Capital projects as real options - Revision history

Dirkjan at 19:23, 27 August 2020

2020-08-27T19:23:43Z

Dirkjan: Replaced content with "Capital projects as real options Category:finance Category:Article Category:M13"

2020-08-27T18:38:37Z

Replaced content with "Capital projects as real options Category:finance Category:Article Category:M13"

Dirkjan: Created page with "Download the article here The article describes an approac..."

2020-08-25T07:21:40Z

Created page with "Download the article <html><a href="/static/files/MBI/Module%2013/Captial%20projects%20as%20real%20options%20-%20hbr.pdf">here</a></html> The article describes an approac..."

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Download the article

<html><a href="/static/files/MBI/Module%2013/Captial%20projects%20as%20real%20options%20-%20hbr.pdf">here</a></html>

The article describes an approach to use option value theory to help with in company project investment decisions. There are several examples where using real option analysis give a better view of your project:
# An R&D program may both:
## generate a cash producing new product , as well as
## '''''opportunities for further R&D aimed to create yet more new products'''''
# Investing in a new market may:
## Lead to immediate cash flow, as well as,
## '''''Future expansion possibilities'''''
# Replacing:
## a first-generation technology with a second, makes it possible to eventually,
## '''''replace the second with a third'''''

All of the above examples, contain ''[[Assets in place|Assets in place]]'' (first bullet item) and ''growth options'' (second bullet item). The value of the growth options are discarded in traditional [[DCF|DCF]] analysis.

The article goes on to describe the concept of [[NPV_q|NPV_q]], [[Options|Options]] and [[Real Options|Real Options]]. The final 'punch line' of the article is the following diagram:

<html><img src = "/static/files/MBI/Module%2013/mappingprojectstocalloptions.png" width="700"/></html>

Note to myself: ''Quadrant 3 lists ''NPV < 0'' which was counter intuitive at first'''. The reason this can happen is that if the risk free rate of return is > 0. The location of this curve varies with r and σ. The curve is located by holding r and σ constant as t varies, and solving for the [[NPV_q|NPV_q]] that corresponds to [[NPV|NPV]]=0. Note that in the extreme case of r=0, the curve is a vertical line passing through [[NPV_q|NPV_q]] =1. As r increases, the slope of the curve decreases, bending to the right, as shown in Figure 6.

<html><img src = "/static/files/MBI/Module%2013/npvqgraph.png" width="700"/></html>

In the graph above there are three sitiuations:
# At the top there are options with no cumulative variance, either time has run out or there is no variance. These options are '''in the money''' and should be exercised immediately. There is no value in waiting.
# Just below are options that are in the money but for which there is still some cumulative variance. The company should wait, ''if possible'', to exercise these options. Early exercise may be desirable when the underlying asset is 'wasting' (subject to competitors actions)
# Finally at the bottom there are options that are promissing because [[NPV_q|NPV_q]] > 1 even though [[NPV|NPV]] < 0. If, as time runs out, neither S nor X changes, then [[NPV_q|NPV_q]] will fall and these options will expire unexercised. But in a large sample of projects, many of them may end 'in the money'
[[Category:finance]]

[[Category:Article]]

[[Category:M13]]

