CF7. Real Options Analysis

STUDY
PLAY
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.
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.
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.
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.
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
Black-Scholes-Merton
C=P(N(d1)) - PV(X)(N(d2))
d1 =
Option Value
NPV0(With Option) - NPV0(Without Option)
Flexibility Value
Increases with:
Likelihood of receiving new information
Ability to respond to new information