Real Options in Capital Budgeting

  • 7-weeks
  • 1.5 credits
  • Prerequisite: F520

F508 is an applied course in capital budgeting under uncertainty and flexibility. Traditional NPV analysis assumes that corporate investments are "now or never" and that they are irreversible. However, most corporate projects have a great deal of flexibility in their timing, scale, etc. Our goal in F508 is to develop more advanced capital budgeting skills so that the student may attack real-world corporate investment decisions in a sophisticated way.

  • Identification of optionality in corporate investments. Before we can apply option pricing theory to corporate decisions, we must be able to correctly characterize the optionality inherent in the projects we are considering.
  • Choosing the proper model for the analysis. The decision-makers goal is to get the best possible approximation of the value of an opportunity given the constraints of time, cost and information. Structured and carefully-defined problems allow for more precision (and thus require more rigor).
  • Handling risk in the proper way. As I will demonstrate, the use of a risk-adjusted discount rate is not appropriate when valuing assets with "optionality." We must employ Martingale (or risk neutral) pricing techniques.
  • Understanding and handling the convenience yield issue. This is perhaps the most difficult concept to grasp, but it is vitally important to a sophisticated analysis. We must adjust our problem for the "convenience yield" or "rate of return shortfall" of an asset whenever there is an "early exercise" feature (i.e. when the option is American).
  • Clear presentation of analysis and results. The ability to construct a sophisticated capital-budgeting model is irrelevant if its structure and results cannot be communicated in a clear and convincing fashion. This is particularly important for real-option valuation, as most managers do not understand the issues of risk-neutralization and convenience yield. Furthermore, there are many that are skeptical of the assumptions required for a contingent claims analysis. Their critiques must be addressed.