LT Lecture 2 - Real Option

Question 1

What is real option?

Answer 1

The right but not the obligation to modify the project in the future

Question 2

Explain types of real options

Answer 2

Question 3

Graphically show the relationship between option value and intrinsic value

Answer 3

Question 4

What is the formula for current NPV?

Answer 4

Question 5

Option to abandon

Option to expand

Option to wait

Answer 5

Question 6

Why do we discount free cash flow instead of the net income?

State and explain at least two key differences between free cash flow and net income.

Answer 6

Any reasonable discussion about the accounting distortions created by net income is fine.

For example,

1. Time value of the money is properly reflected.
2. Capital expenditure (or salvage) is a capital expenditure that is ignored by net income.
3. Depreciation is not a real cash outflow.
4. Net working capital uses up cash but is not reflected in net income.