Financial Options Theory Analysis

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Introduction The real options theory is grounded on the theory of financial options. Those financial options are written on an exchange-traded underlying. The major breakthrough in the financial options theory was accomplished by Fisher Black and Myron C. Scholes. The Black-Scholes model is a mathematical model for the evaluation of financial options, which was published in 1973 and is considered a milestone in the financial industry. After four years, Myers was the first who introduced the concept of “real options” and pointed out the similarities between the financial options and real options. He defined in 1977 the real options as the opportunities to purchase real assets on possibly favorable terms and showed the possibility of valuing…show more content…
Managers take sometimes projects which are relatively low or even negative valued, for strategic reasons, instead of higher valued NPV projects. This results in a gap among financial and strategic analysis. Strategic objectives often involve investments that seem to result in a negative NPV, if only measured by the cash flows, although they can create a strategic advantage to invest in valuable follow-up opportunities. Correctly applied, the financial option theory can link the gap among strategic and financial analyses by valuing the strategic options of a company. A more accurate definition of real options is made by Sick in 1995, who describes real options as the flexibility a manager has for making decisions about real assets. The DCF analysis systematically undervalues every investment opportunity, because it is failing to account for value these flexibility. An example from Copeland and Antikarov (2001) describes how real options are applied by Airbus Industry, a consortium of aerospace manufacturers and shows how to price out the value of flexibility. The objective was justify the airlines why they should purchase the aircraft from Airbus and not from the competitor. This type of…show more content…
This rate is related to the aimed leverage ratio of a company. This means, when the debt ratio increases, so does the risk to the creditors. Consequently, the creditors will require a higher return on the debt to compensate for the additional risk. Usually, the cost of debt may be rationally estimated. (Koller, Goedhart, & Wessels, 2010) give the following three different methods to figure out the cost of debt: The cost of debt for investment-grade companies with a minimum credit rating of BBB can be estimated by using the yield to maturity of option-free, long-term bonds of that company. For companies that has not issued any long-term bonds or only highly illiquid bonds, we can determine the yield to maturity by using an indirect method. First, we ascertain the credit rating of the company’s on unsecured long-term debt. Subsequently, we examine the average yield to maturity on a portfolio of long-term bonds with an equal credit rating. If the company has a poor credit rating (less than BBB), the distinction between expected and promised returns of bond becomes more important, since using the yield to maturity as a proxy for the cost of debt may cause significant error. In this case the cost of debt can be estimated with CAPM, which is in fact a universal pricing model that can be applied to any
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