real options principles of corporate finance seventh edition richard a. brealey stewart c. myers...

Real Options

Principles of Corporate Finance

Seventh Edition

Richard A. Brealey

Stewart C. Myers

Slides by

Matthew Will

Chapter 22

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

22- 2

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Topics Covered

Follow Up Investments Abandon Wait Vary Output or Production

22- 3

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Corporate Options

4 types of “Real Options”1 - The opportunity to make follow-up investments.2 - The opportunity to abandon a project3 - 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

22- 4

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Intrinsic Value

Option to Wait

Option Price

Stock Price

22- 5

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Intrinsic Value + Time Premium = Option Value

Time Premium = Vale of being able to wait

Option to Wait

Option Price

Stock Price

22- 6

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More time = More value

Option to Wait

Option Price

Stock Price

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Example - AbandonMrs. 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%

Option to Abandon

22- 8

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Example - AbandonMrs. 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?

Option to Abandon

Year 0 Year 1 Year 2

120 (.6)

100 (.6)

90 (.4)

NPV = 145

70 (.6)

50 (.4)

40 (.4)

22- 9

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Option to Abandon

Year 0 Year 1 Year 2

120 (.6)

100 (.6)

90 (.4)

NPV = 162

150 (.4)

Option Value =

162 - 145 =

$17 mil

Example - AbandonMrs. 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?

22- 10

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

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

Corporate Options