Behavioural Finance and Real Option - Assignment Example

 BEHAVIORAL FINANCE Real option A real option is a choice or alternative that is available when there is investment opportunity in a business. They can include expansion opportunities and stop projects in case some conditions arise. The term real is used because they are always associated with tangible assets like capital equipment instead of financial instruments. Considering real options has great effect on potential investment valuation. However, there are situations where methods of valuation like NPV exclude benefits provided by real options. Moreover, real options are not derivative instruments but actual options that an enterprise may profit by doing certain activities. For instance, investing in a specific project, downsizing, and expansion or disposing of other projects. Others may include licensing, R&D and M&A. Difference between real options and financial option Real options differ from financial options in that financial options cover short maturities that usually expire in many months. On the other hand, real options contain longer maturity that expires in many years with some specific options having expiring dates that are not finite. The assets contained in financial options are the stock prices compared to business variables that are in real options. Such variables include market demand, cash flow and commodity prices. Hence, in the application of real options to analyze physical assets, there should be carefulness in choosing an underlying variable. The reason behind this is that volatility measures employed in the model relate to underlying variable. In financial option, as a result of inside trade regulations, these holders’ option cannot influence stock price to their benefit. However, real options’ decisions increase the real options of the project value as there are strategic options that can be made by management. Real options have more value compared to financial options. Financial options for many years have been traded but real options just emerged recently more so in the market. The two options can be arrived at using same approaches inclusive of finite differences, differential equations, simulations and binomial lattices. The` reason is that binomial lattices can be easily explained and taken in by managers of a firm as the method is easily understood. Lastly, financial options base their facts on securities traded in markets and asset pries enabling them to be objective. At Real options in contrast, are based on assets that are not traded in the market and seldom, there are proxies that are financially traded. Therefore, management assumptions are vital in real options valuing and not important in financial option valuing. Given a specific project, the management is in a position to strategize which will help them in future. The options’ value can change dependent on their construction. In many cases, the two options are the same. Real options in project management For the past ten years, academics and consultants have been vending real options as a way of refining making of decisions which is used in a project. Presently, nevertheless, the real option valuation use has not been that widely employed as a tool of planning. Most of project managers do worry about the equation of Black Scholes that is always used in evaluation of real options as it requires additional expense on training of experts of finance and expensive software in the project. If used in strategic planning, analysis of decision can aid managers address problems like ways of resource allocation to make sure that the deadlines of projects are met, when to delay or scale up investment and the time to leave a project. More of stock option that provides the holders with purchasing stock right at set prices or future date, real option provides managers with a variety of choices on capital investments which come by with evolving of business conditions. Making an assumption of optimizing decision made through enabling taking of various contingencies into consideration, responses are planned as the come and man the investment efficiently. If compared to NPV, ROV is more advantageous. A modest decision like if to develop a technology or make an acquisition from external parties shows the use of decision tree structure. In development of house needs 3 years hence give three results. In two results, the company anticipates an outstanding value. Although, there is an extent to which the in house project might fail, definitely that this result would have no effect. Therefore, one should apply the decision tree in the making of decisions. The likelihood of the three results is purely on mixed judgment and experience of managers. After calculation of every alternative value, the manager will be in a position to choose the alternative with the highest value. For the alternative of acquisition, subtract 10 million for acquisition cost from 20 million which is payoff yields. For the three results in this development alternative, the cost must be subtracted from the payoff and after which multiply the outcome by the likelihood of success. Hence, for the best of the alternatives, the value expected would be: a value expected calculation- average weight of the results, with the likelihood used as weights-applied in the blending value of the three results in one number. Capital cost of 10% is employed as a discount rate. Performance of this calculation shows the in house value as 7.14 million. The framework of decision tree is important in the organization of multistage projects which are uncertain and redesigning of project for higher value. Redesigning of projects make managers learn a lot on market in the first stages, hence creation of an opportunity in modification of market plan and make market success chances increase. In the revised plan there is an increase in project value because investment follow on is defined after resolution of some uncertainties. The advantage of the real options is that it assumes risks and uncertainties through combining expenditures to opportunity maturation. Breaking up of a single market investment research into two minor investment bets makes the manager of the project to apply options to expand project resource allocation as there is availability of new information. Concept of pilot stage The seven stages in a project as part of project series and running programs have the pilot stage