← Older revision		Revision as of 18:38, 27 August 2020
Line 1:		Line 1:
−	~~Download the article~~	+	Capital projects as real options
−
−	~~<html><a href="/static/files/MBI/Module%2013/Captial%20projects%20as%20real%20options%20-%20hbr.pdf">here</a></html>~~
−
−
−
−	~~The article describes an approach to use option value theory to help with in company project investment decisions. There are several examples where using~~ real ~~option analysis give a better view of your project:~~
−	~~# An R&D program may both:~~
−	~~## generate a cash producing new product , as well as~~
−	~~## '''''opportunities for further R&D aimed to create yet more new products'''''~~
−	~~# Investing in a new market may:~~
−	~~## Lead to immediate cash flow, as well as,~~
−	~~## '''''Future expansion possibilities'''''~~
−	~~# Replacing:~~
−	~~## a first-generation technology with a second, makes it possible to eventually,~~
−	~~## '''''replace the second with a third'''''~~
−
−	~~All of the above examples, contain ''[[Assets in place\|Assets in place]]'' (first bullet item) and ''growth options'' (second bullet item). The value of the growth~~ options ~~are discarded in traditional [[DCF\|DCF]] analysis.~~
−
−	~~The article goes on to describe the concept of [[NPV_q\|NPV_q]], [[Options\|Options]] and [[Real Options\|Real Options]]. The final 'punch line' of the article is the following diagram:~~
−
−
−
−	~~<html><img src = "/static/files/MBI/Module%2013/mappingprojectstocalloptions.png" width="700"/></html>~~
−
−
−
−	Note to myself: ''Quadrant 3 lists ''NPV < 0'' which was counter intuitive at first'''. The reason this can happen is that if the risk free rate of return is > 0. The location of this curve varies with r and σ. The curve is located by holding r and σ constant as t varies, and solving for the [[NPV_q\|NPV_q]] that corresponds to [[NPV\|NPV]]=0. Note that in the extreme case of r=0, the curve is a vertical line passing through [[NPV_q\|NPV_q]] =1. As r increases, the slope of the curve decreases, bending to the right, as shown in Figure 6.
−
−
−
−	~~<html><img src = "/static/files/MBI/Module%2013/npvqgraph.png" width="700"/></html>~~
−
−
−
−	~~In the graph above there are three sitiuations:~~
−	# At the top there are options with no cumulative variance, either time has run out or there is no variance. These options are '''in the money''' and should be exercised immediately. There is no value in waiting.
−	# Just below are options that are in the money but for which there is still some cumulative variance. The company should wait, ''if possible'', to exercise these options. Early exercise may be desirable when the underlying asset is 'wasting' (subject to competitors actions)
−	# Finally at the bottom there are options that are promissing because [[NPV_q\|NPV_q]] > 1 even though [[NPV\|NPV]] < 0. If, as time runs out, neither S nor X changes, then [[NPV_q\|NPV_q]] will fall and these options will expire unexercised. But in a large sample of projects, many of them may end 'in the money'
	[[Category:finance]]		[[Category:finance]]

← Older revision		Revision as of 19:23, 27 August 2020
Line 1:		Line 1:
−	~~Capital projects~~ as ~~real~~ options	+	Download the article
		+
		+	<html><a href="/static/files/MBI/Module%2013/Captial%20projects%20as%20real%20options%20-%20hbr.pdf">here</a></html>
		+
		+
		+
		+	The article describes an approach to use option value theory to help with in company project investment decisions. There are several examples where using real option analysis give a better view of your project:
		+	# An R&D program may both:
		+	## generate a cash producing new product , as well as
		+	## '''''opportunities for further R&D aimed to create yet more new products'''''
		+	# Investing in a new market may:
		+	## Lead to immediate cash flow, as well as,
		+	## '''''Future expansion possibilities'''''
		+	# Replacing:
		+	## a first-generation technology with a second, makes it possible to eventually,
		+	## '''''replace the second with a third'''''
		+
		+	All of the above examples, contain ''[[Assets in place\|Assets in place]]'' (first bullet item) and ''growth options'' (second bullet item). The value of the growth options are discarded in traditional [[DCF\|DCF]] analysis.
		+
		+	The article goes on to describe the concept of [[NPV_q\|NPV_q]], [[Options\|Options]] and [[Real Options\|Real Options]]. The final 'punch line' of the article is the following diagram:
		+
		+
		+
		+	<html><img src = "/static/files/MBI/Module%2013/mappingprojectstocalloptions.png" width="700"/></html>
		+
		+
		+
		+	Note to myself: ''Quadrant 3 lists ''NPV < 0'' which was counter intuitive at first'''. The reason this can happen is that if the risk free rate of return is > 0. The location of this curve varies with r and σ. The curve is located by holding r and σ constant as t varies, and solving for the [[NPV_q\|NPV_q]] that corresponds to [[NPV\|NPV]]=0. Note that in the extreme case of r=0, the curve is a vertical line passing through [[NPV_q\|NPV_q]] =1. As r increases, the slope of the curve decreases, bending to the right, as shown in Figure 6.
		+
		+
		+
		+	<html><img src = "/static/files/MBI/Module%2013/npvqgraph.png" width="700"/></html>
		+
		+
		+
		+	In the graph above there are three sitiuations:
		+	# At the top there are options with no cumulative variance, either time has run out or there is no variance. These options are '''in the money''' and should be exercised immediately. There is no value in waiting.
		+	# Just below are options that are in the money but for which there is still some cumulative variance. The company should wait, ''if possible'', to exercise these options. Early exercise may be desirable when the underlying asset is 'wasting' (subject to competitors actions)
		+	# Finally at the bottom there are options that are promissing because [[NPV_q\|NPV_q]] > 1 even though [[NPV\|NPV]] < 0. If, as time runs out, neither S nor X changes, then [[NPV_q\|NPV_q]] will fall and these options will expire unexercised. But in a large sample of projects, many of them may end 'in the money'
	[[Category:finance]]		[[Category:finance]]