CHAPTER 14

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_________, in which an asset's cash flows are estimated and then discounted to obtain the asset's NPV

Traditional discounted cash flow analysis

DCF were origionally developed to do what?

value securities such as stocks and bonds

Why are securities passive investments?

bc once they have been purchased, most investors have no influence over the cash flows the assets produce.

How are real assets not passive investments?

bc managerial actions after an investment is made can influence its results
-investing in a new project often brings with it the potential for increasing the firm's future investment opportunities

The right, not an obligation, to take some action in the future

option

a contract that gives its holder the right to buy or sell an asset at some predetermined price within a specified period of time

option values

What gives a firm a positive option value?

when they take on projects that expand the firm's set of opportunities

What can destroy an option's value?

any project that is taken on by a firm and reduces the set of future opportunities

opportunities for management to change the timing, scale, or other aspects of an investment in response to changes in market conditions

real options

TF: opportunities are options in the sense that management can, if it is in the company's best interest, to undertake some action; management is not required to undertake the action

true

why are the opportunities in real options considered "real" as opposed to financial?

bc they involve decisions regarding real assets- such as plant, equipment, and land- rather than financial assets like stocks or bonds.

What are four examples of real options?

1. investment timing options
2. growth options
3. abandoment options
4. flexibility options

What are the five possible procedures that can be used to deal with real options?

1. use DCF valuation and ignore any real options by assuming their values are zero
2. use DCF valuation and include a qualitative recognition of any real option's value
3. use decision tree analysis
4. use a standard model for a financial options
5. devel

The right to sell something in the future....

put option

The right to buy something int he future....
-gives the owner the right to purchase a stock at a fixed strike price

call option

When would an investor practice their call option?

only when the stock's price is higher than the strike price

What can ignoring real options do to a firm?

-cause them to overlook potential options that could generate a positive cash flow and lead to lower revenues

An alternative to investing immediately- the decision to invest or not can be postponed until more information becomes available

investment timing option

What is the benefit of an investment timing option?

-by waiting, the investor can make a better and more informed decision, and the investment timing option can add value to the project and reduce risk

When thinking about the decision to take on a new project now, or wait for more information, what should be considered?

-the value of an option is higher if the current value of the underlying asset is high relative to its strike price, other things held constant.

DCF analysis with qualitative consideration of the timing option....

does not require any real calculation, but the decision maker should consider the NPV of the DCF analysis without consideration to the timing option. If the DCF analysis without consideration is very low, putting in the timing options can be more valuable

If a firm does a DCF analysis without considering the timing option and gets and NPV of 1.08 million, what should the decision maker do?

after a qualitative assessment, the low NPV suggest that management should go on to make a quantitate assessment of the situation

with a scenario analysis and decision tree, each possible outcome is shown as a....

branch" on the tree
-each branch shows the CF and probability of a scenatio laid out as a time line

If you are working on a decision tree and your potential project has a coefficient of variation of 22.32, what does this mean?

the project is quite risky under the analysis at that point

When looking at a decision tree with the option to implement immediately and to wait one year bc of unertain CF due to demand, what might you see?

the expected NPV could be much higher in the waiting decision tree. Also, in the low demand scenario, there may be no possibility of losing money under the delay option, which lowers the projects risk. This would indicate that the option to wait is valuab

Can a decision tree provide enough info to make a good decision?

If the decision tree approach is coupled with a sensitivity analysis, you may have enough information for a good decision, but it is often useful to obtain additional insights into the real option's value though an option pricing model

Gives additional insight into a real options value

option pricing model

What must an analysts find in order to gain additional insights into the real options value via an option pricing model?

they must find a standard financial option that resembles the project's real option

The black-scholes option pricing model requires what five inputs?

1. the risk free rate
2. the time until the option expires
3. the strike price
4. the current price of the stock
5. the variance of the stock's rate of return

What is the main goal of black-scholes model?

to find the current value of the underlying asset- that is, the project

TF: the strike price for a call option has no effect on the stock's current price

true

For a real option, the underlying asset is....

the project, delayed or not.

with the black-schols model, the current price is...

the PV of all its future expected CF

When doing the black-scholes model, why do you ignore the projects strike price?

bc the price of a stock is not affected by the strike price of a call option, you would ignore the project's strike price when finding its PV

What are the three approaches that could be used to estimate the last input of black-scholes model, the variance of the project's return?

1. use judgement- an educated guess
2. use the direct method
3. approach based on the scenario data

How would an analysts use judgement to estimate the variance of a project's return?

The analysts should recall that a company is a portfolio of projects (or assets), with each having its own risk. Bc returns on the company's stock reflect the diversification gained by combining many projects, they could expect the variance of the stock's

A method used to estimate the variance of a project's return for the black-schols model
-to estimate the rate of return for each possible outcome, and then calculate the variance of those returns

Direct approach

in the third approach for estimating variance of the annual rate of return based on scenario data, what must an analysts do?

Use the estimated expected value of the project and its standard deviation at the time the option expires. By using this info, an analysts can estimate the variance of the projects annual rate of return

When using the black-scholes model, bc the inputs are based on subjective estimates, what is important?

it is important to determine how sensitive the final outcome is to key inputs

Generally an alternative to accepting or reject a static project, many investment opportunities, if successful, lead to other investment opportunities.
-This adds value to a project

growth options

What does a growth option explain?

why companies are flocking to make inroads into very difficult business environment in china

How does a growth option resemble a call option on a stock?

bc it gives the company the opportunity to purchase a successful follow on project at a fixed cost if the value of the project is greater than the cost.

If a DCF analysis (ignoring the growth option) indicates that the project should be accepted, what should be considered?

-it ignores a potentially valuable real option, the option's time to maturity and the volatile of the underlying project

If a firm has a growth option that matures in two years, and the DCF that ignores the growth option is positive, what should be considered?

-two years is a relativly long time, and the F of the project are volatile. A qualitative assessment could indicate that the growth option could be valuable

When using black-scholes model, when the strike price is greater than the current price, the growth option would be....

Out of the money

CHAPTER 17-6

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What did MM do with capital structures?

He addressed the capital structure and changed it into a rigious, scientific fashion

MM employed the concept of ______ to develop their theory

arbitrage

When does arbitrage occur?

if two similar assets sell at different prices.
-arbitrageurs will buy the undervalued stock and sell the overvalued stock to make a profit

In order for arbitrage to work...

the assets must be equivalent or nearly so

MM models show how money can be made through arbitrage if one can find ways around problems with what 6 assumptions?

1. there are no taxes
2. firms are in an homogenous class of risk
3. all investors have identical estimates of each firms future's EBIT (investors have homogenous expectations about future earnings.)
4. stocks and bonds are traded in perfect capital marke

MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used

trade off theory

What are the advantages of going public

Current stockholders can diversify.
Liquidity is increased.
Easier to raise capital in the future.
Going public establishes firm value.
Makes it more feasible to use stock as employee incentives.
Increases customer recognition.

What are the disadvantages of going public

Must file numerous reports.
Operating data must be disclosed.
Officers must disclose holdings.
Special "deals" to insiders will be more difficult to undertake.
A small new issue may not be actively traded, so market-determined price may not reflect true v

What is a road show

When an investment banker travels and gives presentations about the new IPO