Explore BrainMass

Real Options Valuation

Options are a right, but not an obligation, to undertake some kind of business or financing activity. Financial options are the right to buy or sell an underlying asset or instrument. 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. 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 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. Similarly, there is no easy way to determine the risk-adjusted discount rate.

Types of Real Options

1. 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. If this option is ignored, a traditional NPV analysis will understate the net present value of the project. 
2. The Option to Abandon: If a project goes south, the option to abandon will save a company money. When this option exists, the risk of the project is reduced, increasing the present value of any potential project. 
3. The Option to Delay: Timing options have value when underlying variables are changing with a favorable trend. 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.
4. The Contraction Option: The scale of a project is often not fixed. In good times, we might want to expand a project. If business is slow, we also have the option to reduce the scale of a project. 
5. 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. 

Example - The Option to Abandon

The option to abandon a project has value if demand turns out to be lower than expected. Let's consider the example we've used before. Jim and Jane wish to purchase an oven for their business. The oven is going to cost them $10,000 today. If demand is good, they will make $2,500/year over the five-year life of the oven. However, there is a 10% chance that a new restaurant will open up, creating a lower than expected demand. In this scenario, there is an option to salvage the oven. If it sells the oven, they will get $5,000 next year. If they keep the new oven, it is worth nothing to the business. The discount rate is 5%. 

Decision Tree

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. 

Under a traditional NPV analysis, managers are not seen as having the ability to make decisions after a project is undertaken. As a result, we wouldn't consider the option to salvage when calculating a traditional NPV. 

Expected Payoff (Traditional Analysis) = (0.90 x $10,823) + (0.10 x $0) = $9,740
NPV (Traditional Analysis) = - $10,000 + $9,740 = - $260 

When we consider real options, we take in to account the value of the option to salvage the oven. With this option, the project is now profitable. 

Expected Payoff (with Options) = (0.90 x $10,823) + (0.10 x $4,762) = $10,216
NPV (with Options) = - $10,000 + $10,216 = $216

Tools for valuing financial options, such as Black-Scholes, are also used to price real options. For example, the value of a start-up firm may be calculated using Black-Scholes to find the price of a call option.

Identifying the Appropriate Investment Proposal

Taylor Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept? a. Project C, which is of above-average risk and has a return of 11%. b.

Oracle Localization

Please answer the following questions below. a) Introduction of localization b) Information related to no of OUs already in place and as part of LIO how many new OUs will be added. c) Introductory line for modules. Whether these modules will be affected by LIO? Are part of A&C and already Implemented? d) Information relate

Valuation - NPV

Question 1 Silver Lake Partners is well-known for its other investments. For example, on January 3, 2011 Silver Lake Partners invested (together with other entities) $946 million in Series G preferred shares of Groupon priced at $31.59 per share. According to the Groupon prospectus, on October 31, 2011 each share of Series G pr

Finance: Capital Asset Pricing Model, Risk, Credit Policy

1. The Capital Asset Pricing Model rests on three assumptions. What are those assumptions, and how realistic are they for firms operating in competitive markets? 2. Leverage increases the risk of the equity of a firm. What does that mean, and what does that mean for the value of the stock in a firm? 3. Options are the righ

When Can Real Options Be Useful?

Define the concept of real options. Describe an instance in your professional life (current employer or past employer) where a real option could have been useful.

Discussing a stock valuation method

Discuss the various types of stocks (common stock, preferred stock) and some of the valuation methods used. Discuss a stock valuation method and why it would be interesting to a financial manager of a company.

I need help with growth models practice questions (equity valuation)

1-A firm has a market opportunity over the next four years that will result in supernormal growth. The firm expects dividends to grow by 35 percent over each of the next two years and 20 percent over YR 3 and YR 4 before returning to a constant growth rate of six percent. The firm just paid a dividend of $2.00 and has a required

Conceptual Analysis of Real Options

Highland properties owns two adjacent four-unit apartment buildings that are both on 20,000 square feet of land near downtown Portland, Oregon. One of the properties is in very good condition, and the apartment can be rented for $2,000 per month. The unit in the other property requires some refurbishing and in their current cond

