Question

Briefly explain what real options are.

- Describe the benefits and costs of delaying investment opportunity.

- Give an example of in-the-money real option.

- Will it be optimal to exercise such option immediately? Why or why not?

Answer 1

Benefits : By delaying uncertainty can be resolved to make  better and informed decisions.

Costs :By delaying ,you delay the benefits of taking on the project and your competitor might take advantage of this delay.

The firm may gives up the benefits that may generate in the interim.

Example for In the money real option :

If we invest on a specific project that cost $ 10 million to day and it generates future cash flows for 2 years are $ 6 million and

$7 million respectively.Cost of capital is 5%.

Now calculate NPV of the project.

Year	Cash flows	Discount Factor @5%	Discount cash flows
0	10	1	(10)
1	6	0.9524	5.7144
2	7	0.9070	6.349
NPV of the project			2.0634

So NPV of the project is positive we have to accept the project now, it is called in the money real option .

It is optimal to exercise the real option immediately so that we can get the positive NPV and benefits of the projects otherwise we lose the opportunity to get the interim cash flows.