Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

APPENDIX 22A: FURTHER ILLUSTRATIONS OF REAL OPTIONS IN INVESTMENT PROJECTS

In the section “A Framework for the Valuation of Real Options,” we focused on three types of real options: the growth option, the deferral option, and the abandonment option. In this appendix, we will look at three additional options: the option to default, the option to contract, and the option to shut down. To illustrate these options, we will use the same capital investment project as depicted in Figure 22.9, adjusting it as needed.

Option to Default

The option to terminate a project at some time during the project’s life is called the option to default. By choosing not to invest further and simply dropping the project, the company is, in a way, defaulting, except that no legal implications arise from this type of default. As we discussed in the section “A Framework for the Valuation of Real Options,” a default option accompanied by the opportunity to obtain a salvage value from the project is referred to as an abandonment option.

Recall that the initial outlay for this project illustrated in Figure 22.9 is $1,050. We will assume that the company can make an initial investment of $400 with the option to invest the remaining $650 one period later, but this $650 will be increased at the risk-free rate of interest. Thus, the company can invest $650 × 1.05 = $682.50 at Time 1. If the company does not invest the $682.50 at Time 1, the project terminates and no further value is generated.

Recall from the original ...