2.1 Real Options

Question 1

1. What are the steps in valuating flexibility?

Answer 1

1: Identify Options
2: Value the Flexibility

Question 2

2. What are the conditions when identifying options?

Answer 2

1: News will arrive in the future
2: When it arrives, the news may affect the decision

Question 3

3. “Phases”, “Scenarios”, “Strategic Investment” might be clue for ___

Answer 3

Real Options

Question 4

4. Checklist of frequently encountered options

Answer 4

• Growth option
• Abandonment option
• Option to expand or contract scale
• Timing option
• Option to switch (inpouts, outputs, processes, etc.)

Question 5

5. Timing Options / Option to defer

Answer 5

• Flexibility over the timing of the investment. Can wait to invest

Question 6

6. Timing Options / Option to defer. Important in:

Answer 6

• Real estate, technology

Question 7

7. Staged Investment

Answer 7

Option to reevaluate and/or abandon project at any time

Question 8

8. Staged investment important in

Answer 8

R&D, energy, start-up ventures

Question 9

9. Option to expand/contract scale

Answer 9

If market conditions change, the firm can expand/contract the fraction (for example the production scale)

Question 10

10. Option to expand/contract scale important in

Answer 10

Natural resources,
fashion, real estate,
consumer goods

Question 11

11. Option to abandon

Answer 11

If market conditions decline, management sells off assets.

Like a put option. Can, but don’t have to get rid off…..

Question 12

12. Option to abandon important in __

Answer 12

Capital-intensive industries, new product introduction in uncertain markets

Question 13

13. Option to switch

Answer 13

Management can change product mix or switch inputs

Question 14

14. Option to switch important in

Answer 14

Volatile markets with shifting preferences, energy companies

Question 15

15. Growth options

Answer 15

Allows for follow-up investments if prices or demand changes

Question 16

16. Growth options important in

Answer 16

High tech; industries with multiple product generations

Question 17

17. Multiple Interaction Options + important in?

Answer 17

Project involve a collection of various options – both put and call types.

Important in many industries

Question 18

18. Different real options

Answer 18

1: Timing option (option to defer)
2: Staged Investment
3: Expand/Contract Scale (alter operating scale)
4: Option to abandon
5: Option to switch
6: Growth options
7: Multiple Interacting Options

Question 19

19. In what ways can we value an option

Answer 19

1: Binomial trees
2: Black-Scholes

Question 20

20. What strategies can we use when creating binomial trees?

Answer 20

1: Replicating portfolio
2: Risk Neutral Valuation

Question 21

21. Horizon is a new start-up, and plans to enter 9 new markets in year 2. The key uncertainty is the price markup on transport. its a 50% chance that it’s 25% and a 50% chance its 15%. Assume losses of $ 5.9 million per market then. (You want high markups). If the markup is 25%, they will be able to generate 13,7 per market. Cost of Capital is 16%. Show the value:

Answer 21

One tree up gives 13,7 * 9 = 123

Tree down gives 0 (Investors are not passive, so they will not enter 9 markets)

Value: [0,5 * (9 * 13,7)] / 1,16^2 = 46

Question 22

22. When can you use the decision tree approach?

Answer 22

When you are sure you are facing a zero-beta project

Question 23

23. What discount rate are used with decision trees

Answer 23

Can use Risk-Free Rate or the firms Cost of Capital

Question 24

24. How can you simplify a project with two different phases – and how can you value the lower bound?

Answer 24

Simplify by separating the DCF-analysis of them.

Add the DCF-values together. This is a benchmark for the lower bound

So you only go with Phase 2 if it has positive NPV

Question 25

25. What is risk neutral pricing

Answer 25

* Assumption that all investors are risk-neutral * This means that all financial instruments yield the same return = risk free * Then compute the probability that ensure no arbitrage

Question 26

26. What are some practical issues with real options?

Answer 26

1: What volatility to use 2: Interpretation 3: Which method should be used

Question 27

27. How to find the volatility?

Answer 27

1: Informed Guess 2: Use data available

Question 28

28. How to interpret

Answer 28

Since we use simplified models, results needs to be taken with a grain of salt. Put complexity back into the model with: 1: Sensitivity analysis 2: Conditioning and qualifying of inferences

Question 29

29. Consider two firms that could both do the same project. Both can execute the project early, or they could wait. How much is the option worth when there is a competitor?

Answer 29

• Check both value of investing immediately and - Competitor enters now - Competitor enters later • Do the same calculating the option value of waiting when - Competitor enters now - Competitor enters later Then put payoffs in a matrix and view it as a game. Solve for the Nash Equilibrium

Question 30

30. Under the BS assumptions, the stock price follows a ____

Answer 30

Geometric Brownian motion (GBM)

Question 31

31. How do we get the annual volatility?

Answer 31

* Estimate from daily stock changes | * Ignore days without much trading, i.e. weekends or holidays (concentrate on trading days)

Question 32

32. What does ARCH/GARCH do?

Answer 32

Helps us predict tomorrow’s variance conditional on today’s.