# Principles of Corporate Finance

## Presentation on theme: "Principles of Corporate Finance"— Presentation transcript:

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

Topics Covered Follow Up Investments Abandon Wait
Vary Output or Production

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

Option to Wait Intrinsic Value Option Price Stock Price

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

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

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

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

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

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