CONTINGENT CLAIM VALUATION

Real Option Traditional DCF approaches cannot properly capture

the company’s flexibility to adapt and revise decisions in response to unexpected market developments.

They assume an expected scenario of cash flows and presume an organization’s passive commitment to a certain static operating strategy.

However, the real world is characterized by change, uncertainty and competitive interactions. A company may exhibit flexibility in its operating strategy and agility to respond to changing circumstances and market conditions, to seize and capitalize on favorable future opportunities or to react so as to mitigate losses. This flexibility is like financial options, and is known as Real Options.

Enterprise Value in Real Options Valuation:

The enterprise value using this approach is given as follows:

Enterprise Value = Value of existing operations

+ Value of future potential operations= Value of all discounted future cash

flows + Value of the company’s portfolio of

real options

Types of Real Options Growth Options: In practice, investments that have insignificant NPV maybe accepted to

enable firms to find opportunities in future that add profitability and value. These projects are said to have growth options. Such options allow firms to make further investments in future if the conditions are favourable. It provides flexibility to the firm.

Abandonment Options: This is the option to terminate/shut down /abandon a project prior to its

expected useful life to minimize losses, if the project turns out to be bad or unsuccessful.

There is an abandonment value in that the decision to abandon can lower the project’s risk by limiting downside losses and enhancing profitability.

Timing Options: This is an option to postpone/accelerate /slow down a project in response to

new information.

Flexibility Options: This is the option to redesign the production process by reconfiguring the

plant and machinery to accept multiple inputs and produce a variety of products.

Examples of Real Options:

Option to invest in a new technology-based service/product, as the result of a successful R&D effort.

Equity in a firm with negative earnings and high leverage.

The patent and other intellectual property owned by a firm.

Real options are useful under the following conditions:

Contingent investment decisions High uncertainty Need to wait for more information Value lies in future growth options Flexibility is important Mid course corrections may be needed as the

scenario unfolds The pay offs to investments are non linear Conventional tools fail to capture the upside

potential and trade offs required in strategic decisions.

OPTIONS In general, the value of any asset is the present

value of the cash flows on that asset

Exception to the rule: The assets derive their value from the values of other assets The cash flows on the assets are contingent on the occurrence of specific events These are Options Their PV of expected cash flows will understate

their true values

FINANCIAL OPTION An option is a contract which gives its

holder the right, but not the obligation, to buy (or sell) an asset at some predetermined price within a specified period of time.

It does not obligate its owner to take any action. It merely gives the owner the right

to buy or sell an asset.

Call and Put Buyer of a call option – long call Seller of a call option – short call Buyer of a put option – long put Seller of a put option – Short Put

Underlying asset could be Stocks, bonds, commodity, indices, foreign currency & real assets

BLACK SCHOLES OPTION PRICING METHODS : Assumptions

i. The stock underlying the call option provides no dividends during the call option’s lifeii. There are no transaction costs for the

sale/purchase of either the stock or the optioniii. Risk Free Rate of Return (RRF) is known and

constant during the option’s lifeiv. Buyers may borrow any fraction of the purchase

price at the short-term risk-free ratev. No penalty for short selling and sellers receive

immediately full cash at today’s pricevi. Call option can be exercised only on its expiration dateVii Security trading takes place in continuous time, and stock prices move randomly in continuous time

MATHEMATICAL EQUATIONS

P – Price of the Share X – Exercise Price rRF – Risk Free rate of return t – Time to expiry of options s - Volatility

HOW IN PRACTICE TO CALCULATE?

One option is to use http://www.bseindia.com/derivatives/

optioncalc.asp Free ware based on Excel etc.,

available Build your own model in Excel

Disadvantages of Real Option Valuation Models:

When real options are valued, many of the inputs for the option pricing model are difficult to obtain.

For instance, R&D projects do not trade and thus getting a current value for a project or its variance may be a daunting task.

Conclusions:

a. The option pricing models derive their value from an underlying asset. Thus, to do option pricing, we first need to value the assets. It is therefore an approach that is an addendum to another valuation approach.

b. Traditional valuation procedures cannot properly capture the company’s flexibility to adapt and revise later decisions in response to unexpected competitive/technological/market developments.

c. The real option technique can value the company’s flexibility to alter its initial operating strategy in order to capitalize on favorable future growth opportunities or to react so as to mitigate losses.

d. Valuations computed using the real option technique are often closer to market valuations for high growth stocks in high-risk industries.