1. Principles of Corporate Finance
Seventh Edition
Richard A. Brealey
Stewart C. Myers
Chapter 22
Real Options
Slides by
Matthew Will
McGraw Hill/Irwin
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2. Topics Covered Follow Up Investments Abandon Wait
Vary Output or Production

3. Corporate Options 4 types of “Real Options”
1 - The opportunity to make follow-up investments.
2 - The opportunity to abandon a project
3 - The opportunity to “wait” and invest later.
4 - The opportunity to vary the firm’s output or
production methods.
Value “Real Option” = NPV with option
- NPV w/o option 37

4. Option to Wait
Intrinsic Value
Option Price
Stock Price

5. Option to Wait Intrinsic Value + Time Premium = Option Value
Time Premium = Vale of being able to wait
Option Price
Stock Price

6. Option to Wait
More time = More value
Option Price
Stock Price

7. Option to Abandon Example - Abandon
Mrs. Mulla gives you a non-retractable offer to buy your company for $150 mil at anytime within the next year. Given the following decision tree of possible outcomes, what is the value of the offer (i.e. the put option) and what is the most Mrs. Mulla could charge for the option?
Use a discount rate of 10% 38

8. Option to Abandon Example - Abandon Year 0 Year 1 Year 2 120 (.6)
Mrs. Mulla gives you a non-retractable offer to buy your company for $150 mil at anytime within the next year. Given the following decision tree of possible outcomes, what is the value of the offer (i.e. the put option) and what is the most Mrs. Mulla could charge for the option?
Year 0 Year 1 Year 2
120 (.6)
100 (.6)
90 (.4)
NPV = 145
70 (.6)
50 (.4)
40 (.4) 39

9. Option to Abandon Option Value = 162 - 145 = $17 mil Example - Abandon
Mrs. Mulla gives you a non-retractable offer to buy your company for $150 mil at anytime within the next year. Given the following decision tree of possible outcomes, what is the value of the offer (i.e. the put option) and what is the most Mrs. Mulla could charge for the option?
Year 0 Year 1 Year 2
120 (.6)
100 (.6)
90 (.4)
NPV = 162
150 (.4)
Option Value = =
$17 mil 40

10. Corporate Options Reality
Decision trees for valuing “real options” in a corporate setting can not be practically done by hand.
We must introduce binomial theory & B-S models 41