as one of the major stages. It is the second stage of the 7 key stages of project management to deliver a successful and a robust project. This stage exists to trial or test a projected implementation solution or process in order to critic the benefit and impact and workability of going on with a whole implementation. The stage proceeds from the stage of definition and heads stage design. The pilot stage makes one to make a whole implementation that is based on the pilot’s finding, route the pilot according to plans and projects that have been approved and analyze and measure pilot outcomes. The pilot stage can save costly mistakes and results are not expected during a complete implementation by thoroughly testing out plans and ideas in a measured, controlled and contained environment. The pilot stage is where the whole process is inspected and all that is entailed is spotted. Commercial stage At this point, the team of the project has the responsibility for demonstration of commercial project feasibility. The project team is supposed to know whether there is a market for new processes or project and the newly provided information satisfy the knowledge gap. All of economic, energy, legal issues and barriers and regulatory should be determine before inflowing the stage review. While ITP stage continues being involved via this stage of completion, the decision to move ahead to commercial launch depends on industrial partners. In some instances, the industrial partner fails the federal participation involvement to protect property of the intellectuals. Under the same condition, the federal gatekeepers will know if obligation to the project leads to a completion or if more activities to spread important information should be followed. Prospective spread activities may be inclusive of support for flow of information about new technology although would not have any activities that are associated to commercial launch. Real option evaluation In project valuation and strategic planning flexibility is one of the major concepts introduced by real option. In 1986 Siegle and MacDonald studied in an irreversible project the ideal investment time taking into consideration that the organization has the probability of lagging the project. Nevertheless, Pindyck (1991) also stressed the values and significance of flexibility in strategic planning. Dixit (1992) showed the flexibility that is contained in a project has a value that is positive. The case is backed up by Dixit’s observation that organizations invest in those projects that have return rates on capital cost equivalent to four or three times. This means that organizations invest only when there is rise in prices above average cost in the long run. It shows that flexibility that is contained in market leaving or entering option may substantially increase the return rate given by an endowment. Moreover, Eberly and Abel (1996) employed the options use to increase flexibility by analyzing the real option use to perfect investment problems in reversibility existence. These individuals presented irreversible and costless-reversible investment (but an organization may resell assets got at the time of investment, resale prices fall below compensation costs). Following Caballero and Bertola (1994), they illustrated that in costly reversibility presence and under uncertainty, there is an inaction range under which the firm would not invest hence leading to an interesting vision that taking into account flexibility may actually lead to no action in various circumstances. The major conclusion from this analysis is the firm’s value is increased by increase in its flexibility. For this case, the firm’s value which, according to Trigeorgis (1998) is strategic NPV is equivalent to the static NPV’s sum (without considering the options existence) and the options value. Moreover, in the approach of real option, flexibility is considered to be the ability to change, delay to exit a commitment as a result of receiving changing new information the way the organization views the problem. It is during the process of planning that there would be a re-commitment. The organization commits itself step by step, sequentially as future unfolds, taking assumption that it takes the option that is possibly best. In overall, there are many examples of real options that are objected at increasing the value and flexibility related to various strategic types decisions found within an organization and should be taken into account in the process of creating strategy. According to Trigeorgis (1998), there are these options: a) Switching option. If the demand or prices change, there may be an option by the management to change output or input mix. For instance, an electricity production company owning many generation technologies ( for instance, pumped storage and combined gas turbines) may employ one plant or an optional one at various times depending on what time in the day. During the night, when prices tend to be low, the gas turbine is shut down and electricity is employed to pump water to storage reservoir. At day time, when the demand hours are average it runs turbines of the natural gas and seize to run the pumped storage section. At the time when the prices peak, or at the time prices escalates at fast rates, it runs the storage turbine and the gas turbine. This example illustrates how there are many options that are interacted in a simple portfolio management of electricity generation sections such as restart and shutdown, and that the several options may lead to fuel mix input change employed in the generation of electricity. b) Options of growth. An early endowment may be viewed as the beginning of serial interrelated projects that give access to growth opportunities in the future. As it will be shown, a company may create an early decision to the entrance into a market as a manner in which doors open to opportunities and other investments. In order to resolve real problems, the communities of real options have employed the adapting of basic framework to resolve real issues. For instance: Salinas, Schwartz and Cortazar (1998) presented real options applications to environmental investment valuation. Bollen (1999) brought to table an option framework that externally integrated a life cycle product. Loch and Huchzermeier (2001) employed the theory of real options to analyze development of projects in oil and gas industry. Behavioral Finance