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Corporate Options
3 types of Real Options
1 - The opportunity to expand and make follow-up
investments.
2 - The opportunity to wait and invest later.
3 - The opportunity to shrink or abandon a project.
Value Real Option = NPV with option
- NPV w/o option
Microcomputer Forecasts
Example Mark I Microcomputer ($ millions)
1982
After-tax operating cash flow (1)
Capital investment (2)
Increase in working capital (3)
Net cash flow (1)-(2)-(3)
450
0
-450
1983
100
0
50
60
Year
1984
159
0
100
59
1985
295
0
100
195
1986
185
0
-125
310
1987
0
0
-125
125
Microcomputer Forecasts
Example Mark II Microcomputer ($ millions)
Forecasted cash flows from 1982
1982 .
After-tax operating cash flow
Increase in working capital
Net cash flow
Present Value @ 20%
Investment, PV @ 10%
Forecasted NPV in 1985
467
676
Year
1985
1986
220
100
120
807
900
-93
= 467 676
= - $209 million
1987
318
200
118
1988
590
200
390
1989
370
-250
620
1990
0
-250
250
Microcomputer Forecasts
Example Mark II Microcomputer
PV (exercise price)
900
676
3
1.1
OC N ( d1 ) P N ( d 2 ) PV ( EX )
d1
log[ S / X ] (r
)T
2
2
(35%)
log(467 / 900) (10%
)3
2
0.1879
35% 3
d 2 d1 t .4184
N (d1 ) .574508
N (d 2 ) .337844
Microcomputer Forecasts
Example Mark II Microcomputer (1985)
Distribution of possible Present Values
Probability
Required investment
($807)
($900)
Option to Wait
Intrinsic Value
Option
Price
Stock Price
Option to Wait
Intrinsic Value + Time Premium = Option Value
Time Premium = Vale of being able to wait
Option
Price
Stock Price
Option to Wait
More time = More value
Option
Price
Stock Price
Option to Wait
If you commit an investment worth $ 180Mn, you have a
project worth $ 200 Mn immediately. If the demand
turns out to be low in yr. 1, the cash flow will be $ 16
Mn and the value of the project will fall to $ 160 Mn.
But if the demand is high in year 1, the cash flow is $
25 Mn. And the value rises to $250 Mn. Should you
invest immediately or wait. Use the risk free rate of
5%.
Note: If you undertake the investment right away, you
capture the first years cash flow ($16 or $25). If you
delay you miss out on this.
Option to Abandon
Example - Abandon
Mrs. Mulla gives you a non-retractable offer to
buy your company for $150 mil at anytime
within the next year. Given the following
decision tree of possible outcomes, what is the
value of the offer (i.e. the put option) and what is
the most Mrs. Mulla could charge for the
option?
Option to Abandon
Example - Abandon
Mrs. Mulla gives you a non-retractable offer to buy your company for
$150 mil at anytime within the next year. Given the following decision
tree of possible outcomes, what is the value of the offer (i.e. the put
option) and what is the most Mrs. Mulla could charge for the option?
Year 0
Year 1
Year 2
120 (.6)
100 (.6)
90 (.4)
PV = 145
70 (.6)
50 (.4)
40 (.4)
Option to Abandon
Example - Abandon
Mrs. Mulla gives you a non-retractable offer to buy your company for
$150 mil at anytime within the next year. Given the following decision
tree of possible outcomes, what is the value of the offer (i.e. the put
option) and what is the most Mrs. Mulla could charge for the option?
Year 0
Year 1
Year 2
120 (.6)
100 (.6)
90 (.4)
PV = 162
Option Value =
162 - 145 =
150 (.4)
$17 mil
Option to Abandon
Dawn East, the chief financial officer of Maine Subductor
Corp., has to decide whether to start production of
zircon subductors. The investment required is $12 Mn.
$ 2 Mn. For roads and site preparation and $10 Mn.
For the equipment. To operate the equipment it costs
$ 0.7 Mn. p.a. (a fixed cost). The expected life of the
project is 10 years and the depreciation of the
machine is done following WDV method @ 10% p.a.
The revenue at todays prices is $1.7 Mn and shall
grow @ 9% p.a. Also, the S.D. of earnings is 14%.
The risk free rate is assumed to be 6% p.a.
Option to Abandon
Example Ms. East Value
u e T e0.14*1 1.15
1
d 0.87
u
Expected return 0.15* p 0.13*(1 p) .06
Prob of up change 0.6791
Prob of down change 0.3209
Option to Abandon
Example Ms. East - Revenues
2.25
1.96
1.7
1.7
1.48
1.29
Option to Abandon
Example Ms. East Cash Flows
1.55
1.26
1.0
1.0
0.78
0.59
Numericals
Numericals
Numericals
Numericals
Numericals