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9 terms

Real Options

Alternate decisions that appear with tangible assets as opposed to financial instruments.

Types of Real Options

1.Option to Invest (Delay Investment)

2.Option to Expand

3.Option to Abandon Operations.

2.Option to Expand

3.Option to Abandon Operations.

Option to Invest

Call Option

Exercise Price = Investment Cost

Asset Value = PV of net cash flows of operating project

Option Premium = Cost to establish the option

Volatility = Forecast variability of the future cash flows from the project

Term to Expiry = period of time you have the right to

exercise the option.

Exercise Price = Investment Cost

Asset Value = PV of net cash flows of operating project

Option Premium = Cost to establish the option

Volatility = Forecast variability of the future cash flows from the project

Term to Expiry = period of time you have the right to

exercise the option.

Option to Expand

Call Option

Exercise Price = Expansion Cost

Asset Value = PV of incremental net cashflows of expanded operation

Option Premium = Cost to establish the option

Volatility = Forecast variability of the future incremental cash flows from the project

Term to Expiry = period of time you have the right to

exercise the option.

Exercise Price = Expansion Cost

Asset Value = PV of incremental net cashflows of expanded operation

Option Premium = Cost to establish the option

Volatility = Forecast variability of the future incremental cash flows from the project

Term to Expiry = period of time you have the right to

exercise the option.

Option to Abandon

Put Option

Exercise Price = Salvage value of abadoned assets

Asset Value = PV of net cash flows of continuing ops

Option Premium = Cost to establish the option

Volatility = Forecast variability of the future cash flows from the project

Term to Expiry = period of time you have the right to

exercise the option.

Exercise Price = Salvage value of abadoned assets

Asset Value = PV of net cash flows of continuing ops

Option Premium = Cost to establish the option

Volatility = Forecast variability of the future cash flows from the project

Term to Expiry = period of time you have the right to

exercise the option.

Early Exercise of an Option

American only

Call - the underlying asset is about to pay a significant dividend.

Put - the option is deep-in-the-money such that there is little likelihood that you will regret receiving the exercise price early.

Invest - To avoid missing out on cash flows (same as Call dividends)

Abandon - When PV of CFs of operations is below salvage value of assets

Call - the underlying asset is about to pay a significant dividend.

Put - the option is deep-in-the-money such that there is little likelihood that you will regret receiving the exercise price early.

Invest - To avoid missing out on cash flows (same as Call dividends)

Abandon - When PV of CFs of operations is below salvage value of assets

Black-Scholes-Merton

C=P(N(d1)) - PV(X)(N(d2))

d1 =

d1 =

Option Value

NPV0(With Option) - NPV0(Without Option)

Flexibility Value

Increases with:

Likelihood of receiving new information

Ability to respond to new information

Likelihood of receiving new information

Ability to respond to new information