CP

Financial Options 623

Traditional discounted cash flow (DCF) analysis—where an asset’s cash flows are es-

timated and then discounted to obtain the asset’s NPV—has been the cornerstone for

valuing all types of assets since the 1950s. Accordingly, most of our discussion of cap-

ital budgeting has focused on DCF valuation techniques. However, in recent years a

growing number of academics and practitioners have demonstrated that DCF valua-

tion techniques do not always tell the complete story about a project’s value, and that

rote use of DCF can, at times, lead to incorrect capital budgeting decisions.^1

DCF techniques were originally developed to value securities such as stocks and

bonds. These securities are passive investments—once they have been purchased,

most investors have no influence over the cash flows the assets produce. However, real

assets are notpassive investments—managerial actions can influence their results. Fur-

thermore, investing in a new project often brings with it the potential for increasing

the firm’s future opportunities. Opportunities are, in effect, options—the right but not

the obligation to take some action in the future. As we demonstrate in the next sec-

tion, options are valuable, so any project that expands the firm’s set of opportunities

has positive option value.Similarly, any project that reduces the set of future oppor-

tunities destroys option value. A project’s impact on the firm’s opportunities, or its op-

tion value, may not be captured by conventional NPV analysis, so this option value

should be considered separately. We begin the chapter with an explanation of financial

options, after which we build on this foundation to discuss real options.

Financial Options

An option is a contract that gives its holder the right to buy (or sell) an asset at some

predetermined price within a specified period of time. All managers should under-

stand option pricing theory, since many projects create opportunities that are in

essence options. In addition, financial managers must understand option pricing the-

ory when they use derivative securities for risk management or issue hybrid securities

such as convertible bonds.

Option Types and Markets

There are many types of options and option markets.^2 To illustrate how options work,

suppose you owned 100 shares of General Computer Corporation (GCC), which on

Friday, January 11, 2002, sold for $53.50 per share. You could sell to someone the

right to buy your 100 shares at any time during the next four months at a price of, say,

$55 per share. The $55 is called the strike, or exercise, price. Such options exist, and

they are traded on a number of exchanges, with the Chicago Board Options Exchange

(CBOE) being the oldest and the largest. This type of option is defined as a call op-

tion, because the buyer has a “call” on 100 shares of stock. The seller of an option is

called the option writer. An investor who “writes” call options against stock held in his

or her portfolio is said to be selling covered options. Options sold without the stock to

back them up are called naked options. When the exercise price exceeds the current

stock price, a call option is said to be out-of-the-money. When the exercise price is less

than the current price of the stock, the option is in-the-money.

(^1) For an excellent general discussion of the problems inherent in discounted cash flow valuation techniques
as applied to capital budgeting, see Avinash K. Dixit and Robert S. Pindyck, “The Options Approach to
Capital Investment,” Harvard Business Review,May–June 1995, 105–115.
(^2) For an in-depth treatment of options, see Don M. Chance, An Introduction to Derivatives(Fort Worth, TX:
The Dryden Press, 1995).
The textbook’s web site
contains an Excel file that
will guide you through the
chapter’s calculations. The
file for this chapter is Ch 17
Tool Kit.xls, and we encour-
age you to open the file and
follow along as you read the
chapter.

618 Option Pricing with Applications to Real Options