Principles of Corporate Finance_ 12th Edition

592 Part Six Options

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Don’t jump to the conclusion that real-option valuation methods can replace discounted cash

flow (DCF). First, DCF works fine for safe cash flows. It also works for “cash cow” assets—that

is, for assets or businesses whose value depends primarily on forecasted cash flows, not on real

options. Second, the starting point in most real-option analyses is the present value of an underly-

ing asset. To value the underlying asset, you typically have to use DCF.

Real options are rarely traded assets. When we value a real option, we are estimating its value if

it could be traded. This is the standard approach in corporate finance, the same approach taken in

DCF valuations. The key assumption is that shareholders can buy traded securities or portfolios with

the same risk characteristics as the real investments being evaluated by the firm. If so, they would

vote unanimously for any real investment whose market value if traded would exceed the investment

required. This key assumption supports the use of both DCF and real-option valuation methods.

Taxes are not tracked specifically in the several real-options examples presented in this chap-

ter. But remember that all cash flows from real options should be projected after corporate tax.

The discount rate in the risk neutral method should also be after-tax.

The Further Reading for Chapter 10 lists several introductory articles on real options. The Spring

2005 and 2007 issues of the Journal of Applied Corporate Finance contain additional articles.

The Spring 2006 issue contains two further articles:

R. L. McDonald, “The Role of Real Options in Capital Budgeting: Theory and Practice,” Journal of

Applied Corporate Finance 18 (Spring 2006), pp. 28–39.

M. Amram, F. Li, and C. A. Perkins, “How Kimberly-Clark Uses Real Options,” Journal of Applied

Corporate Finance 18 (Spring 2006), pp. 40–47.

The standard texts on real options include:

M. Amran and N. Kulatilaka, Real Options: Managing Strategic Investments in an Uncertain World

(Boston: Harvard Business School Press, 1999).

T. Copeland and V. Antikarov, Real Options: A Practitioner’s Guide (New York: Texere, 2001).

A. K. Dixit and R. S. Pindyck, Investment under Uncertainty (Princeton, NJ: Princeton University

Press, 1994).

H. Smit and L. Trigeorgis, Strategic Investment, Real Options and Games (Princeton, NJ: Princeton

University Press, 2004).

L. Trigeorgis, Real Options (Cambridge, MA: MIT Press, 1996).

Mason and Merton review a range of option applications to corporate finance:

S. P. Mason and R. C. Merton, “The Role of Contingent Claims Analysis in Corporate Finance,” in

E. I. Altman and M. G. Subrahmanyam (eds.), Recent Advances in Corporate Finance (Homewood,

IL: Richard D. Irwin, Inc., 1985).

Brennan and Schwartz have worked out an interesting application to natural resource investments:

M. J. Brennan and E. S. Schwartz, “Evaluating Natural Resource Investments,” Journal of Business 58

(April 1985), pp. 135–157.

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FURTHER

READING

Select problems are available in McGraw-Hill’s Connect.

Please see the preface for more information.

BASIC

1. Expansion options Look again at the valuation in Table 22.2 of the option to invest in
   the Mark II project. Consider a change in each of the following inputs. Would the change
   increase or decrease the value of the expansion option?
   a. Increased uncertainty (higher standard deviation).

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PROBLEM

SETS