Real Options

Question 1

What are real options?

Answer 1

These arise when a company faces a decision that can wait. This can include when to invest in a new project, whether to postpone a followup part of a project or to abandon.

Question 2

Why are real options used?

Answer 2

• The decision is irreversible
• Flexability about timing of investment
• Uncertainity about future states

Question 3

What are the different types of real options?

Answer 3

1) Invetsment option
2) Abandoment option
3) Growth option

Question 4

Advantages over traditional NPV analysis

Answer 4

• Allows the analysis of “optimal timing” of a corporate decision.
• Acknowledge the flexibility of managers’ decisions.
• The potential use of an asset is considered in valuing the asset.

Question 5

Disadvantages of traditional NPV

Answer 5

1) Treats invetsments as now or never
2) Project stays constant and cannot be adapted
3) No decision making role for managers once project is implemented

Question 6

What is the trade off for abandoning a project

Answer 6

Receives abandonment value of a certain amount A while giving up uncertain future cash flows with expected current value.

Question 7

How to find 𝜋^∗ or the risk neutral probability

Answer 7

(1+𝑟𝑓−𝑑)/ 𝑢−𝑑

Question 8

What does max(𝑉1,𝑢 − 𝐼, 𝐶1𝑢) show?

Answer 8

The max( payoff of immediate excerise, payoff of not exercising)

Question 9

How to find 𝜋^∗ or the risk neutral probability if there are interim cashflows

Answer 9

((1+𝑟𝑓 / 1+𝛿) − 𝑑) / 𝑢−𝑑