...Second Order Moment Approach to Real Options Analysis Submitted as a Component of Required Courses for the Award of Bachelor of Engineering (Civil) Honours School of Civil Engineering University of New South Wales Author: Ariel Hersh October 2010 Supervisor: Professor David G. Carmichael i ORIGINALITY STATEMENT ‘I hereby declare that this submission is my own work and to the best of my knowledge it contains no materials previously published or written by another person, or substantial proportions of material which have been accepted for the award of any other degree or diploma at UNSW or any other educational institution, except where due acknowledgement is made in the thesis. Any contribution made to the research by others, with whom I have worked at UNSW or elsewhere, is explicitly acknowledged in the thesis. I also declare that the intellectual content of this thesis is the product of my own work, except to the extent that assistance from others in the project's design and conception or in style, presentation and linguistic expression is acknowledged.’ Signed …………………………………………….............. Date …………………………………………….............. ii 1. ABSTRACT Real options analysis can be used by investors to determine the value of potential investments that offer an owner the right but not the obligation to exercise a strategic decision at a predetermined time and price. Tools which are popular for valuing financial ...
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...may grant a competitive edge. We explore strategic investments that are required to compete effectively in uncertain and turbulent environments. Managers often throw up their hands and argue that planning isn’t useful when the landscape is shifting rapidly. However, with the right set of tools, strategic management can have an even greater impact in this setting. We place special emphasis on competitive advantages that stem from valuable and hard-toimitate resources or capabilities. Accordingly, we will focus much of our energy on the question of how to build, acquire or ally to gain access to such capabilities while maximizing the value that accrues to the company. Given the uncertainty inherent in such investments, we will explore how real options analysis may assist managers in making strategic investments of this type. Learning Objectives Our primary goal is to synthesize the set of tools and knowledge students have gained to address challenging strategic management...
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...Corporation; and Charles Kantor, Lehman Brothers. Moderated by Jeff Greene, Ernst & Young. The Case for Real Options Made Simple 39 Raul Guerrero, Asymmetric Strategy Valuing the Debt Tax Shield 50 Ian Cooper, London Business School, and Kjell G. Nyborg, Norwegian School of Economics and Business Administration Measuring Free Cash Flows for Equity Valuation: Pitfalls and Possible Solutions 60 Juliet Estridge, Morgan Stanley, and Barbara Lougee, University of San Diego Discount Rates in Emerging Markets: Four Models and an Application 72 Javier Estrada, IESE Business School Rail Companies: Prospects for Privatization and Consolidation 78 James Runde, Morgan Stanley A Real Option in a Jet Engine Maintenance Contract 88 Richard L. Shockley, Jr., University of Indiana A Practical Method for Valuing Real Options: The Boeing Approach 95 Scott Mathews, The Boeing Company, Vinay Datar, Seattle University, and Blake Johnson, Stanford University Accounting for Employee Stock Options and Other Contingent Equity Claims: Taking a Shareholder’s View 105 James A. Ohlson, Arizona State University and Stephen H. Penman, Columbia University A Practical Method for Valuing Real Options: The Boeing Approach by Scott Mathews, The Boeing Company, Vinay Datar, Seattle University, and Blake Johnson, Stanford University he field of real options has been...
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...Managerial Finance | Use of Real Options Theory in Financial Management/Modeling | Tiffany Allen | BUS 650 | Prof. Achilles | 11/14/2011 | | Abstract In business, as in life, you always have options to choose from. In today's extremely unstable market, managers realize how incredibly risky some investment opportunities can be, and how useful a flexible strategy can be. Using real options theory, managers can more effectively analyze opportunities to pursue, delay, modify, or abandon projects as events unfold. This paper analyzes the use of real option theory in financial management and modeling. It discusses issues included in the implementation of the theory in financial management and modeling. It explains new learning in real option theory and a case study that was able to apply the theory along with the application of the theory to my current business which has helped me understand real option theory. Use of Real Options Theory in Financial Management/Modeling The Real Option Theory has struck some interest with managers in the last couple of decades. Back in the day, companies had plenty of time to make decisions to make changes when they felt it was necessary. Now, if they take their time deciding on changes, chances are by the time they finally make a decision, another company has already made the move. Times have change and especially with how the economy is today, it’s a “Dog Eat Dog World” and in this competitive market, you...
