IIM LUCKNOW NOIDA CAMPUS

ATSC Project Proposal

Study how to minimize risk and uncertainty
through option theory: A case study

Submitted To: Prof M Akbar








Submitted By:

Ajit Jha (WMP08052)
Khushboo Mamtani (WMP08067)
Kaif Akbar (WMP07103)
Vikas Hajela (WMP08093)
Yogesh Verma (WMP08095)

10/14/2013




Contents
Executive Summary: ...................................................................................................................................... 2
Statement of Problem ................................................................................................................................... 2
Objectives ..................................................................................................................................................... 3
Approach ....................................................................................................................................................... 3
References .................................................................................................................................................... 3














Executive Summary:

Today economics of the world is highly dynamic with changing prices in market (energy, foreign
exchange etc.), uncertain government policies on climate change and uncertain international regime on
climate change, all poses to uncertainties in different industrial investment. Traditionally Discounted
cash flow (DCF was used by national governments & development banks for evaluating the project
investment but DCF do not quantify these uncertainties and risks. Real Option analysis offers a nuanced
approach to the strategic investors so that they can quantitatively take into account investment risk.
Real option valuation or Real option analysis is an option valuation technique to capital budgeting
decision. With real options (e.g. real call or real put), we can take decision such as to invest in the
expansion of a firm's factory now, later, or alternatively to sell the factory.
We study the interplay between profitability vis--vis uncertainty and risk via option theory, where
profitability is multiplicative with the managerial effort. Investors who face greater uncertainty desire
faster learning, and consequently offer higher managerial incentives to induce higher effort from the
manager. In contrast to the standard negative risk-incentive tradeoff, this learning-by-doing effect
generates a positive relation between profitability uncertainty and incentives.

In this paper, we would fist study the theoretical aspect of option theory (in terms of both benefits &
limitations) and further present the practical case for using Real Option Analysis (ROA) to strategies IT
Projects.
Statement of Problem

Real option results to real value (i.e. counterpart in financial Market). In cases where analysis is
applicable in situations where the analysis returns a large positive net present value, the execution
seems fairly straight forward. And the results do not necessarily require any further validation; DCF is
successfully applicable. But where NPV is not very large the analytical tools such as DCF fail to recognize
value of option and systematically undervalue investment opportunity.
In such situation we real options analyses can more accurately model the nature of the investment, and
therefore provide a better basis for the investment decision. . Also, companies use real options analysis
when future growth is a significant source of the investments value, when a traditional DCF analysis
returns a low or slightly negative net present value, and when the options associated with the
investment could change managements decision from no go w go.
Objectives

Following are the objectives:
Present study on the theoretical model of Option theory and how to reduce risk & uncertainties.
o Type of Options
o Project Valuation Methodology with option theory
o Gaps in Real Option theory (Where it fails)

Present the practical case for using Real Option Analysis (ROA) to strategies IT Projects

Approach

To justify the real option theory we will study an IT Project case. Here we would do following
Identify the attributes for analysis (e.g. NPV etc)
Evaluate project via both DCF & Real Option
Compare DCF valuation with Real option valuation
Present strategy how can we mitigate risk through real option theory.

References

http://en.wikipedia.org/wiki/Real_options_valuation
http://www.sjsu.edu/faculty/watkins/realoptions.htm
http://www.palantirsolutions.com/getattachment/c31dadea-e465-4df1-aa00-0434704f39bb/Risk,-
Uncertainty-and-Investment-Decision-Making-i.pdf