Corporate Finance

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Corporate Finance

There are six categories of real options:

• Timing option,


• Growth option,


• Abandonment option,


• Option to expand scale,


• Option to switch inputs and outputs, and


• Option to contract scale.

Timing Option

Capital projects are like call options; in the sense that both involve the right but not the obligation to acquire
an asset at a specified price on or before a certain date. The analogy between characteristics of a capital
project and call option is given in Exhibit 12.3.

Exhibit 12.3 The analogy between capital projects and a call option

Present value of project’s

free cash flow

Expenditure required to

acquire project assets

Length of time the decision

may be deferred

Time value of money

Riskiness of project assets

Stock price

Exercise price

Time of expiration

Risk-free rate

Variance of returns

S

X

t

Rf

σ^2

Investment opportunity Variable Call option

The amount spent on the project is the exercise price. The present value of cash flows from the project is
the stock price. The length of time the company can defer the investment decision without losing the investment
opportunity corresponds to time to maturity. The uncertainty in the project’s cash flows corresponds to the
standard deviation of returns. The cash flows lost due to competitors who have fully committed corresponds
to dividends.
The impact of changes in option variables on the value of the option is as shown:

Variable Value of real option

Increase in the PV of the project Increase
A higher investment cost Decrease
A longer time to maturity Increase
Increase in uncertainty (Volatility of cash flows) Increase
Increase in risk-free rate Increase
Increases in cash flow lost Decrease

Timing option enables managers to defer investment for a certain period of time without losing the
opportunity. In other words, managers would always want to spend later rather than sooner. If an investment