The Valuation of Real Option in the Corporate Finance - Assignment Example

The Valuation of Real Option in the Corporate Finance As a discipline, the analysis of real option extends from the applications its conducts in the corporate finance to making of decisions under uncertainty in general. This is by adapting the various techniques developed for the financial options in the real life decisions. For instance, R&D managers may use these options in real valuation to assist them in allocating their R&D budgets among different projects. This makes the decision makers to be more explicit on the various assumptions that underlie in their projections. This makes real options valuation one of the ways employed in the formulation of business strategies. Due to the flexibilities viewed in management, actual real options are quite to relate properly to the size of the project, the operation of the project and the timing of the project once it has been established. In all cases used, every upfront expenditure that has not been recovered yet and related to this type of flexibility refers to the option premium. Additionally, real options apply in valuation of stock. There are different types of real options. The first one is options that relate to the size of the project (Angelis, 2002). This is whereby the scope of the project is not certain, constitutes are optional and the flexibility of the size of various facilities is valuable. In real options to expand, the project is designed with capability in excess of the output levels that are expected for it to give a high rate. The management gets the option of expansion that is exercising the options in case the given conditions go out to be favorable. Projects having expansion options cost more in establishing, he excess referred to as the option premium. In real options to contract, the project is designed in a way that the given output may be contracted in the future in case the conditions become unfavorable. Option exercise consists of one forgoing these future expenses. According to Angelis (2002), this is the same as put option and the excess upfront expense is the option premium. In real options to expand, projects are developed in a way that it can operate dynamically. The second type of real option is options that relate to timing and the project life. In this type of category, growth options are the most generic because they have options of exercising the projects that are profitable when initiated. When initiating the project, the management has the flexibility on the time the project needs to start. Moreover, the management may abandon a given project in its life so that it may realize the projects salvage value. Incase the value of the cash flows that remained fall below the value of liquidation, the asset in the project may be sold. This is exercising the put option effectively. Sequencing options are the timing issued to different projects that are interrelated (Angelis, 2002). The valuation of real option is said to be considerably corresponding with the valuation of financial options. Many procedures of real option valuation that are from valuation of financial options have problems that they do not trail the similar assumptions. For instance, the values in financial options may not be negative but other real options may have asset values that are negative (Datar & Matthews, 2007). Information found in the value of financial options parameters are easily accessible to every person in the market. This is not found in real options. Financing options have short maturities while real options take time to mature. Additionally, real options are time varying and have volatility while financial options are volatility adequately stable. The underlying variables found in financial options are asset price or equities while on real options they are free cash flows compelled by demand, management and competition. There are no possibilities in controlling and manipulating the option value in financial option while there are flexibilities and managerial decisions in increasing option value in real options. There are traded and marketable comparable information in financial option whereas there are no marketable comparables that are traded in real options. Real option is mainly attained by the management while financial option is acquired actively by side bets. The assumptions made by the management have no consequences on valuation in financial options though the real option value is driven by assumptions and actions of the management. In real option, market value and competition drive value of planned option but in financial options, market value and competition have no effect on valuation (Datar & Matthews, 2007). Additionally, decisions in real option are large scale though the financing option has small values. In financial option, accuracy of the numerical is vital however in real option, framing the option case is vital. Financing options have single options and real options have a compound and rainbow options that are sequential and parallel and have interactions. Many financial options are solved by the use of simulation reduction methods and closed form PDE’s. On the other hand, real options are solved by closed form solutions by the use of underlying variables. Additionally, financial options have been in existence for over thirty years while real options have been used practically for nearly two decades (Datar & Matthews, 2007). Real options depend mostly on risk adjusted premiums and risk free interest rates but financial options depend mostly on the risk free interest rates. Financing options can be hedged while it is not necessary to hedge real options. Some of the real options may be developed in the course of the project but in financial options, all projects are known from the start. On the other hand, valuation parameters in financial options are observable and primary variable thus the parameters used in real options are secondary, estimated and derived from the cash flow simulation primary parameters. According to Datar & Matthews (2007), real options may not be diversified while financial options are diversified. In financial options, computational efficiency is vital while in real option computer efficiency is less significant. Another difference is that real option is American by nature while financial options are European. Financial options have nonstop information flow while real options have separate information flow with sporadic managerial reactions (Datar & Matthews, 2007). There are regular payoff functions in financial option thus complex and different payoff functions in real options. To add to that, underlying assets of real options may have values that are negative though financial options do not have negative values (Datar & Matthews, 2007). Investment decisions may be treated as exercising a given option. Every firm needs and has investment options. In pilot and commercial stages, if the investments are irreversible, there are opportunity costs of investing again (Pindyck, 2008). The larger the uncertainty, the larger the firm’s option value in investing. The firm’s value is considered to be the capital value plus the growth option's value. Investments can be valued as important real options such as offshore oil reserves, land value and patents that give a firm an option in investing. Additionally, investments can determine the flexibility value. For instance: value of contract provisions considered to be flexible and flexibility of suspending construction of electric power plants. According to Pindyck (2008), option theory lays emphasis on uncertainty and handles it correctly. A lot of managers ignore or underestimate the implications and extent of uncertainty. Managers are forced by this theory to address uncertainty. When evaluating a project, net present value equals to inflows present value subtracting present outflows value. A firm needs to invest when the net present value is greater than zero. On the other hand, discounted analysis of cash flow makes assumptions of fixed scenario for operations and outlays and ignores the option value. For instance, options used in delaying a given project (Pindyck, 2008). This is the paradigm in the study concerning financial markets by the use of models considered to be narrower than the models based on Von Neumann-Morgenstern estimated and arbitrage assumptions and utility theory. Precisely, behavioral finance contains two building blocks. These are the limits to arbitrage and cognitive psychology. Cognitive psychology refers to how individuals think. A huge psychology literature that documents people making systematic errors in thinking that they are overconfident and putting a lot of weight on the current experience is available (Barberis & Richard, 2003). The preferences of these people may also lead to distortions. On the other hand, behavioral science uses knowledge body instead of the arrogant approaches supposed to be ignored. By limiting arbitrage, it shows the arbitrage forces considered to be effective and the forces that will not be effective. Behavioral finance uses different models whereby particular agents are not fully rational. This is because of the mistaken beliefs or preferences given. For instance, many people are less unenthusiastic. This means that a $2 increase may make a lot of people to feel better but a $1 loss may make them feel worse. These mistaken beliefs arise due to the fact that people are considered to be bad Bayesians. The modern finance has as a building block considered being the same as the Efficient Market Hypothesis (EMH) (Barberis & Richard, 2003). This Efficient Market Hypothesis states that competition made between various investors who need abnormal profits drives the goods prices into their correct value. The Efficient Market Hypothesis does not give assumptions that every investor is rational, but it gives assumptions that all markets are rational. Efficient Market Hypothesis does not give assumptions that various markets can predict the future, but it gives assumptions that available markets make unbiased future predicts. In contrast, behavioral science has assumptions that financial markets are not efficient informationally. However, psychological biases does not at all time lead to misvaluations (Barberis & Richard, 2003). A quite number of them are because of the imbalances in demand and temporary supply. For instance, the tyranny of indexing may cause demand shifts that have relations to the company’s future cash flows. In December 1999, when yahoo was included in the S&P 500, managers from the index fund were forced to purchase the stock despite of it having inadequate public float. This additional demand increased the price by more than 50% weekly and more than 100% monthly. After eighteen months, the price of the stock reduced by more than 90% from where the stock price was after it was added to the S&P (Barberis & Richard, 2003). In cognitive biases, many psychologists have documented different patterns that describe how different individuals behave. The first pattern is Heuristics also referred to as rules of thumb. It is used in making decisions easier. Nevertheless, at other times, they can lead to biases specifically when things adjust. These patterns can cause suboptimal investments choices. When a lot of people face N choices in the methods to use while investing their retirement money, they mostly allocate it by using the 1/N rule. In case there are three different funds; a third is divided into each of them. In case two of them are stock funds, two third is taken to equities. A lot of people are using 1/N rule currently (Barberis & Richard, 2003). The second pattern is Overconfidence. A lot of individuals become over optimistic due to the abilities they have. Many entrepreneurs are overconfident and overoptimistic. Overconfidence is seen in different ways. An example is too diminutive diversification due to a tendency in investing a lot in the goods one has knowledge about. As a result, individuals invest in local firms despite of it being unscrupulous from a diversification