Options are a financial instrument with which one can reduce risk. Financial options are used by companies for this purpose and come in many forms, for example commodity, currency or interest rate options.
Options are also embedded in real investment decisions, for example in the form that a company gains the possibility (or option) to make a very profitable future investment (B), but only under the condition that the original investment (A) is made. This possibility increases uncertainty about the future, and has a value to the purchaser of the asset (A) at the time of purchase. Option pricing attempts to value this. This offers an alternative form of investment appraisal to the traditional Discounted Cash Flow (DCF) methods such as Net Present Value (NPV), that do not and can not account for and place a value on this uncertainty. There are two major methods of valuing options. One is the binomial method and the other is the Black & Scholes Formula. The options valued here all use the Binomial Model assuming European Options.
Table of Contents
Introduction
Calculating a Development Option (Call)
Land Acquisition Strategy
Change in Exercise Date
Change in Probability of Success
Real Options
Follow on Investment
Abandonment
Timing
Flexibility
Other points about NPV
Problems with Real Options
Summary
Objectives and Core Themes
This assignment evaluates the application of option pricing models in corporate finance, specifically focusing on how these methods address uncertainty and strategic flexibility in investment decisions compared to traditional Discounted Cash Flow (DCF) models.
- Application of the binomial option pricing model for real investment scenarios.
- Strategic use of the Put-Call-Parity formula in land acquisition.
- Sensitivity analysis regarding changes in exercise dates and success probabilities.
- Comparative evaluation of Real Options against traditional Net Present Value (NPV) techniques.
Excerpt from the Book
Calculating a Development Option (Call)
To value the land in question the binomial option pricing method is used to determine the value of having the option to develop the land after purchase. The specific method used in this case is the Hedging Method.
Today’s price = So = 95.000
Land Value goes up = Su = 300.000
Land Value goes down = Sd = 80.000
Exercice Price = ExPr = 90.000
Exercice Date = ExDt = 1 Year
Risk free interest rate = Rf = 5%
Calls value if Su = Cu = 210.000
Calls value if Sd = Cd = 0
So is 95.000 because this is the net effect of taking the current asking price at 175.000 minus the current achievable resale value of 80.000.i.e. the current net actual value of the land.
Summary of Chapters
Introduction: Provides an overview of how financial options are used to manage risk and introduces their role in real investment decisions as an alternative to traditional DCF methods.
Calculating a Development Option (Call): Explains the practical application of the hedging method within the binomial pricing model to value land development potential.
Land Acquisition Strategy: Demonstrates how the Put-Call-Parity formula can be manipulated to create an effective investment strategy for land acquisition.
Change in Exercise Date: Analyzes how extending the duration of an option affects its value due to increased uncertainty and flexibility.
Change in Probability of Success: Discusses the impact of re-weighting expected outcomes based on varying success probabilities for projects.
Real Options: Details the four common forms of real options and highlights their importance in strategic management decisions.
Other points about NPV: Critically evaluates the limitations of NPV in a changing, uncertain world compared to active strategy models.
Problems with Real Options: Addresses the practical difficulties in implementing complex option pricing models within a corporate environment.
Summary: Concludes that while option pricing is theoretically superior for complex strategic projects, NPV remains the more practical tool for everyday corporate applications.
Keywords
Corporate Finance, Real Options, Binomial Model, Hedging Method, Net Present Value, Put-Call-Parity, Investment Appraisal, Risk Management, Strategic Planning, Volatility, Capital Budgeting, Asset Valuation.
Frequently Asked Questions
What is the fundamental focus of this assignment?
The assignment explores the use of option pricing methods to value real-world investment projects, contrasting them with traditional DCF and NPV approaches.
What are the primary themes discussed?
The core themes include the binomial option pricing model, the Put-Call-Parity formula, the role of strategic flexibility, and the practical challenges of implementation in corporate finance.
What is the main research objective?
The objective is to demonstrate how option pricing can incorporate value from strategic uncertainty that traditional NPV methods typically fail to account for.
Which scientific methods are employed?
The study utilizes the Binomial Option Pricing model, the Hedging Method, and the Put-Call-Parity formula to analyze investment scenarios.
What is the focus of the main section?
The main body examines the step-by-step valuation of a land development option, followed by strategic applications and an assessment of why and when real options are preferable to NPV.
Which keywords characterize this work?
Key terms include Real Options, Binomial Model, NPV, Investment Appraisal, Put-Call-Parity, and Strategic Flexibility.
How does changing the exercise date affect the value of a development option?
Extending the exercise date increases the value of the option because it allows more time for uncertainty to resolve, effectively providing the investor with more flexibility to react to new information.
Why might a company choose to use NPV despite the theoretical advantages of Real Options?
NPV is often preferred for its simplicity, accessibility, rational nature, and time-effectiveness, making it easier to implement for standard corporate investment decisions where models need to be widely understood.
- Quote paper
- Andrew Brabner (Author), 2002, Corporate Finance - Assignment Two, Munich, GRIN Verlag, https://www.grin.com/document/7644
