Concept explainers
Real options Respond to the following comments.
- a. “You don’t need option pricing theories to value flexibility. Just use a decision tree. Discount the cash f lows in the tree at the company cost of capital.”
- b. “These option pricing methods are just plain nutty. They say that real options on risky assets are worth more than options on safe assets.”
- c. “Real-options methods eliminate the need for DCF valuation of investment projects.”
a.
To discuss: To respond to the statement on whether to use a decision tree rather using option theories.
Explanation of Solution
The possible response to the given statement is as follows:
Discount rates cannot be used for any of the option payoffs, because the risk of the option varies as the asset value changes time to time.
b.
To discuss: To respond to the statement on whether option pricing methods are plain nutty.
Explanation of Solution
The possible response to the given statement is as follows:
The risky asset might be worth less as an outcome of its riskiness, yet the option on the risky asset is progressively significant on the grounds that the option proprietor can underwrite from upward moves while not losing because of downward moves.
c.
To discuss: To respond to the statement on whether real options methods eliminate the discount cash flow valuation.
Explanation of Solution
The possible response to the given statement is as follows:
The worth of an option relies upon the value of the underlying asset. The discounted cash flow valuation of investment projects is vital so as to decide the worth of the underlying asset.
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Chapter 22 Solutions
Principles of Corporate Finance
- 4. Introduction to real options Consider the following statement about real options: Decision tree analysis is more commonly used in valuing securities than real assets. True or False: The preceding statement is correct. True False Which type of real option allows a project to be expanded if demand turns out to be greater than expected? Flexibility option Abandonment option Expansion option Timing option Consider the following example: Smoltz Motors has plants around the country that specialize in specific models of cars. Smoltz has determined that lower demand has led the firm’s inventory of SUVs to be too high. Smoltz wants to stop production for its SUVs and focus on its sedans. This example describes a real option to (expand/ abandon) . Please do not answer in excel, use math formulas Thank you!arrow_forwardAn asset manager and he is overweight in equities because he believes that equities have more upside in the long run. However, he is worried that any negative news regarding COVID-19 may cause a short-term sell off in the stock markets. The asset manager thinks that any sell-off will be limited in size and duration. He is also concerned that implied volatility is very high, so he would like to minimize his vega exposure. Outline 2 different strategies that the asset manager could follow and explain the advantages and disadvantages of each strategy.arrow_forwardThe project is accepted اخترأحد الخيارات a. If the profitability index is zero b. if the profitability index is less than one c. If the profitability index is greater than hundred d. If the profitability index is negative e. None of the option What is the limitation of Traditional approach of Financial Management? اخترأحد الخيارات a. All of the option b. More emphasis on long term problems c. Ignores allocation of resources d. One-sided approacharrow_forward
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