The document discusses real option valuation as an alternative to traditional discounted cash flow approaches. Real option valuation treats a company's ability to adapt its strategy over time as a type of financial option. This flexibility allows the company to capitalize on opportunities or cut losses, affecting its overall enterprise value. The document outlines different types of real options like growth, abandonment, and timing options. While more accurate than discounted cash flows, real option models also have disadvantages due to difficulties in obtaining inputs for the underlying valuation models.

1. CONTINGENT CLAIM
VALUATION

2. 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.

3. 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

4. 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.

5. 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.

6. 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.

7. 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

8. 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.

9. 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

10. BLACK SCHOLES OPTION PRICING
METHODS : Assumptions
i. The stock underlying the call option provides no
dividends during the call option’s life
ii. There are no transaction costs for the
sale/purchase of either the stock or the option
iii. Risk Free Rate of Return (RRF) is known and
constant during the option’s life
iv. Buyers may borrow any fraction of the purchase
price at the short-term risk-free rate
v. No penalty for short selling and sellers receive
immediately full cash at today’s price
vi. Call option can be exercised only on its expiration
date
Vii Security trading takes place in continuous time,
and stock prices move randomly in continuous time

11. MATHEMATICAL EQUATIONS

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

13. 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

14. 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.

15. 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.