Financial Management

PART C. (7.5 marks)

Traditional project evaluation/capital budgeting analysis assumes a firm’s only choice is accept or reject a program. In a real business situation, firms face many choices with respect to how to operate a project, both before it starts and after it is underway. Any time a firm has the ability to make choices, there is value added to the project in question – Traditional NPV analysis ignores this value. The study of real options attempts to put a dollar value on the ability to make choices.

a)     

What are real options and how are they valued.

b)     

Discuss the following

Locate the following article

IRREVERSIBILITY, UNCERTAINTY, AND INVESTMENT

(Robert S Pindyck – Massachusetts Institute of Technology March – 1990 – old but gold)

Most major investment expenditures have two important characteristics which together can dramatically affect the decision to invest. First, the expenditures are largely irreversible; the firm cannot disinvest, so the expenditures must be viewed as sunk costs. Second, the investments can be delayed, giving the firm an opportunity to wait for new information about prices, costs, and other market conditions before it commits resources.

c)     

Calculate the following

Pindyck supplies a simple two-period example to illustrate how irreversibility can affect an investment decision and how option pricing methods can be used to value a firm’s investment opportunity, and determine whether or not the firm should invest.

Using the following example replicate Pyndick’s two-period example.

Consider a firm's decision to irreversibly invest in a widget factory. The factory can be built instantly, at a cost of $7m, and will produce 1000 widgets per year forever, with zero operating cost. Currently the price of widgets is $700, but next year the price will change. With probability .6it will rise to $800, and with probability (l-q) it will fall to $600. The price will then remain at this new level forever. Assume that this risk is fully diversifiable, so that the firm can discount future cash flows using the risk-free rate, which we will take to be 10 percent.