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Trading real options analysis course - business cases and software applic - Mun P.D.

Mun P.D. Trading real options analysis course - business cases and software applic - Wiley publishing , 2003. - 318 p.
ISBN 047-43001-3
Download (direct link): tradingohnathan2003.pdf
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? Expansion factor—TDN will double its net cash flow
? Time to expiry—anytime over the next five years
? Volatility—implied volatility of 45 percent
? Risk-free rate—5 percent assumed
? Implementation cost (exercise price)—the amount of additional funds required—assumed to be $20 million to fund acquisition
Case Studies
289
Based on the preceding assumptions and using the backward induction technique, the lattice is calculated back to obtain a value of $63 million for the firm inclusive of the expansion option. As the underlying static value of TDN was $38 million, the cost for the VC of acquiring another investment with similar cash flows and risk is (2 x $38) - $20 = $56 million; that is, the value of twice its current operations less the acquisition costs. The $56 million is the static NPV without flexibility of the expanded operation. The additional $7 million is the real option value. In other words, the growth option embedded in TDN contributed an additional 12.5 percent to a static valuation analysis.
Conclusion
The analysis did show that by using the traditional valuation methods, the VC would have undervalued TDN and potentially might have missed investing in a lucrative venture. However, I believe the main benefit of undertaking a real options analysis for the VCs is that it forces them to think and identify what options exist in the investee entity or how they may create options within their investment. Seek to invest in entities that provide the greatest investment opportunity. The key benefit for the management teams of start-ups seeking to raise funds by undertaking such analysis is that it provides them with a powerful negotiating tool to highlight to potential investors the array of options embedded in their business. It also helps them extract better terms from VCs in terms of equity ownership ratio.
Notes
1. I used the real options approach to analyze the business and to help the management team articulate its business case to VCs during the capital-raising phase. However, in this case study, the analysis has been flipped around and is done from the perspective of a venture capitalist wanting to value the business.
2. To maintain confidentiality, the underlying numbers used to produce the results quoted in this case study are not the actual numbers; however, I am willing to share the thought process and technique used to obtain the results.
Index
Abandonment option case illustration, 95-108 characteristics of, 22-23, 26, 30, 125-126 creating and solving, 225 option to choose, 128-130, 132, 134
pharmaceutical R&D example, 50
Real Options Analysis Toolkit software, 242-243 Acquisitions, 107-108 American Abandonment Option.
See Abandonment option American options
binomial lattices, 76-77, 82-83 calculations, 218 call options, 76, 82-83, 143 contraction, 123-124 expansion, 108-109, 115 sequential compound, 136, 145 trinomial lattices, 90-94 value, 76-77 Arbitrage, 73 Asset value, 67 At-the-money options characteristics of, 48 dividend impact table, 274-275
Backward-induction analysis, 190 Backward induction techniques,
26, 120, 129, 159 Barrier options characteristics of, 171-175, 236
Real Options Analysis Toolkit software, 240-241, 246-247 venture capitalists and, 285 Base-case variable forecasts, 41-42 Bayesian probability, 71 Bifurcation binomial lattices, 74-75 nonrecombining lattice, 196 trinomial lattices, 90 Binomial convergence, 183-189 Binomial lattices abandonment options, 104, 125 Black-Scholes model, 168-169 with closed-form models, 22 contraction options, 124-125 five-step, 25, 78 granularity, 77-79 overview, 73-76 Real Options Analysis Toolkit software, 240, 242-244, 246
time-steps, 74-75 trinomial lattice compared with, 90-91 Black-Scholes model binomial convergence, 183 call options, 244-245 with dividends, 167-171 European models, with dividends, 167-171 European options, 77-78 expansion options, 105-106, 116 generalized, 167
295
296
INDEX
Black-Scholes model (cont.) option to choose, 129 put options, 245 Real Options Analysis Toolkit software, 244-245 Break-even point, 123 Break-even projects, 46, 70 Brownina motion, Geometric Brownian motion, 63 Business conditions, implications of, 108
Call options. See also specific types of call options Black-Scholes model, 167-171 characteristics of, 76-77, 82-83 Real Options Analysis Toolkit software, 239-242,
246-249 Call sensitivity, Real Options
Analysis Toolkit software, 249
Call value, 86-88 Capital utilization rationalization process, 283 Carrying cost, Real Options
Analysis Toolkit software, 244-245 Case studies
abandonment option, 95-108 discounted cash flow (DCF) models, 286-288 Halliburton, 281-284 managerial constraints, 209 sequential compounding option, 201-208 The Digital News, Inc., 284-289 Cash flow, generally annual, 59 discount rate, 62 free, 67, 74
full-year discounting, 59-60
future, 64, 117, 120, 136, 148, 154
mid-year conventions, 59-60 negative, 65
present value and, 44, 60 volatility and, 72, 74 Cash-flow returns, 64 Certainty level, 20-21 Changing cost option characteristics of, 154-157, 233 Real Options Analysis Toolkit software, 244 Changing volatility options, 158-162, 197-199, 234-235,237-238 Chooser options. See Option to choose Closed-form approaches abandonment options, 95-96 American options
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