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...Multi-period Capital Budgeting under Uncertainty: Real Options Analysis” Table of Contents Section | Name | Page no. | Letter of Transmittal | i | Acknowledgement | ii | Table of Contents | iii | Section-A | Introduction | 01-02 | | A.1 Introduction | 01 | | A.2 Rationale of the study | 01 | | A.3 Objective of Our Study | 02 | | A.4 Scope | 02 | | A.5 Methodology of the Study | 02 | | A.6 Limitations of the Study | 02 | Section-B | Comparing NPV with Decision Trees and Real Options | 03-08 | | B.1 Comparing NPV with Decision Trees and Real Options | 03-05 | | B.2 Recognizing Real Options | 05 | | B.3 Differences between NPV, Decision Trees, and Real Options | 05-08 | | B.4 Risk-Neutral Probabilities | 08 | Section-C | Three Key Assumptions for pricing Real Options | 09-10 | | C.1 Three Key Assumptions for pricing Real Options | 09-10 | Section-D | Valuing Real Options on Dividend-Paying Assets | 10-12 | | D.1 Valuing Real Options on Dividend-Paying Assets | 10-12 | Section-E | Types of Real Options | 12-13 | | E.1 Types of Real Options | 12-13 | Section-F | Valuing Combinations of Simple Real Options | 13-16 | | F.1 Valuing Combinations of Simple Real Options | 13-16 | Section-G | Valuing Compound Options | 17-21 | | G.1 Simultaneous Compound Options | 17-19 | | G.2 Sequential Compound Options | 19-21 | Section-H | Switching Option | 22-26 | | H.1 Switching Option | 22-26 | Section-I | An Example of how to...
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...Greene, Ernst & Young Liquidity, the Value of the Firm, and Corporate Finance 32 Yakov Amihud, New York University, and Haim Mendelson, Stanford University Real Asset Valuation: A Back-to-Basics Approach 46 David Laughton, University of Alberta; Raul Guerrero, Asymmetric Strategy LLC; and Donald Lessard, MIT Sloan School of Management Expected Inflation and the Constant-Growth Valuation Model 66 Michael Bradley, Duke University, and Gregg Jarrell, University of Rochester Single vs. Multiple Discount Rates: How to Limit “Influence Costs” in the Capital Allocation process 79 The Era of Cross-Border M&A: How Current Market Dynamics are Changing the M&A Landscape 84 Transfer pricing for Corporate Treasury in the Multinational Enterprise 97 The Equity Market Risk premium and Valuation of Overseas investments John Martin, Baylor University, and Sheridan Titman, University of Texas at Austin Marc Zenner, Matt Matthews, Jeff Marks, and Nishant Mago, J.P. Morgan Chase & Co. 113 Stephen L. Curtis, Ernst & Young Luc Soenen,Universidad Catolica del Peru, and Robert Johnson, University of San Diego stock Option Expensing: The Role of Corporate governance 122 Sanjay Deshmukh, Keith M. Howe, and Carl Luft, DePaul University Real Options Valuation: A Case study of...
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...and Derivations What is the cost of using excess capacity? Firms often use the excess capacity that they have on an existing plant, storage facility or computer resource for a new project. When they do so, they make one of two assumptions: 1. They assume that excess capacity is free, since it is not being used currently and cannot be sold off or rented, in most cases. 2. They allocate a portion of the book value of the plant or resource to the project. Thus, if the plant has a book value of $ 100 million and the new project uses 40% of it, $ 40 million will be allocated to the project. We will argue that neither of these approaches considers the opportunity cost of using excess capacity, since the opportunity cost comes usually comes from costs that the firm will face in the future as a consequence of using up excess capacity today. By using up excess capacity on a new project, the firm will run out of capacity sooner than it would if it did not take the project. When it does run out of capacity, it has to take one of two paths: &Mac183; New capacity will have to be bought or built when capacity runs out, in which case the opportunity cost will be the higher cost in present value terms of doing this earlier rather than later. &Mac183; Production will have to be cut back on one of the product lines, leading to a loss in cash flows that would have been generated by the lost sales. Again, this choice is not random, since the logical action to take is the one that leads to the lower...
