LT (2) Real Options Flashcards
What is a real option?
real options: the right but not the obligation to modify a project in the future.
Do managers in the real world just watch the future unfold? NO! As new information arrives over time, they may:
Follow up with additional investment to capitalise on initial success
Abandon or shrink a project to avoid future losses
Why are real options valuable?
If the future is certain, flexibility is meaningless:
Every aspect of an investment decision (what, when, how much) can be optimised up-front.
There is no need to deviate from this plan.
But if the future is uncertain, flexibility is valuable: Opportunity to make more money
Opportunity to avoid losses
The more uncertain the future, the greater the value of the real options that provide this flexibility.
Project valuation should account for the value of any built-in real options.
What is a decision tree, and what do they help managers determine?
Decision tree: a diagram of sequential decisions and possible outcomes.
Decision trees help managers determine their options by showing:
Available actions
The sequence/timing of events and actions
Possible outcomes (i.e. payoffs)
What are the two types of risk a manager faces?
Two types of risk:
Market-type risk – idiosyncratic (e.g type of customer) Cash-flow risk – systematic (e.g. economic growth)
How do you valaute a project without no real options?
Baseline Valuation: no real options (i.e. tradtional NPV)
Remember to use risk-adjusted discount rate (CAPM)
What are the two ways you can determine the value of a real option?
Two ways in which you can determine the value of a real option:
1) Real option NPV - No option NPV
2) Value it directly by working with associated probabilities (and work with incremental cash flows)
e.g. Abandoment option value = value of company with abadonment option - value of company without abandonment option
Is it worthwhile to wait for market research (if the market research delays the implementation of the project?
It depends! Recall option theory:
Early exercise of an American call on a non-dividend paying stock is never optimal
Early exercise may be optimal for a dividend-paying stock
The drop in value of not begining project straight away is analogous to a dividend. We miss out on the dividend by not exercising early.
So, if no costs on waiting then wait for more info, but if there are costs to waiting it may be worthwile to begin the project.
Waiting can be costly if valuable production opportunities (e.g. revenues) are sacrificed.
Similar to losing dividends when delaying the exercise of an American call option.
What are the three main types of real options?
Option to abandon (temporary abadnoment or permanant abandonment)
The project may no longer be profitable going forward Value comes from reducing/avoiding future losses
Option to grow/expand
Investment may turn out to be more profitable than expected Value comes from being able to capitalise on additional earnings opportunities
Option to wait (timing option)
You have a +NPV project but if implemented in the future, the NPV may be even higher
Value comes from the ability to delay investment and learn more about market conditions.
Option to wait value formula
Option value = intrinsic value + Time premium
Current NPV = Net furture value at date T / (1+R)^T
Choose year with highest NPV
Intrinsic value: our profit if we exercise right now
Time Premium: value of being able to wait
The option to wait has value: Even if a project has a positive NPV now, it may be even more valuable if delayed until a more opportune time.
There is a trade-off if waiting means we lose revenues or incur additional costs (akin to foregone dividends).
