4. Option
Option is a contract which gives the buyer (the owner or holder of the option)
the right, but not the obligation, to buy or sell an underlying asset or instrument
at a specified strike price prior to or on a specified date, depending on the form of
the option.
A substantial part of the market value of most companies can be attributed to
their options to invest and grow in the future
5. Call option
A company with an opportunity to invest is holding something like a finanacial
call option- gives the holder the right, but not the obligation, to buy an asset in
future.
When a company makes an irreversible investment expenditure, it “exercises,”
in effect, its call option.
Lost Option
The lost value of an option is an opportunity cost that must be included as part of
the cost of the investment.
6. Simple rule of NPV to remove uncertainty
Calculate the net Present value of an investment project and determine whether
it is positive or negative.
If NPV is greater than zero, the rule tells the manager to proceed with the
project otherwise ignore it.
7. Net Present Value (NPV)
Net present value is the difference between the sum of discounted cash flow and
the initial investment of a project.
NPV is a financial tool to make future investment decisions
8. What is wrong with NPV rule?
It is built on false assumption:
The investment is reversible i.e the cost can be somehow recovered in future
If the investment is irreversible, it is a “now or never” proposition
Ability to delay the investment also undermines the ability of NPV rule
it ignores the value of creating options.
The NPV rule compares investing today with never investing.
9. What Modification is needed in NPV?
The present value of the expected stream of cash from a project must exceed the
cost of the project by an amount equal to the value of keeping the investment
option alive.
10. What make an investment inreverisble?
When they are specific to a company or to an industry. For example marketing
or advertising (Sunk Cost)
Depereciation Cost
Irreversibility can also arise because of government regulations, institutional
arrangements, or differences in corporate culture.
investments in new workers ( costs of hiring, training, and firing)
11. Effect of uncertainty on opportunity value
The greater the uncertainty over the potential profitability of the investment, the
greater the value of the opportunity and the greater the incentive to wait and to
keep the opportunity alive rather than exercise it by investing at once.
12. How oportunities are created?
Investment opportunities flow from a company’s
Managerial resources
Technological knowledge
Reputation
Market position
Possible scale
14. Economies of scale VS flexibility
ECONOMIES OF SCALE
Economies of scale can be an important
source of cost savings for companies.
Building large operating units
infrequently
FLEXIBILITY
Flexibity can be proved costly
Building capacity by adding small
units to deter uncertainty
15. What managers should do?
Options create flexibility, and, in an uncertain world, managers should have the
ability to value and use flexibility .
Managers should make decisions that increase flexibility
16. Bottom Line
Learning how to execute the net present value rule is not sufficient. To make
intelligent investment choices, managers need to consider the value of keeping
their options open.
