Traditional project evaluation or capital budgeting analysis supposes a firm’s only choice is accept or refuse a program. In a real business situation, firms face lots of choices with respect to how to operate a project, both before it begins and after it is underway. Any time a firm has the ability to make choices, there is value added to the project in problem – Traditional NPV analysis ignores this value. The study of real options attempts to put up a dollar value on the ability to make choices.
a) What are real options and how are they valued.
b) Discuss the given:
Locate the given article:
IRREVERSIBILITY, UNCERTAINTY AND INVESTMENT:
(Robert S Pindyck – Massachusetts Institute of Technology March – 1990 – old but gold)
Most major investment expenditures have two important characteristics which together can dramatically affect the decision to invest. First, the expenses are largely irreversible; the firm can’t disinvest, thus the expenses must be viewed as sunk costs. Second, the investments can be delayed, giving the firm an opportunity to wait for new information regarding prices, costs and other market conditions before it commits resources.
c) Compute the given:
Pindyck supplies a simple two-period illustration to describe how irreversibility can affect an investment decision and how option pricing techniques can be employed to value a firm’s investment opportunity, and find out whether or not the firm should invest.
By using the given ex replicate Pyndick’s two-period illustration.
Consider a firm's decision to irreversibly invest in the widget factory. The factory can be built instantly, at a cost of $7m, and will generate 1000 widgets per year forever, with zero operating cost. Presently the price of widgets is $700, but next year the price will change. With probability .6 it will mount to $800 and with probability (l-q) it will fall to $600. The price will then remain at this new level forever. Suppose that this risk is fully diversifiable and hence the firm can discount future cash flows by using the risk-free rate, which we will take to be 10 percent.
Please mention all the references and sources for the assignment in haward style.