Chapter 22, Problem 1PS

Real options Respond to the following comments.

1. a. “You don’t need option pricing theories to value flexibility. Just use a decision tree. Discount the cash f lows in the tree at the company cost of capital.”
2. b. “These option pricing methods are just plain nutty. They say that real options on risky assets are worth more than options on safe assets.”
3. c. “Real-options methods eliminate the need for DCF valuation of investment projects.”

Summary Introduction

To discuss: To respond to the statement on whether to use a decision tree rather using option theories.

Explanation of Solution

The possible response to the given statement is as follows:

Discount rates cannot be used for any of the option payoffs, because the risk of the option varies as the asset value changes time to time.

Summary Introduction

To discuss: To respond to the statement on whether option pricing methods are plain nutty.

Explanation of Solution

The possible response to the given statement is as follows:

The risky asset might be worth less as an outcome of its riskiness, yet the option on the risky asset is progressively significant on the grounds that the option proprietor can underwrite from upward moves while not losing because of downward moves.

Summary Introduction

To discuss: To respond to the statement on whether real options methods eliminate the discount cash flow valuation.

Explanation of Solution

The possible response to the given statement is as follows:

The worth of an option relies upon the value of the underlying asset. The discounted cash flow valuation of investment projects is vital so as to decide the worth of the underlying asset.