Behavioral finance refers to a structure that supplements other sections of standard while replacing other parts. It gives a description of mangers’ and investors’ behaviors in capital and financial markets. It recommends more efficient behavior for managers and investors. According to Wiley in his book standard finance, which is also referred to as portfolio modern theory that has four blocks of foundation: investors are naturally rational, there is efficiency in markets, investors are supposed to make their portfolios in accordance to mean variance rules in portfolio theory and expected returns forms a risk alone and risk function? Modern portfolio theory has ceased to be modern. According to the theory the expected returns differences are defined exclusively by risk differences and the risk measure is beta. Behavioral finance gives an alternate block for every standard finance foundation block. According to this finance, investors tend to be irrational and normal. The markets are not effective and efficient as much as they are hard to beat. Investors make portfolios in accordance to behavioral portfolio rules not the theory of mean-variance portfolio. The expected returns conforms to the theory of behavioral pricing of asset in which expected returns are defined by past risk and beta does not measure risk. Cognitive biases in behavioral finance In contrary to rationality assumption of preferences, people seem to get and process information by the use of a restricted number of heuristic or intuitive rules. The rules, even though reduce the problems’ complexity, can lead to significant and systematic errors (Tversky 1974) According to the experiments that have been carried out, gathering of information is always done on using available heuristics and processing of information is done according to anchoring and representation of heuristics. The availability of heuristics refers to influencing of individuals by the easiness which information can be captured in the mind. Hence, the frequency representation of an event exposes itself to misinterpretation as a result of familiarity. There are various biases in behavioral finance and are mainly grouped into heuristic and cognitive biases. First and foremost, individuals assess likeness, probability or frequency of an event occurrence that are personally, recent or vivid in experience thus being available in memory. For instance, people purchase stock which possess high coverage media or that experience high volumes of trade or substantial price fluctuations (Gadarowski 2002; Odean 2008). Most surveys have it that market expectation trends are influenced by recent trends. Secondly, is the case where an event’s retrieval becomes difficult, there have to be construction of scenarios, with the incurring possibility in procedural errors? For example, the likeliness of achievement subjectively assigned to plan of an industry depends on the easiness with which weak and strong points are represented. The ones that can be visualized with greater immediacy and intensity can define errors in estimation. Another bias is when people may judge 2 events that are independent as correlated if the assessment in probability has been based on memories that are available. For instance, taking a consideration of a company’s default probability showing certain signs that an analyst tries to remember bankrupt company cases with similar symptoms, ignoring firms that have the same but never went bankrupt. Bias entails viewing an event and evaluate as to the closeness it corresponds to the other events as in the entire population. Its implication is the tendency of ignoring objective frequencies. For example, if a an individual’s personality description that is detailed matches ones experience with individuals of a specific profession, individuals tend to substantially overestimate the real probability that some given people belong to the given profession. Moreover, another bias of behavioral finance is the trend to ignore the size of a sample. The statistical law properties of huge numbers are not rightly assigned to minor samples. For example, in gambling people maintain that an event that is casual is likely to happen if it does not occur at a specific time. To add to that there is a tendency of regression ignorance to mean and uphold that extreme repercussions should reflect extreme assumptions. For instance, the trend on stock expectation to be pessimistic or optimistic for stocks which underperformed or over performed the index of the market for a specific period. Another bias is the conjunction fallacy. Deducing a conjuction probability of two occurrences on availability heuristic or representativeness basis may lead to probability overestimate of conjunction itself referring to likelihood of its constituents. For example, an experiment that is famous takes into consideration two bets compensating a similar stake. Optimism and overconfidence is another bias. For instance, an assumption to beat a market. Moreover, there is conservatism. For example, financial analysts do not react well to the new info (Shefrin 2000). There is also confidence as a bias. For instance, an assumption to beat market. Lastly, is the conjunction fallacy as a bias. Representative heuristic labels the peoples’ propensity to approximate probabilities on familiar and stereotypes basis situation. It may lead to neglecting relevant prior probabilities or base rates and to cognitive biases size of sample. Finally, anchoring shows the habit of forecasting beginning with from an initial statement or an information piece that is considered noticeable and hence performs as an anchor in succeeding adjustments. It produces under reaction to events and new information. It can lead to conjunction fallacy, which is the likelihood of two events happening at the same time that is estimated to be greater than the likelihood of either one happening alone. Anchoring affects the description of probability subjectivity distribution on a quantity which is judge of confidence interval. The heuristic can also produce optimism and over confidence. Over confidence may occur in various ways. It may define phenomenon variability over estimation. It can also substitute the belief to make it better. It may cause illusion which is the habit of disregarding the vitality of the situation if the person skill role is believed to prevail. Associated to over confidence is the optimism. Read More