Real options valuation inc11/2/2022 ![]() ![]() When we consider real options, we take in to account the value of the option to salvage the oven. As a result, we wouldn't consider the option to salvage when calculating a traditional NPV.Įxpected Payoff (Traditional Analysis) = (0.90 x $10,823) + (0.10 x $0) = $9,740 Under a traditional NPV analysis, managers are not seen as having the ability to make decisions after a project is undertaken. The firm has two decisions to make: (1) to undertake the project or not (purchase the oven) and (2) to abandon the project or stay the course. If they keep the new oven, it is worth nothing to the business. The discount rate is 5%. In this scenario, there is an option to salvage the oven. If it sells the oven, they will get $5,000 next year. However, there is a 10% chance that a new restaurant will open up, creating a lower than expected demand. If demand is good, they will make $2,500/year over the five-year life of the oven. The oven is going to cost them $10,000 today. Jim and Jane wish to purchase an oven for their business. Let's consider the example we've used before. The option to abandon a project has value if demand turns out to be lower than expected. Production Options: Financial managers often have the option to make changes to the input and output mix as well as the operating scale (rate of output, for example) for the products the business creates. If business is slow, we also have the option to reduce the scale of a project.ĥ. In good times, we might want to expand a project. ![]() The Contraction Option: The scale of a project is often not fixed. For example, when commodity prices are rising or political risk is falling, it might make sense to delay a mining operations until a future date.Ĥ. The Option to Delay: Timing options have value when underlying variables are changing with a favorable trend. When this option exists, the risk of the project is reduced, increasing the present value of any potential project.ģ. The Option to Abandon: If a project goes south, the option to abandon will save a company money. If this option is ignored, a traditional NPV analysis will understate the net present value of the project.Ģ. The Option to Expand: If a project is successful, we should consider the possibility of expanding the project to get a larger net present value. Similarly, there is no easy way to determine the risk-adjusted discount rate.ġ. Real options valuation recognizes that there exist some disadvantages to the NPV approach. The traditional NPV approach assumes that the scale of the project is fixed and it ignores adjustments that firm can make after a project is accepted. These options help manage risk and provide opportunity for increased returns. Real options look at business opportunities such as delaying, abandoning, expanding, staging, or contracting capital investment projects and making decisions about input and output mix or operating scale for products. Real options, on the other hand, typically are not traded as securities in financial markets, nor are the underlying assets of a real option traded as securities. Financial options are the right to buy or sell an underlying asset or instrument. Options are a right, but not an obligation, to undertake some kind of business or financing activity. ![]()
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