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The Promise and Peril of Real Options

In: Business and Management

Submitted By aegis1234
Words 5005
Pages 21
Aswath Damodaran
Stern School of Business
44 West Fourth Street
New York, NY 10012

In recent years, practitioners and academics have made the argument that traditional discounted cash flow models do a poor job of capturing the value of the options embedded in many corporate actions. They have noted that these options need to be not only considered explicitly and valued, but also that the value of these options can be substantial.
In fact, many investments and acquisitions that would not be justifiable otherwise will be value enhancing, if the options embedded in them are considered. In this paper, we examine the merits of this argument. While it is certainly true that there are options embedded in many actions, we consider the conditions that have to be met for these options to have value. We also develop a series of applied examples, where we attempt to value these options and consider the effect on investment, financing and valuation decisions.3
In finance, the discounted cash flow model operates as the basic framework for most analysis. In investment analysis, for instance, the conventional view is that the net present value of a project is the measure of the value that it will add to the firm taking it.
Thus, investing in a positive (negative) net present value project will increase (decrease) value. In capital structure decisions, a financing mix that minimizes the cost of capital, without impairing operating cash flows, increases firm value and is therefore viewed as the optimal mix. In valuation, the value of a firm is the present value of the expected cash flows from the assets of the firm.
In recent years, this framework has come under some fire for failing to consider the options that are embedded in each of these actions. For instance, the net present value of a project does not capture the values of the options to...

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