FIN 338 - Ch. 14 Real Options

NPV - Net Present Value
Is the present value of a projects expected future cash flows, discounted at the WACC
Name the 4 Types of Real Options
1. Investment Timing Options
2. Growth Options
3. Abandonment Options
4. Flexibility Options
Investment Timing Options
The ability companies sometimes have whether they want to delay the decision to begin a project until later when more information will become available to them
Growth Option
This resembles the call option on a stock, it gives a firm the opportunity to "purchase" a successful follow up project at a fixed cost if the value of the project is greater than the cost
Flexibility Options
This permits the firm to alter operations depending on how conditions change during the life of the project
Real Options
Opportunities for management to change the timing, scale or other aspects of an investment in response to changes in market conditions - They are real opposed to financial because they involve decisions regarding real assets - such as plants, equipment, and land rather than financial assets likes stocks and bonds
Five Possible Procedures used to Deal with Real Options
1. Use discounted cash flow (DCF) valuation and ignore any real options by assuming their values are zero
2. Use DCF valuation and include a qualitative recognition of any real options value
3. Use decision tree analysis
4. Use a standard model for a financial option
5. Develop a unique, project specific model using financial engineering techniques
A "Call"
This gives the owner the right to purchase a stock at a fixed "strike" price, but only if the stock's price is higher than the strike price will the owner exercise the option and buy the stock
Strike Price
The price at which a specific derivative contract can be exercised. For call options, the strike price is where the security can be bought (up to the expiration date), while for put options the strike price is the price at which shares can be sold.
The Expected NPV
This is the weighted average of a series of Cash Flow outcomes, where the weight for each outcome is its probability
What Five Things are Required for the Black Scholes Option Pricing Model
1. The Risk Free Rate
2. The Time Until the Option Expires
3. The Strike Price
4. The Current Price of the Stock
5. The Variance of the Stock's Rate of Return
What is a stocks price represent?
The present value of its expected future cash flows
A High Coefficient of Variation represents what?
That a project is very risky