Question

(a) Write a short essay in which you compare the relative advantages and shortcomings of Discounted Cashflow (DCF) and REAL options analysis. Does the latter always replace the former? ) You are given the Black-Scholes Option Pricing formula as: ????? ?? ???? ?????? = [?(?1 )??] − [?(?2 )???(??)] (1) Where: ?1 = 1 ?√?−? {?? ( ? ??(??) )} + ?√(?−?) 2 (2) ?2 = ?1 − ?√(? − ?) (3) N(di) = cumulative normal probability density function of i i=1,2 EX = exercise price of option; PV(EX) = present value of EX = PV(EX) = ?? 1+?? rf = the risk-free rate T = the exercise date (T-t) = time to maturity P = current share price σ = standard deviation per period rate of return on shares

Answer 1

The discounted cash flow model is a method of valuation in whichres future cash flows of the company are discounted to gain whether the investment is overvalued, undervalued or equal and helps make investors take a decision whether to invest or not. Calculation of the NPV or Net Present value is the extention of the discounted cash flow analysis in valuation for projects and company's future prospects. The DCF method has one major issue in its working, the managers take lot of assumptions in calculating future cash flows, a slight mis-calculation can make future cash flows very lucatrative for investing but in reality may not give proper returns whereas making future cash flows very low making it costly for investors but in reality turned out to be missed opportunities.

A Real option analysis focuses on the physical investments of a company, be it plant, machinery or land. The business managers use NPV method to valuate the physical investments of any project. The only drawback of Real option valuation is that the market is very uncertain and managers have to take into account the level of uncertainity.

Both these methods use NPV to calculate and evaluate a project the main difference is that the discounted cash flow method is used for evaluating stocks and companies whereas the real options method is used for evaluating physical projects and assets. The other difference between the 2 methods is that in discounted cash flow method the scope of error in calculation and assumptions can change the valuation whereas in real option method it is the risk of market uncertainity.