perspective as their houses are tied to the fortunes of the firm. Many people invest more in the stock of the firm they are working. Different researchers analyzed that many men merchandised more and had more mistakes than the women investors. The third pattern is Mental Accounting. Individuals single decisions that are supposed to be joined together. For instance, many individuals have food household budgets and entertaining household budgets. When they are at home, they will not take expensive food but when they are in restaurants, they may order expensive meals (Barberis & Richard, 2003). The fourth pattern is Framing which is a notion of the way different concepts are presented to individual problems. Cognitive psychologists have stated that health practitioners create recommendations that are not the same in case they see the presented evidence as survival likelihoods than mortality rates despite adding up mortality rates and survival likelihoods to 100%. The fifth pattern is Representativeness. Individuals do not put more weight on long term averages as the recent experience. This is also known as the small numbers law. For instance, after the equity returns have increased for a long period of time, a lot of individuals start to accept as true that this increase in high equity returns is ordinary. The sixth pattern is Conservatism hereby things change and individuals become slow in adapting to the changes. If things change, individuals may not react due to their conservatism bias. In case the pattern is long enough; the individuals adjust to the pattern and may also overreact thereby reducing the long term average. The seventh pattern is Disposition effect which is a pattern avoided by a lot of people when they recognize paper losses and strive for to recognize paper gains. A major condemnation of behavioral finance is that when an individual chooses a bias to emphasize, he or she can expect either overreaction or under reaction. This criticism may be referred to as model dredging (Barberis & Richard, 2003). As stated in the Open & Reform policy recommended by Mr. Deng Xiao’ping since 1978, the economy of China has gone through sustaining reforms. These reforms planned to improve the local industrial structure, strengthen and build the connection available between the global economy and the Chinese economy. These reforms were to enhance the Chinese companies’ competitiveness and develop the economy generally. As a vital source of foreign direct investment, China’s emergence in the market is remarkable in many countries that are developing. Cross border mergers and acquisitions have become the major mode used in Chinese enterprises that are ready in pursuing extra benefits in the worldwide market (Pecht, 2006). In the report issued by the U.S. China Economic and Security Review Commission, it stated that the investments made by China in other countries are increasing even though there is a decrease in worldwide foreign direct investment. According to the transaction values accumulated as well as the foreign direct investments foreseen, the diving forces in China’s cross border mergers and acquisitions focus on issuing the long and middle energy supply and additional raw materials. These types of deals are accomplished according to the National Industrial policy whereby the government encourages enterprises in China to invest globally and also obtain strategic channels and assets (Pecht, 2006). By guaranteeing raw materials and energy, the need securing progressively access to cross borders raw materials and energy resources in supporting the increasing economic growth rate in China, goes by to be an important strategic driving force. It is indisputable that every resource seeking wave implemented by the foreign direct investment by the multinational companies in China have been guided inconspicuously by the national industrial security policy that aims at securing the oversees supply. China has maintained good public relations with nations that are in the developing world (Pecht, 2006). Additionally, Chinese firms merge with firms having quality assets and distinctive brands. The acquirers in China say that these firms are a good way in gaining a foothold in the established markets and learn more marketable skills. For instance, a financial crisis that aroused lowered the cost of many firms being acquired and the firms from China having a lot of cash took advantage of the given opportunity. Firms such as Tengzhong Heavy Industrial Machinery and Geely Holding Group Co. acquired famous brands such as Hummer from Ford and GM and Volvo. In conclusion, by these developing nations establishing R&D centers, Chinese firms come and take advantage of these nations’ innovation and research capabilities. For instance, Lenovo a Chinese computer producer has from time to time set up networks on overseas R&D centers across the developed nations. This has made Lenovo firm to be one of the fourth largest computer manufacturers in the world. Another reason why China has cross border mergers and acquisitions is to evade the trade obstruction. The Chinese government was struggling in negotiating with other nations on tariffs and quotas set on the Chinese goods before it joining world trade organization. For instance, many light industrial goods did not enter the United States market. References Pindyck, R.S. (2008). Lectures on Real Options: part 1-Basic Concepts. Cambridge: Massachusetts Institute of Technology. Datar, V. & Matthews, S. (2007). A practical method for valuing real options: the Boeing approach. Journal of Applied Corporate Finance 19:2 95–104 Angelis, D. (2002). An option model for R&D valuation. Int. J. Technology Management 24:1 44-56. Barberis, N. & Richard, T. (2003). “A survey of behavioral finance.” in G. Constantinides, M. Harris, and R. Stulz (editors) Handbook of the Economics of Finance North-Holland, Amsterdam. Pecht, M. (2006). China’s Electronics Industry: The Definitive Guide for Companies and Policy Makers with Interest in China. Norwich: William Andrew. Read More