A small change in the discount rate could have a considerable effect on the final output. It's now opportune for us to identify the key types of real options that companies come into contact with on a regular basis. That is, do they ever represent the right to sell an asset rather than buy an asset? Consider an industry with a large number of competitive firms, each of which has rational expectations about the strategies of the other firms; the cost of entering the industry is K, and having paid K, each firm can produce a single unit of output at zero cost. 0000014473 00000 n The option to expand operations in response to a positive change in market conditions, and finally, the option to abandon operations as market conditions change adversely and significantly against the firm. The values of the abandon and delay options are estimated as the difference between each of their NPVs and the NPV for the “immediate investment or acquisition” case. xref “Valuable” in this context implies the potential for an investment that is worth more than it costs, just as the final $60 stock price was above the $50 “exercise price” in the above example. Are real options ever put options? Real options relate to managerial flexibility, where there is a call option to invest in a project which may or may not be exercised. Having the right, but not the obligation to commence factory operations has value, even where the project is not currently wealth producing. • Underlying asset values are generally discontinous.! The third method involves the valuation of the real option as a put or call, assuming that the underlying asset has the characteristics of a financial option. If you were to exercise your right to abandon operations, then you'd be giving up £10,000 in value from future operations but gaining £120,000 immediately through the asset sale. Example of “Real Options” Analysis • Suppose the key source of uncertainty is the markup of price over carrier settlements. Figure 8.2 summarizes the results provided in Table 8.3 in a decision tree framework. Asset versus Liability Strategies. Three ways to value real options are discussed in this book. Because the option gives you the right to trade only after you know if it is a good idea, options are valuable, even though they might end up worth nothing. But what about the £500 spent on permits? • Suppose that there is a 50% chance that the mark up is high (25% mark up) and a 50% chance that it is low (15% mark up). We don't observe the price paid for an option in a payoff diagram, as the payoff diagram reflects the terminal payoff from the option. The first is to use discounted cash flow, relative-valuation, or asset-oriented methods and ignore alternative real options by assuming that their value is zero. The second factory, factory B, is a larger factory, that could mean increased production but would cost you an additional £1,000 up front. Suppose that the output price is given by, where X is a state variable that affects the industry inverse demand and follows the diffusion process (34), and Q is the number of active firms. Each branch shows the cash flows and probabilities associated with each cash flow scenario displayed as a timeline. The local government that we're dealing with to establish operations in the area is very keen to promote small business and to ensure that such businesses are committed for the long term. If it is still at $40, you do not “exercise” the option, because it makes no sense to pay $50 for something you can buy for $40. Financial options provide the right but not the obligation to make a financial investment at a future time, after you know for sure whether making the trade is a good idea. All else equal, we expect the results of a DCF estimate of the cost of capital for a company with valuable real options to understate the company's actual cost of capital.
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