248 Corporate Finance
SuccessSuccessSuccessStartFailureFailureFailureSo, it would be incorrect to value Amazon.com on the basis of sales from books alone. The valuation
should take into account its option to expand into music and video. The correct approach is as depicted here:
DCF of
booksOption
value
DCF of
booksDCF of
musicOption
valueDCF of
booksDCF of
musicDCF of
video^OptionValuation of Real Options
The binomial option-pricing model is currently the most widely used real options valuation method. The
binomial model describes price movements over time, where the asset value can move to one of two possible
prices with associated probabilities. Given here is a binomial process through a decision tree:
P 1P 2P 3Good, GoodBad, Bad(1–P 1 )(1–P 3 )BadStart
Good
1–P 2
Good, BadConsider a project that has a best outcome of Rs 1.3 crore and a worst outcome of Rs 90 lac. Each outcome
is equally likely to occur (probability is 0.5). Expected value of the project, the weighted average of outcomes,
is Rs 1.1 crore. The discounted value at a discount rate—of, say 10 percent—is Rs 1 crore. If the initial