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...STEP 1: Picture the problem When it comes to visualizing real options, we are really trying to visualize how the flexibility to alter an investment’s scale, scope, and timing enhances the value of an investment. In effect, visualizing the real options involves trying to look into the future and imagining how the project at hand might be altered to increase its value. STEP 2: Decide on a solution strategy Real options arise out of flexibility or opportunities to do different things with an investment over its useful life. So we need to look for the opportunities presented to Imperial Properties in the two properties. STEP 3: Solve The primary option presented to Imperial in this situation is the option to develop the properties and change them from two 4-apartment units to two luxury 10-apartment units. However, to exercise this option Imperial must commit to a $1.5 million building program for each building. Moreover, we are left with the impression that Imperial holds the option to develop one or both buildings. This suggests that if the firm undertakes one of the building projects it can defer the second until it sees how the first proceeds. STEP 4: Analyze Options add value to projects and generally indicate that static NPV calculations will underestimate the value of the investment opportunity. This results from the fact that where managers have the flexibility (options) to respond to changing economic conditions, they can modify or halt the operation of the...
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...Question 1 The rationale of an Apache acquisition of MW Petroleum is plausible, yet there are outstanding concerns. By completing a deal, Apache stands to benefit from several aspects. First, MW isa large company which has more than double Apache’s reserves and it includesproperties that are well-suited to Apache’s operating capabilities. Moreover, on behalf of MW, Amoco operated fields accounting for approximately 80% of MW’s production. Such high operating percentage would promise Apache significant cost-saving opportunities. The acquisition would more than double Apache’s reserves, it would shift Apache’s oil-to-gas ratio from 20-80 to 40-60, and would further diversify Apache geographically. Shifting the oil-to-gas ratio is important because gas prices were highly volatile during this time period while oil was less volatile and, therefore, more predictable. Apache’s revenue stream was high levered and the company’s acquisition driven growth strategy would be more difficult when there is an instability of gas prices. With an acquisition, Apache could also recognize several synergies that would make the deal even more attractive. The properties of MW would diversify Apache geographically and make it more stable in the US market.These include acquired technical data (further exploration possibilities) and several production optimization techniques. Apache would have access to Amoco’s data, which could lead to undiscovered reserves despite that both parties agreed that...
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...Company Name: MW Petroleum Amoco Corporation was the fifth largest oil company in United States with 28 billion in operating revenues and 1.9 billion in net income. The low oil prices in the 1980s depressed the profitability of many oil companies and most of which responded with downsizing and other cost cutting measures aimed at overhead expenses. Amoco had already sold more than 750 million worth of small properties, which it felt could be more economically operated by companies with low overhead costs. Amoco conducted an extensive study on capital structure and profitability in 1988 and found that 85% of its margin in United States was provided by 11% of its producing fields and rest had disproportionately high overhead costs and repair costs. Based on this a strategy was formed to divest up to 1.2 billion worth of additional properties. As the spinoff could take almost two years it was decided to assemble the properties in a new free standing E&P company called MW Petroleum. In the 1990s MW was up for sale and Apache expressed interest in the deal. Apache, a Denver based operator of small- medium sized properties was an efficient and cost effective company and the business strategy was to “rationalize and reconfigure”. The strategy involved acquiring and controlling producing properties, and quickly turn around the efficiency. Apache was specifically interested in MW as it was a large company that would more than double Apache’s reserves and was comprised of properties...
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...could lower the reported earnings by as much as 50% and would adversely affect stock prices (Berton, 1993).A study by R.G. Associates Inc. found that in the year 2000, stock options overstated the earnings of the S&P companies by 9% (Geewax, 2002). For 2001, the average earnings of S&P companies would have been 23% lower if options were expensed (Weil & Segal, 2002). Botosan and Plumlee (2001) examined the effect of stock option expense on diluted EPS and Return on Assets (ROA) of 100 high growth US companies Based on an assessment of the SFAS 123 disclosures, these authors report that stock option expense has a material impact on diluted EPS and ROA for a majority of their sample companies. They also note that expensing of stock-based compensation is void if the financial impact of doing so is immaterial. Financial press reports suggest that Australian firms’ reported profits could be “collectively stripped of hundreds of millions in reported net profit” if accounting standards require the expensing of employee options ((2002) (August), p. 15.Oldfield, 2002). Merrill Lynch (Revell, 2004) reports that the average reduction in S&P 500 firms’ 2001 (2002) reported earnings would be 21% (23%) if stock options were expensed. More recent research also finds similar results. Using stock option disclosures, recent studies provide evidence that if stock-based compensation were to be expensed, it would significantly affect key financial performance measures of firms in...
