Real Options Flashcards
(23 cards)
NPV Formula
= - Initial outlay + PV of expected cashflows. If NPV is negative, reject the project, it will not be in the share holders interest. If NPV is positive, accept the project
APV (adj PV) formula
NPV + Option Value
Profitability index rule
NPV/Initial Investment.
When there is an option to delay, a good rule of thumb is to invest only when the index is atleast 1
Hurdle rate rule
Cost of capital * Callable annuity rate/risk-free rate
Callable annuity rate is the risk-free that can be earned on annuity that can be called anytime
American option
Can be exercised at anytime up to the expiry date
European Option
Can only be exercised on the expiry date
What are the two main option valuation models?
The binomial one and Black-Schoels model
What does the Put-call parity do?
It helps calculate the value of a put option. It is based on two investment strategies that produce the same output
The higher the volatility of the stock…
The higher the price of the options
If the APV is positive then…
It will be worthwhile to invest in the project
What is a real option in finance?
A real option gives managers the right, but not the obligation, to make certain business decisions, such as deferring, abandoning, expanding, or contracting a project.
What is the Timing Option?
The timing option allows a firm to delay an investment to a future date when conditions might be more favorable.
What is the abandonment option in project evaluation?
It’s the option to exit or “abandon” a project if future cash flows turn out to be unfavorable, similar to a put option.
What is the Expansion Option?
It’s the opportunity to scale up operations or investment if a project turns out to be successful, similar to a call option.
What is the Black-Scholes formula for a call option?
C=SN(d1)−XN(d2)*e ^−rt
What is N(d) in the Black-Scholes model?
The cumulative probability from the standard normal distribution.
What does a positive APV imply in real option analysis?
It means the project is worthwhile even if the NPV is negative, due to the added value of real options.
What are the steps that determine whether you should invest?
We need to find the APV, using the … (need to continue this)
The option to abandon is equivalent to
a put option
We use APV = NPV +C (call option)
For an expansion call option
Delay option (it is a call option) as you are still buying but at a delay
We just use C
Because it is the delay option, we calculate C = S’* N(d1) - XN(d2) where S’ = S - PV of missed cashflows
Expansion option - also a call option
APV = NPV + call option
Abandon option - Put option
APV = NPV + Put option
