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Chapter Brealey, Myers, and Allen Principles of Corporate Finance 11th Edition REAL OPTIONS 22 Copyright © 2014 by The McGraw-Hill Companies, Inc. All.

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Presentation on theme: "Chapter Brealey, Myers, and Allen Principles of Corporate Finance 11th Edition REAL OPTIONS 22 Copyright © 2014 by The McGraw-Hill Companies, Inc. All."— Presentation transcript:

1 Chapter Brealey, Myers, and Allen Principles of Corporate Finance 11th Edition REAL OPTIONS 22 Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

2 22-2 22-1 VALUE OF FOLLOW-ON INVESTMENT OPPORTUNITIES Four Types of Real Opinions Opportunity to expand, make follow-up investments Opportunity to wait, invest later Opportunity to shrink or abandon project Opportunity to vary firm’s output or production methods Value of real option = NPV with option − NPV without option

3 22-3 TABLE 22.1 CASH FLOW AND FINANCIAL ANALYSIS OF MARK I MICROCOMPUTER Mark I Microcomputer in Millions

4 22-4 TABLE 22.2A MARK II MICROCOMPUTER

5 22-5 TABLE 22.2B MARK II MICROCOMPUTER

6 22-6 TABLE 22.3 CASH FLOW OF MARK II MICROCOMPUTER Forecasted from 1982 in millions

7 22-7 FIGURE 22.1 POSSIBLE PRESENT VALUES FOR MARK II IN 1985 Distribution shows range of possible present values for Mark II project 1985 Expected value roughly $800 million (less than required investment of $900 million) Option to invest pays off in shaded area above $900 million

8 22-8 FIGURE 22.1 POSSIBLE PRESENT VALUES FOR MARK II IN 1985

9 22-9 22-2 TIMING OPTION Option price Intrinsic value Stock price Option to Wait

10 22-10 22-2 TIMING OPTION Intrinsic value plus time premium equals option value Time premium equals value of being able to wait Option price Stock price

11 22-11 22-2 TIMING OPTION Option to Wait More time equals more value Stock price Option price

12 22-12 FIGURE 22.2 TIMING OPTION EXAMPLE Possible cash flow and end-of-period values for malted herring project shown in black Project costs $180 million Red figures in parentheses show payoffs from option to wait and invest later in project, now positive-NPV at year 1 Waiting means loss of first year cash flow; figuring out current value of option is difficult

13 22-13 FIGURE 22.2 TIMING OPTION EXAMPLE

14 22-14 22-2 TIMING OPTION High demand generates $25 million, $250 million value at end of year Low demand generates $16 million with no value High DemandLow Demand Risk neutral return

15 22-15 22-2 TIMING OPTION Calculate probability of high demand for malted herring project Option value

16 22-16 FIGURE 22.3 DEVELOPMENT OPTION FOR VACANT LAND

17 22-17 22-3 ABANDONMENT OPTION Example Mrs. Mulla gives nonretractable offer to buy company for $150 million at anytime within next year Given possible outcomes What is value of offer? What is most Mrs. Mulla could charge for that option? Use discount rate of 10%

18 22-18 22-3 ABANDONMENT OPTION Year 0Year 1Year 2 120 (.6) 100 (.6) 90 (.4) NPV = 145 70 (.6) 50 (.4) 40 (.4) Example

19 22-19 22-3 ABANDONMENT OPTION Year 0Year 1Year 2 120 (.6) 100 (.6) 90 (.4) NPV = 162 150 (.4) Option value = 162 − 145 = $17 Million

20 22-20 FIGURE 22.4 VALUE OF TANKER

21 22-21 FIGURE 22.5 PRICE OF ELECTRICITY IN U.K.

22 22-22

23 22-23 FIGURE 22.6 AIRCRAFT PURCHASE OPTION If implemented at year 3, option guarantees fixed price and delivery at year 4 Without option, plane can still be ordered at year 3 but with uncertain price and delivery

24 22-24 FIGURE 22.7 AIRCRAFT PURCHASE OPTION

25 22-25 FIGURE 22.8 DECISION TREE FOR FIGURE 22.6

26 22-26 22-6 CONCEPTUAL PROBLEM Real options are not always feasible to use Options can be complex; it is sometimes impossible to arrive at “perfect” answer No clear structure to path and cash flows Competitors have real options, which alter option values by altering underlying assumptions and environment that serves as basis of valuation


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