Introduction to Finance
Introduction to Finance UGBA 103
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This 22 page Class Notes was uploaded by Melba Champlin on Thursday October 22, 2015. The Class Notes belongs to UGBA 103 at University of California - Berkeley taught by T. Odean in Fall. Since its upload, it has received 81 views. For similar materials see /class/226753/ugba-103-university-of-california-berkeley in Business Administration at University of California - Berkeley.
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Date Created: 10/22/15
Chapter 22 Real Options Real Versus Financial Options Real Option 39 The right to make a particular business decision such as a capital investment 39 A key distinction between real options and nancial options is that real options and the underlying assets on which they are based are often not traded in competitive markets Decision Tree Analysis Decision Tree 39 A graphical representation of future decisions and uncertainty resolution Decision Tree Analysis cont39d Assume Megan is nancing part of her MBA education by running a small business She purchases goods on eBay and resells them at swap meets o Swap meets typically charge her 500 in advance to set up her small booth Ignoring the cost of the booth if she goes to every meet her average pro t on the goods that she sells is 1100 per meet Decision Tree Analysis cont39d The decision tree showing Megan s options looks like the one on the following slide 39 Because the NPV of setting up a booth is 600 the optimal decision shown in blue would be to set up the booth 1100 500 600 Megan s Choices Profit 1100 500 2 600 Mapping Uncertainties on a Decision Tree Megan is aware that attendance at swap meets is weather dependent 39 In good weather her pro ts are 1500 39 In bad weather she will incur a loss of 100 There is a 25 chance of bad weather This adds another element of uncertainty for Megan to consider Effect of the Weather on Megan s Options Mapping Uncertainties on a Decision Tree cont39d Decision Nodes 39 A node on a decision tree at which a decision is made 39 Corresponds to a real option Information Nodes 39 A type of node on a decision tree indicating uncertainty that is out of the control of the decision maker Mapping Uncertainties on a Decision Tree cont39d The square node represents the decision to pay the fee and go to the swap meet or do nothing The round node represents the uncertain state of nature sunshine versus rain 39 In this case Megan must commit to going to the meet before she knows what the weather will be Mapping Uncertainties on a Decision Tree cont39d What if must pre pay for the booth but Megan does not have to commit to going to the swap meet before she knows the weather conditions 39 Megan understands that the 500 loss for the booth is unavoidable but in bad weather she can simply stay home and not incur the additional 100 loss at the meet Megan s Decision Tree When She Can Observe the Weather Before She Makes the Decision to Go to the Meet Real Options Megan s option to wait until she nds out What the weather is like before she decides Whether she should go to the meet is a real option 39 This exibility has value to Megan Real Options cont39d Assume Megan is risk neutral about the risk from the weather 39 The value of the real option can be computed by comparing her expected pro t Without the real option to wait until the weather is revealed to the value with the option to wait Real Options cont39d If Megan commits to go regardless of the weather her expected pro t is 1100 39 075 X 1500 025 X 100 I 1100 However if she goes only when the weather is good her expected pro t is 1125 39 075 X 1500 025 X 0 3 1125 The value of the real option is the difference 25 Real Options cont39d If Megan has to pay for the booth only the day before the meet and before she knows What the weather will be the NPV of paying for the booth ignoring discounting for one day is 625 39 1125 500 625 Since the NPV is positive Megan should always pay for the booth Real Options cont39d Corporations face similar options 39 The option to delay an investment opportunity 39 The option to grow 39 The option to abandon an investment opportunity The Option to Delay an Investment Opportunity In Megan s case once the booth is paid for there is no cost to waiting to nd out about the weather In the real world there is often a cost to delaying an investment decision The Option to Delay an Investment Opportunity cont39d By choosing to wait for more information the rm gives up any pro ts the project might generate in the interim In addition a competitor could use the delay to develop a competing product 39 The decision to wait therefore involves a tradeoff between these costs and the bene t of remaining exible Heliskiing It is the beginning of September and you have been offered the following deal to go heli skiing If you pick the first week in January and pay for your vacation now you can get a week of heli skiing for 2000 However if you cannot ski because of bad weather no snow or your are sick you do not get a refund There is a 30 probability that you will not be able to ski If you wait until the last minute and go only if you know that conditions are perfect the vacation will cost you 5000 You estimate that the pleasure you get from heli skiing is worth 7000 per week to you ie if you had to pay more than that you would choose not to go If your cost of capital is 12 per year should you book ahead or wait Time Time NPV at Time 0 Can 357000 070 7 000 030 0 4 2000 2 271835 112E 0 7000 5000 O7Ogt lt 7000 5000 O30O 134810 i 11212 30
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