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Real Option in Capital Budgeting

Real Option in Capital Budgeting

Real Option in Capital Budgeting

The traditional analytical methods project evaluation (IRR, NPV, etc.) assume management’s passive commitment to a certain “operating strategy” – viz., initiate the project immediately and operate it continuously at a set scale until the end of its pre-specified expected useful life.

These methods typically ignore the synergistic effects that an investment project can create.

Sometimes the performance of one project will allow you to perform a second project that would not have been possible without the first (e.g., many research and development projects).

Real Option in Capital Budgeting

Options in Capital Budgeting The following is a list of options that may exist in a capital budgeting project.

Long call:

• Right to invest at some future date, at a certain price

• Generally, any flexibility to invest, to enter a business, to expand a business

 Long put:

• Right to sell at some future date at a certain price

• Right to abandon at some future date at zero or some certain price

• Generally, any flexibility to disinvest, to exit from a business.

Short call:

• Promise to sell if the counterparty wants to buy

• Generally, any commitment to disinvest upon the action of another party

Short put:

• Promise to buy if the counterparty wants to sell

• Generally, any commitment to invest upon the action of another party

Valuation of Real Options:

The methods employed to valuation of real options are same as used in valuation of Financial Options. However, sometimes it becomes difficult to identify the value of certain inputs. The various type of cash flows associated with Real Option can be analysed with cash flows involved in Financial options and method used in financial options can be employed easily.

For example cost of an expansion decision is the exercise price or premium in financial option.

Broadly, following methods are employed in Valuation of Financial Options.

(a) Binomial Model

(b) Risk Neutral Method

(c) Black-Scholes Model

Real Option in Capital Budgeting

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