ThisanalysiswouldsuggestthatGulfOilwasovervaluedat
$70 per share.
Value of Flexibility
Inrecentyears,therehavebeencritiquesofdiscountedcash
flowvaluationthathaveemanatedfromthosewhobelievein
the real-options approach. Their basic theme is that
discountedcashflowsmodels,byusingexpectedcashflows
anddiscountingthemback,understatethevaluesoffirmsthat
have the options, if things go right, to expand into new
marketsandbusinesses(withsubstantiallyhighercashflows)
or, if things gowrong,to cut backor abandonbusinesses
(thus saving on negative outcomes). In this section, we
considerwhentheoptionstoexpandandabandonhavevalue
and how to incorporate them into the values of companies.
Option to Expand into New Markets and Products
Firmssometimesinvestinprojectsbecausetheinvestments
allow themeither to make furtherinvestments or to enter
othermarketsinthefuture.Insuchcases,theinitialprojects
createoptionsallowingthefirmtoinvestinotherprojectsand
weshouldthereforebewillingtopayapriceforsuchoptions.
Putanotherway, afirmmayacceptanegativenetpresent
valueontheinitialprojectbecauseofthepossibilityofhigh
positive net present values on future projects.
Payoff on the Option to Expand
Theoptiontoexpandcanbeevaluatedatthetimetheinitial
projectisanalyzed.Assumethatthisinitialprojectwillgive
thefirmtherighttoexpandandinvestinanewprojectinthe