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Cost of capital and capital investment decisions

Real options

4.1 Basic idea

 The traditional NPV method tends to undervalue projects because it does not
consider the value of options associated with a project.

 Strategic NPV = traditional NPV + value of embedded real options.

4.2 Types of real option

 Abandonment options:

– financial put option

– the ability to ‘bail out’, should events turn out worse than expected.

 Timing options:

– financial call option

– 'wait and see options'.

 Strategic investment options:

– financial call option

– 'follow-on options'.

4.3 Valuing real options using Black-Scholes option pricing model

 Key variables are:

– present value of the future project cash flows

– outlay on additional investment (proceed of future sale)

– time until the opportunity disappears

– variability of project returns (measured as a standard deviation)

– risk-free rate of interest.

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