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Real Options

Real Options

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Published by Siddharth Kothari

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Categories:Types, Research
Published by: Siddharth Kothari on Jul 23, 2009
Copyright:Attribution Non-commercial

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08/04/2013

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International Institute of Planning &Management
CIP Report
Topic: -
W
hat are the four main types of real options? Explain theimplications of real options in case of analyzing the project.
Submitted to: -
Prof. Paresh Shah
Prepared By: -
Siddharth KothariPGP/SS/08-10/B
IIPM, AhmedabadPage 1
 
What are Real Options?
Real options are methods which quantify the value of management flexibilityin the uncertainty prevailing world. These options are said to be the strategicoptions. They adapt to the decisions wherein they have to response touncertainty or unexpected market developments. Conceptually saying, RealOptions allows the management to determine and communicate thestrategic value of the project wherein investments have been made. Traditional Methods like NPV etc. sometimes fails to determine the economicvalue on investments in such an environment where there is hugeuncertainty and rapid change, and that is where Real Options are useful.Identifying, managing and exercising Real Options can also be used forcreating the shareholders value which is compounded by their investmentportfolio.The real options method represents the new state-of-the-arttechnique for the valuation and management of strategic investments. Thereal option method enables corporate decision-makers to leverageuncertainty and limit downside risk. A firm has always one or more options totake strategic decisions during lifespan of a project. For example, a naturalresource firm can take decision to not extract the gold from the mine if theprice of the gold falls below the cost of extraction and vice versa
.
 Thesestrategic options, which are known as real options, are typically ignored instandard discounted cash flow (DCF) analysis where a single expectedpresent value is computed. These real options, however, can significantlyincrease the value of a project by eliminating unfavorable outcomes
Types of Real Options
 There are basically four types of Real Options:-1)Abandonment or Shutdown Options
IIPM, AhmedabadPage 2
 
2)Investment Timing Options3)Growth Options4)Flexibility Options
1)Abandonment or Shutdown Options
In traditional business format, a project is said to run throughout itslifetime but a firm may have option of ceasing the project anytimeduring its life. This is called abandonment or shutdown options. Thisoption means the right to sell the cash flows over the remainder of theprojects life for some value.When the present value of the remainingcash flows falls below the liquidation value, the asset may be sold.Abandonment is effectively the exercising of a put option. Theseoptions are particularly important for large capital intensive projectssuch as nuclear plants, airlines, and railroads. They are also importantfor projects involving new products where their acceptance in themarket is uncertain.
Example:
Suppose your resource management company has a two-year leaseover a small copper deposit and is deciding whether or not to mine thedeposit. At the end of the lease, all rights to the property revert to thegovernment. It is known that the deposit contains eight million poundsof copper. Mining would involve a one-year development phase thatwould cost $1.25 million immediately. The company would then pay allextraction costs to a subcontractor, in advance, at a rate of 85 centsper pound. This amounts to a cash payment of $6.8 million one yearfrom now. Your company would then sell the rights to the copperrecovered (8 million pounds) to a third party at the spot price of copper
IIPM, AhmedabadPage 3

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