w5 : real options & investment decisions Flashcards
what is a call option?
the right to buy shares for a specified price in the future
what is a put option?
the right to sell shares for a specified price in the future
what is an european option?
option can only be exercised on a particular day
what is an american option?
option can be exercised on or at any time before a particular day
why do we use real options to value a project?
dcf approach assumes managers are passive and ignores the value of management. active decision making increases uncertainty, so must consider options of behaviour of managers.
state the three categories of real options.
- timing option (call option)
- abandonment option (put option)
- expansion option (out of money call option)
explain the timing option.
when considering managers decision making there is uncertainty, so cannot just use npv rule to determine whether to accept project. must consider option to delay project as may be better conditions in future (lower IR).
how is the timing option used?
calculate value of option to delay and compare whether npv is larger than current npv.
why is there a trade off with the timing option?
if exercise immediately, lose value of option to wait.
if you wait to start project, lose possible positive cash flows today.
explain the abandonment option.
not all investments go way that predicted. if cash inflows are low, good to know that option to abandon project. option to abandon is equivalent to put option (right to sell).
how is the abandonment option used?
use put call parity to value abandoning project.
APV += NPV (not abandon) + value of abandonment put option
explain the expansion option.
many invesments have follow-on opportunities attached to them. adds value to project in future. may become worthwhile investing in negative npv project, if option to expand later. is an out-of-money call option (when exercise price higher than stock price)
how is the expansion option used?
APV = NPV (no expansion) + value of expansion call option
state the equation for PI.
NPV / initial investment
recommends investment if >1
what is the hurdle rate rule?
raises the discount rate by using higher discount rate than wacc to compute npv. if project can jump hurdle with positive npv at higher discount rate, then should be undertaken.
state the equation for the hurdle rate rule.
cost of capital x (callable annuity rate / risk free rate)
