wait before taking an action until more is known.
• To abandon- to sell or close down a project if market conditions are not favourable.
• To switch- to alter the mix of inputs or outputs of a production process in response to market prices.
• To contract- to reduce the scale of a project’s operation in response to demand to mitigate losses.
• To expand- the managers can make a choice among two, three or more strategies.