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...WHEN TO ISSUE THE NONVOTING CLASS A STOCK MLCM believed that market condition would deteriorate further during the week of October 5, and strongly recommended that Spiegel price the Class A shares in the next 48 hours or postpone the offering indefinitely. Now whether MLCM was right or not it will be judged by real option valuation. We showed the decision analysis by using both the FCF and the net cash flow. We have used three options such as a. Timing option, b. Decision Tree Analysis, and c. Option to Wait (Black Scholes Model). |1. Timing Option | We have used Timing Option to calculate the NPV if the stocks were issued immediately. Here we consider FCF in the three methods. Here, we assume 30% probability for high demand, 40% for average and 30% for low demand. We calculated the net annual cash flow for each scenario and then calculated the expected NPV for the issuance. |Demand |Probability |Annual FCF |E(NPV) | |High |30% |142400.97 |686590.51 | |Average |40% |109539.20 |526734.24 | |Low |30% |76677.44 |366877.96 | If Spiegel issued the stocks immediately the Expected net present value gained by the company would be...
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...In Deloitte case sooner or later is issuing stock options to employees in order to align their compensation with the performance of the company. Thus, management believe that this options only be vested if revenue for the company is greater than $10 million for following three years. According to article we assume that we have already vested, the fair value does not change during the life of the award unless we modified the term. If company able to measure compensation cost at $6 grant date fair value only when revenue factor was fulfill. However, whether or not the $6 is based on the fair value of the employee’s share. Accordingly, we believe that the arrangement in the question must be accounted as compensation under ASC 718. Even If the performance compensation based has not met, the award price relatively stays stable. As long as the employee meet the fair value measurement. The company recognize the compensation cost on the grant date, which is when the employee performer the service. Soon or later should use fair value $6 at grant date. According to ASC, 178-10-30-6, “the measurement objective for equity instruments awarded to employees is to estimate the fair value at the grant date of the equity instruments that the entity is obligated to issue when employees have rendered the requisite service and satisfied any other conditions necessary to earn the right to benefit from the instruments (for example, to exercise share options). That estimate is based on the...
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...risk * How does fit into Peru and our strategic objectives? * Tax rates/relief * Capital market conditions (we need a lot of capital) If you had to evaluate this as a traditional NPV project, what cash flows and what discount rate? * Project cash flows depend on price path → Monte Carlo simulates different paths * We can then use three possible outcomes (high, medium and low) and if we take the EV of the three → expected cash flows * We need to take the appropriate discount rate → probably pretty high Is this the right way to model this project? We are ignoring the options → flexibility is worth something * Abandon after exploration without penalty * Spend less on development * If we’re not happy with prices, we can lower or temp shutdown production * Abandon the project How do we value a project using real options? * Use traditional option models (binomial model or Black Scholes) to model variability/risk/the stochastic nature (as opposed to static nature) of key variables * Simulation models, e.g., a Monte Carlo...
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...Accounting for Stock Options http://www.nysscpa.org/printversions/cpaj/2005/805/p30.htm Print Accounting for Stock Options Update on the Continuing Conflict By Nicholas G. Apostolou and D. Larry Crumbley AUGUST 2005 - In December 2004, a decade after bending to Congressional pressure and backing away from requiring the expensing of options on financial statements, FASB issued a revised standard to recognize stock-option compensation as an expense on income statements. Many in Congress may try to thwart the proposal before it becomes effective. A bill by Representative Richard Baker of Louisiana that would require expensing the cost of stock options for only the top five executives of a company has drawn the support of those groups still resolutely opposed to expensing. This time, however, FASB is likely to prevail. Investors are demanding tougher accounting standards, and the International Accounting Standards Board (IASB) has already passed rules requiring the expensing of options. Many large U.S. corporations have already voluntarily agreed to expense options. Finally, there is more concern about, and less support for, Congressional interference in FASB’s standards-setting process. History of the Debate Accounting for stock options has been one of the most controversial topics in accounting during the last decade. The principal debate is whether compensation expense should be recognized for stock options and, if so, the periods over which it should be allocated. Before 1995...
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