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Capital Projects as Real Options: An Introduction

Capital Projects as Real Options: An Introduction. The Traditional Approach: An Irreversible Commitment to Invest. Cash Flow. Good News. Invest. Bad News. Cash Flow. Cash Flow. Good News. Don’t Invest. Cash Flow. Bad News. The Alternative Approach: An Option to Invest. Invest.

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Capital Projects as Real Options: An Introduction

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  1. Capital Projects as Real Options: An Introduction

  2. The Traditional Approach: An Irreversible Commitment to Invest Cash Flow Good News Invest Bad News Cash Flow Cash Flow Good News Don’t Invest Cash Flow Bad News

  3. The Alternative Approach: An Option to Invest Invest Cash Flow Good News Don’t Invest Cash Flow Invest Cash Flow Bad News Cash Flow Don’t Invest

  4. Option Pricing Payoff Diagrams Determinants of Value Comparative Statics Put-Call Parity Complications: Dividends Early Exercise Basic Capital Budgeting Incremental Cash Flows Opportunity Cost Basic Discounting Time Value Risk NPV Rule Definitions of Terms

  5. Mapping Project Characteristics Onto Call Option Contracts Project Variable Call Option Cost of Project X Exercise Price Value of Assets S Stock Price Length of Time t Time to Expiration Decision May be Deferred Risk of Assets 2 Variance of returns Time value of money r Risk-free rate of return

  6. Expressing NPV as a Quotient Rather than a Difference NPVq = PV(Expected Cash Flows)/PV Cost = S/PV(X) NPVq < 1 NPVq > 1 Projects here have negative NPVs; call options here are out of the money Projects here have positive NPVs; call options here are in the money

  7. Pricing Call Options: NPVq and Cumulative Variance NPVq Out of Money In Money Low Call option value increases in this direction Black Scholes value of European call option, expressed as a percentage of underlying asset value Call option value increases in this direction Call option value increases in this direction High

  8. Mapping Projects Into Call Option Space Out of Money NPVq= 1.0 In Money VI. Exercise Never I. Exercise Now II. NPV > 0 and NPVq > 1 Wait if possible, otherwise exercise early V. NPV < 0 and NPVq < 1, and cumulative variance is low. Doubtful prospects III. NPV < 0, but very promising because NPVq > 1 and cumulative variance is high IV. NPV < 0 and NPVq <1 Less promising, but high cumulative variance. These projects require active development

  9. Quiz on Real Options 1. Exclusive use of a discounted cash flow (NPV) approach to capital budgeting will _____________ the value of a high-variance project that can be deferred. A. Overstate B. Understate C. Fairly Represent 2. Exclusive use of a discounted cash flow (NPV) approach to capital budgeting will _____________ the value of a high-variance project that cannot be deferred. A. Overstate B. Understate C. Fairly Represent 3. According to the “real options” approach to capital budgeting, a high-risk negative NPV project that can be deferred should be A. Immediately rejected by the firm B. Immediately accepted by the firm C. Neither A nor B 4. According to the “real options” approach to capital budgeting, a high-risk positive NPV project that can be deferred should be A. Immediately rejected by the firm B. Immediately accepted by the firm C. Neither A nor B

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