NPVs, IRRs, and MIRRs for Edelman Engineering

Edelman Engineering is considering including two pieces of equipment, a truck and an overhead pulley system, in this year's capital budget. The projects are independent. The cash outlay for the truck is $17,100 and that for the pulley system is $22,430. The firm's cost of capital is 14%. After-tax cash flows, including depreciat

Valuation for Investment Banking

As an investment banking analyst at Deutsche Bank, you are asked to perform a discounted cash flow analysis. Your associate provides you with the following information from the company's operating model and asks you to calculate the present value of the company's first five years of unlevered free cash flows assuming a 10% di

Real Options Valuation

Mr. Doe is considering investing some money in the new high-tech venture. One relatively new valuation is methods employed something known as "real options." Real options theory originates in the theory about how stock options are priced, but extends options pricing theory to a wide variety of situations including valuation of n

Bradford Services: Real Options

Bradford Services Inc. (BSI) is considering a project that has a cost of $10 million and an expected life of 3 years. There is a 30% probability of good conditions, in which case the project will provide a cash flow of $9 million at the end of each year for 3 years. There is a 40% probability of medium conditions, in which c

The hot potatoe Pricing Strategy and Channel distribution

Pricing strategy and Channel Distribution. 1. Determine and discuss a pricing strategy (Penetration or Skimming). 2. Determine and discuss pricing tactics (Product line pricing, Value pricing, Differential pricing, or Competing against private brands) to be used for your product. 3. Identify any legal a


1. Which, if any, of the following statements are false? A. Market interest rates and bond prices vary inversely. B. For a given absolute change in interest rates from the same base level, the proportionate increase in bond prices when rates fall is smaller than the proportionate decrease in bond prices when rates rise. C.

Calculating Fair Value of a Real Estate

You are considering the purchase of real estate that will provide perpetual income that should average $50,000 per year. How much will you pay for the property if you believe its market risk is the same as the market portfolio's? (The T-bill rate is 5%, and the expected market return is 12.5%).

Stock valuation and Negative Growth Rate

Bikes R Us is a mature manufacturing firm. The company just paid a $10.50 dividend, but management expects to reduce the payout by 4.5 percent per year, indefinitely. If you require a 10 percent return on this stock, what will you pay for a share today?

Stock Value Growth Rate Question

If two firms have the same current dividend and the same expected growth rate, their stocks must sell at the same current price or else the market will not be in equilibrium. This is a t or f question or True if markets are semi strong form efficient True if investors are risk adverse

Asor Products Inc. Case Study: NPV and Strategic Analysis

Can you help me get started on this assignment? Jenny Rene, the CFO of Asor Products, Inc., has just completed an evaluation of a proposed capital expenditure for equipment that would expand the firm's manufacturing capacity. Using the traditional NPV methodology, she found the project unacceptable because NPV traditional =

Decision Case: Alternative Payment Options for Kathy Clark's ice cream machine

Decision Case: Alternative Payment Options Kathy Clark owns a small company that makes ice machines for restaurants and food-service facilities. Kathy knows a great deal about producing ice machines but is less familiar with the best terms to extend to her customers. One customer is opening a new business and has asked Kathy


What is valuation? How would you apply valuation methods? Why is valuation an important tool in risk management? Explain.

Evaluating Using Traditional NPV and the Real Options Approach

SIMPLE EXAMPLE: A company must decide whether to invest $100 million in developing and implementing a new enterprise system in the face of considerable technological and market (demand for product and market share) uncertainty. The firm's cost of capital is 10%. 1. Evaluate Using Conventional NPV Analysis There can be a

Stock valuation (Mill Due Corporation)

(Stock valuation) Let's say the Mill Due Corporation is expected to pay a dividend of $5.00 per year on its common stock forever into the future. It has no growth prospects whatsoever. If the required return on Mill Due's common stock is 14%, what is a share worth?

Valuing an Energy Investment Using Oil Options

The Pampa Oil Company operates oil and gas exploration throughout the panhandle of Texas. The firm recently was approached by a wildcatter named William "Wild Bill" Donavan with the prospect to develop what he thought was a sure thing. Wild Bill owned the lease and wanted to sell it to Pampa to meet some rather pressing gambling

Writing Options

One reason that writing options can be a viable and profitable investment strategy is that a. the option writer collects the quarterly dividends. b. an option writer can exercise the option to avoid a potential loss. c. an option writer determines when the option is exercised. d. most options ex