Real Options Analysis
Companies resort to capital budgeting in the process of taking decisions with regard to making long-term investments. The projects involving capital budgeting are chosen by the companies in terms of expected generation of cash flows. Since profitability is the main criterion for long-term investments of the companies the strategic decisions with regard to the long-term investments involves a cost-benefit analysis in terms of cost of investments and expected generation of cash flows over the period of time. Emphasis is being laid on the concepts of Net Present Value and Internal Rate of Return etc. To assess the benefits of long-term investments against the cost of capital invested. The cost of capital of a firm signifies towards the cost of obtaining of capital by the firm that is used for long-term investments. Generally the firms define economic profit as the operating profit excluding the tax and cost of capital.
The terminology, Economic Value Added is also used to mean the economic profit. A positive economic profit indicates greater returns of the company over the cost of capital. In order that the company operates with a real profit it should be ensured that the returns are more than the cost of capital conversely it leads to loss. The long-term investments are associated with uncertainty, and therefore necessitate firm decision making techniques analyzing and estimating the probability of outcomes taking and the values of these expected outcomes. Even though the firm managers try to put all their efforts for reducing risk taking assistance of the best possible information available, the uncertainty of weather and markets cannot be avoided. This makes essential the firms to depend upon the various decision making techniques while making strategic long-term investments. [Budgeting and decision-making techniques]
The choice among the investment opportunities are made by the managers using different techniques for valuing the opportunities. Presently four different techniques are available with the managers in order to value the investment opportunities they are payback rules, accounting rate of return, net present values and real options. The technique of payback rules indicates the assessment by the managers of the minimum period that the firm requires in order making the cumulative cash flow of the asset greater than the cost of capital invested. The project is approved only if the period so estimated is less than the benchmark period of the firm. This technique does not take into consideration the expected cash flows that the asset generates beyond such periods. Managers are not concerned about the positive or negative cash flows in subsequent periods. [Using real options in strategic decision]
The accounting rate of return normally depends upon the average returns of profit over period of time that the asset accrues through out its life excluding the depreciation and tax involved during the period. The accounting rate of return is calculated in terms of the ratio of such returns to the average cost of capital. The project is approved if accounts for the profitable over the period of time. These methods are resorted to commonly for its simplicity of calculation involving easy forecasting of the cash flows in near future. Since the data relating to the accounting rates of return are maintained in the firm as a routine matter, the comparison of data and its monitoring is comparatively easier. Estimation of the expected future cash flows and determination of an appropriate discount rate is necessitated for calculation of the Net Present Value of the investment. The Net Present Value approach is based on the principle of capital budgeting that involves subtraction of the present value of cash inflow from the present value of the cash outflows. The Net Present Value involves comparison of the present value of every dollar invested with that of the returns that the dollar fetches taking into consideration the rate of inflation and rate of return in to account. [Using real options in strategic decision]
The approval of the long-term project necessitates a positive Net Present Value and alternatively, a negative Net Present Value rejects the proposal since it indicates the negative returns in terms of negative cash flows. Initially, the Net Present Value technique was developed to assess the future flow of investment in bonds. The investors in bonds are said to passive since they have no control over the alteration of the coupons that they receive, the future cash flow and the principal paid or on the rate of return after discount at an appropriate rate. On the other hand the Companies...
Real Options Valuation Market investors often carry out their research in a sell side or buy side method. Sell side carry out their investment research to enable them satisfy buy side customers. They carry out this research to generate business or reach the goal of generating transactions. The buy side follows the prospective of banking customers as away of attracting new customers and a service to past customers. Sell side firms
The reason that the subject lends itself to natural resources or real estate is that there will be some information available in those areas, making the valuation less difficult than in innovative areas. The pessimistic approach is characterized by the divest/shrink option. When a firm is divesting or shrinking it can first scale down, which means that it can "shrink or shut down a project part way through if new
Real options valuation: KLM airlines flight options The object of this paper is to deliver a real option valuation of an option on an air ticket from KLM Airlines. The paper consists of several parts: (i) a file explaining the problem, the modeling choices and the solutions (ii) a table with calculations and; (iii) the conclusion. The value of an options contract relies on a variety of different variables. In addition to
Different theorists and proponents of real options theory identify different specifics of the theories operation, but in one widely held view there are five real options: the waiting-to-invest option, the growth option, the flexibility option, the exit option and the learning option (Wade 2005). Each one of these options takes in a different value given other environmental and internal considerations, and from the plotted valuations of these real options more
(Economou and Trichias, 2009) Remuneration is stated to be as follows for each of these actors: (1) real estate brokers -- Commission based on percentage of the transaction value; (2) lawyers -- Commission based on percentage of the transaction value; (3) Notaries -- Commission base don percentage of the transaction value; (4) Civil Engineers -- According to specific regulations, taking into account elements of the property in question; and (5) Constructors -- percentage of
Financial Analysis Introduction ( a ) A real option is just that -- the option to do something, if a particular situation arises. The principle is the same as for a financial option. The difference is that real options pertain to physical things -- usually pieces of equipment, real estate or other such assets (Investopedia, 2015). An example of a real option would be when you sign a lease on a piece
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