Real option valuation in high-tech firm

According to the traditional financial theory, the discounted cash flow model (or NPV) functions as the fundamental framework for the majority of analyses. In performing valuation analysis, the traditional view is that the net present value (NPV) of a project is the measure of the value which is the current value of expected cash flows included with the initial cost. Therefore, investing in a positive (negative) net present value project will increase (decrease) value. Lately, this framework has come under some fire for failing to take into account the options which are the managerial flexibilities, which are the collection of opportunities. A real-option model (Option-based strategic NPV model) is estimated and solved to yield the value of the project plus the option value which is linked with managerial flexibilities. The majority of past empirical studies have considered the initial-investment decision (based on NPV model) but have ignored the possibility of flexible operation thereafter. Now the NPV must be weighed against the strategic option value, by which investment is optimal while the NPV is negative. This leads investors to losing the chances to expand themselves. In the report we customize the NPV by taking into consideration real options theme of this paper, or strategic interactions. R&D, Equity and Joint Ventures will be considered real options in practice of case studies of this report.


Part I: Static Tools for Valuation
1 Introduction
1.1 Background
1.2 Problems Identification
1.3 Objectives
1.4 Limitations
1.5 Methodology
2 Traditional Valuation Method
2.1 Major Approaches to Determine the Discount Rate
2.1.1 Capital Asset Pricing Model (CAPM)
2.1.2 Weighted Average Cost of Capital (WACC) Approach
2.2 DCF-NPV Approach to Project Valuation
2.3 DCF-NPV Approach to Firm Valuation
2.4 Failure of DCF-NPV Method
Part II: Expanding of Financial Option to Real Option
3 Financial-Options and Option-Pricing Theory
3.1 Basic Concepts of Options
3.2 Pricing for Options
3.3 Option Pricing Models
3.3.1 The Binomial Model
3.3.2 Extending the Binomial Model to Continuous Time—Black-Scholes Option Pricing Model
3.3.3 Comparison between Binomial Model and Black and Scholes Model
4 Real Options
4.1 Survey of Real Option
4.1.1 The Option to Defer a Project
4.1.2 The Option to Expand a Project
4.1.3 The Option to Abandon a Project
4.1.4 Managerial Flexibility, Asymmetry, and Strategic (Expanded) NPV
4.2 Inputs for Real Options
4.3 Valuing a Firm as a Real Option
4.3.1 Stocks and Bonds
4.3.2 M&M vs. Option Approach
4.3.3 About the Assumptions of Option Approach on Equity Valuation
4.3.4 Other Corporate Financial Claims
4.4 Compound Options Correspond to Interrelated Projects
4.5 Advantage and Disadvantage of Real Option Approach
4.5.1 Advantage of Real Option Approach
4.5.2 Disadvantages of Real Option Approach
Part III: Implementation of Real Options
5 Case Studies
5.1 Projects as Real Options
5.1.1 Valuation for R&D
5.1.2 Valuation for Equity (Capital Structure)
5.2 Joint Ventures as Real Options
5.2.1 Microsoft and Ericsson Alliance on Wireless Access
6 Conclusions

Source: Goteborg University

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