Intermediate Finance

Session 6
Real Options
 Real Options
• NPV analysis, as well as all the other
approaches, ignore the adjustments that a
firm can make after a project is accepted
• These adjustments are real options
 Real Options
• NPV analysis, as well as all the other
approaches, ignore the adjustments that a
firm can make after a project is accepted
• These adjustments are real options
• But why should we care?
 Real Options
• NPV analysis, as well as all the other
approaches, ignore the adjustments that a
firm can make after a project is accepted
• These adjustments are real options
• In this respect NPV underestimates the true
value of a project
The Option to Expand
The Option to Expand
 The Option to Expand
• This would be the situation without real
option
The Option to Expand
 The Option to Expand
• Situation with real option of expanding
The Option to Abandon
The Option to Abandon
• Abandonment may seem cowardly, but it can
often save companies a great deal of money.
• Option to abandon increases the value of
any potential project.
The Option to Abandon
• There is a 50 percent probability that annual
cash flows will be $6 million and a 50 percent
probability that annual cash flows will be -$2
million.
• Situation without real option
The Option to Abandon
• As of Date 1, the entrepreneur will know
which forecast has come true.
• If cash flows equal those under the
optimistic forecast, Conrad will keep the
project alive.
• If, however, cash flows equal those under the
pessimistic forecast, he will abandon the
hotel.
The Option to Abandon
• Situation with real option
The Option to Abandon
• Situation with real option
The Option to Abandon
• Situation with real option
The Option to Abandon
Timing Options
 Timing Options
• Any examples of timing options?
Timing Options
 Decision Trees
• Step 1: Divide analysis into risk phases.
• Step 2: In each phase, estimate the
probabilities of the outcomes
• Step 3: Define decision points
• Step 4: Compute cash flows/value at end
nodes
• Step 5: Folding back the tree
Timing Options
Why use Decision Trees
• What are the advantages of using decision
trees?
 Why use Decision Trees
• Dynamic response to risk
• Value of information
• Risk management
Any drawbacks of
associated with
decision trees?
 Issues
• There are some types of risk that decision trees
are capable of handling and others that they
are not.
• The expected value of a decision tree is
heavily dependent on the assumption that we
will stay disciplined at the decision points in
the tree.
ASSESSMENT 1
SYLLABUS : MODULE 1
WEDNESDAY
29TH SEPTEMBER IN-CLASS