A Cursory Introduction to Real Options. Andrew Brown 5/2/02. Background. Real Options Analysis (ROA) was developed as a method to find the value of projects and assets more accurately then earlier methods such as Discounted Cash Flows (DCF) and Decision Tree Analysis (DTA).
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V0 = F0 - 115*n
At time one the value is:
V1 = F1 – n* P1
= (170-65) – 170n OR
= (0) – 65n
The return will be risk free if V1 is always the same… (170-65) – 170n = 0 - 65n
Solving for n gives: n = 0.524
This gives the value of V1 to be: -$34.08
Return = V1 - V0 - .10*115*n
= (-34.08) – (F0 - 115*0.524) – 1.15*0.524
= 25.58 - F0
The return must be equal to 10% of the initial cost, i.e.,
25.58 - F0 = 0.1(F0 - 115*0.524)
F0 = $28.73
So, ROA gives an even greater value to the project then DCF (-$6.48) and DTA ($23.40)
Some of these limitations can be avoided by re-deriving or modifying the Black Scholes equation.
p is the risk neutral probability that the random value goes up in a period
u is the multiplier the value goes up by.
d is the multiplied the value goes down by
Rf- per period risk free rate
T/N – number of periods