CP

(National Geographic (Little) Kids) #1
Questions 649

 Investing in a new project often brings with it a potential increase in the firm’s fu-
ture opportunities. Opportunities are, in effect, options—the right but not the
obligation to take some future action.
 A project may have an option valuethat is not accounted for in a conventional
NPV analysis. Any project that expands the firm’s set of opportunities has positive
option value.
 Financial options are instruments that (1) are created by exchanges rather than
firms, (2) are bought and sold primarily by investors, and (3) are of importance to
both investors and financial managers.
 The two primary types of financial options are (1) call options, which give the
holder the right to purchase a specified asset at a given price (the exercise, or
strike, price) for a given period of time, and (2) put options, which give the
holder the right to sell an asset at a given price for a given period of time.
 A call option’s exercise value is defined as the maximum of zero or the current
price of the stock less the strike price.
 The Black-Scholes Option Pricing Model (OPM) can be used to estimate the
value of a call option.
 Opportunities to respond to changing circumstances are called managerial op-
tionsbecause they give managers the option to influence the outcome of a project.
They are also called strategic optionsbecause they are often associated with
large, strategic projects rather than routine maintenance projects. Finally, they are
also called real optionsbecause they involve “real,” rather than “financial,” assets.
 Many projects include a variety of embedded optionsthat can dramatically affect the
true NPV. Examples of embedded options include (1) “investment timing options”
that allow a firm to delay a project, (2) “growth options” that enable a firm to manage
its capacity in response to changing market conditions, (3) “abandonment options,”
and (4) “flexibility” options that allow a firm to modify its operations over time.
 An investment timing optioninvolves not only the decision of whetherto pro-
ceed with a project but also the decision of whento proceed with it. This opportu-
nity to affect a project’s timing can dramatically change its estimated value.
 A growth optionoccurs if an investment creates the opportunity to make other po-
tentially profitable investments that would not otherwise be possible. These include:
(1) options to expand output, (2) options to enter a new geographical market, and (3)
options to introduce complementary products or successive generations of products.
 The abandonment optionis the ability to abandon a project if the operating cash
flows and/or abandonment value turn out to be lower than expected. It reduces the
riskiness of a project and increases its value. Instead of total abandonment, some
options allow a company to reduce capacity or temporarily suspend operations.
 A flexibility optionis the option to modify operations depending on how condi-
tions develop during a project’s life, especially the type of output produced or the
inputs used.
 There are five possible procedures for valuing real options: (1) DCF analysis only,
and ignore the real option; (2) DCF analysis and a qualitative assessment of the
real option’s value;(3) decision tree analysis; (4) analysis with a standard model
for an existing financial option; and (5) financial engineering techniques.

Questions

Define each of the following terms:
a.Option; call option; put option
b.Exercise value; strike price
c.Black-Scholes Option Pricing Model
d.Real options; managerial options; strategic options; embedded option

17–1

644 Option Pricing with Applications to Real Options
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