capital projects as real options: an introduction
TRANSCRIPT
Capital Projects as Real Options: An Introduction
The Traditional Approach: An Irreversible Commitment to Invest
Invest
Don’t Invest
Good News
Bad News
Good News
Bad News
Cash Flow
Cash Flow
Cash Flow
Cash Flow
The Alternative Approach: An Option to Invest
Good News
Bad News
Cash Flow
Cash Flow
Cash Flow
Cash Flow
Invest
Invest
Don’t Invest
Don’t Invest
Definitions of Terms
• 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
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
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
Pricing Call Options: NPVq and Cumulative Variance
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
Call option value increases in this direction
2 * t
NPVqOut of Money In Money
Low
High
Mapping Projects Into Call Option Space
NPVq= 1.0 In MoneyOut of Money
2 * t
VI. Exercise Never I. Exercise Now
II. NPV > 0 and NPVq > 1
Wait if possible, otherwise exercise early
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
V. NPV < 0 and NPVq < 1, and cumulative variance is low. Doubtful prospects
Quiz on Real Options1. 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