MAKING REAL OPTIONS REALLY WORK(A CASE ANALYSIS OF WHETHER REAL OPTIONS ARE A COMPLEMENT OR A SUBSTITUTE OF DCF’S METHOD OF VALUATION)

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INTRODUCTION

This Paper talks about two different valuation techniques and how these two techniques will compliment each other:

Discounted Cash Flow Method Options Valuations

The basic ideology of this paper is that, at times a lot of projects are left just because they do not generate positive NPV, but these projects because of uncertainty might have positive returns in the long run.

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DISCUSSIONS OF THIS PAPERThe basic discussion of this paper is that :-

Will integrating Options valuation with DCF’s will work?

Does DCF takes into account ample uncertainty to go ahead with the project?

How to adjust the factor for options valuations?

How much value or positive value of NPV is enough for a financial manager to go ahead with the project?

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BEFORE WE MOVE AHEAD

Lets quickly look at how does an options valuation work: If a project is highly uncertain the financial managers will use a huge discounting factor to discount the cash flows which will give low or negative NPV.

At the same time if the uncertainty is high the options valuation will give high value to the project.

So, it is the uncertainty factor which is important.

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AN EXAMPLE

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METHODOLOGYFinancial Managers at times abandon many projects with medium or very less NPV.

So to get over this it is suggested that the project be evaluated simultaneously by Options valuation.

This will help them get a TVP = Value of NPV + Options Value

This will help in incorporating the value of uncertainty related with the projects which will increase the total value.

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THE COMPONENTS OF TOTAL PROJECT VALUE

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PROBLEMS WITH OPTIONS It is difficult to get the proxies for inputs as these are very difficult to estimate for innovative projects which have never happened before.o For eg: the value of the underlying asset

Option valuation does not incorporate the uncertainty related with cost.

Contd..

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To incorporate the cost volatility in the Options valuation an “Adjusted Options Valuation” has to be worked to incorporate the cost uncertainty

For this if the cost volatility is more than revenue volatility then

Adjusted Volatility = Project volatility *(revenue volatility/ Cost Volatility)

For example overall Volatility estimate= 45%

Revenue Estimate= 40%

Cost estimate= 60%

Therefore the Adjusted value by which the options value will be discounted will be 45%*40/60= 30%

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