Real Options

Question 1

What is the range of value a real option can cost ?

Answer 1

0 < Real Option < n

Because managers will only exercise if > 0. OPTION is not an OBLIGATION

Question 2

What is the 3 Characteristifcs of the Real Option

Answer 2

1. Option >= 0, will only be exercised (= incorporated in the NPV)/ if adds value to the project
2. Lumpy => You do the whole thing ( a lump sum), Do not open 1/3 of a factory then see.
3. Irreversible: Cannot build a factory and sell it right away for at the same value.
   - What gives the option value is the time you wait before making a decision. Because it is not easy to reverse business decisions.

Question 3

What is the deep idea behind options

Answer 3

Project competing against itself. Waiting time to make educated decisions based on unkown variables.

Question 4

Growth Options

Answer 4

Option to Invest in the future project

Question 5

Deferral Option

Answer 5

The option to delay a investment project ( invest today vs in a year )

Question 6

Abandmoent Option

Answer 6

sell or close down a project

Question 7

Contraction Option

Answer 7

reduce the projects scale of operation

Question 8

Expansion Option

Answer 8

Scaling up a project, extending the life

Question 9

Switch Opton

Answer 9

Switch between 2 projects, inputs or outputs ( Abandmoent and growth )

Question 10

What are the elements that compose a decision tree.

Answer 10

1. Decision node => Node where decisions are made
2. Decision branches => Represents possible decisions
3. Event Node => uncertantity is resolved
4. Event Branches => possible events

Question 11

What is the Rool Back Method

Answer 11

Starting form the end to the beggining

Making all optiomal decisions at each stage in order to acept or reject the project

Question 12

What are the limitations of Decision Trees

Answer 12

• No insight of what would be an appropriate Risk Dicount Rate
• Need to know probabillities of things happening
• Limit to number of branches
• Hard to define Events

Question 13

What is the criticism for the Replicating Portifolio Aproach

Answer 13

Projects do not allow for arbritage so value of project might be different from value of stock. Law of one price does not hold

Question 14

European Option

Answer 14

Cannot exercise before the termination date

Question 15

American Option

Answer 15

Can be exercised at any point before expiration

Question 16

What is the defense of the Replicating Portfolio Approach

Answer 16

Finantia Markets are complete, combination of traded securities can pair the payoff pf a inflexible project