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Real Options

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Real Options in Corporate Finance
Ellen Bjarnadóttir

Thesis of 30 ECTS credits Master of Science in Financial Engineering June 2013

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Real Options in Corporate Finance (Notkun Raunvilnana við töku Fjárfestingaákvarðana)

Ellen Bjarnadóttir

Thesis of 30 ECTS credits submitted to the School of Science and Engineering at Reykjavík University in partial fulfillment of the requirements for the degree of Master of Science in Financial Engineering

June 2013 Supervisor: Dr.Sverrir Ólafsson. Professor in Financial Mathematichs, Reykjavík University, Iceland Examiner: Dr. Rögnvaldur Sæmundsson Associate Professor, Reyjavík University, Iceland.

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Abstract
The way companies value their investment opportunities has changed in recent years. With changing market conditions companies are constantly confronted with investment decisions that are increasingly uncertain. Known investment analysis such as net present value and decision tree analysis increasingly undervalue investment opportunities as they lack the flexibility and ability to modify projects when new information is available. A method based on financial option valuation has become the basis for a new technique to value high risk investment opportunities. It is based on valuation in the risk-neutral world and therefore eliminates investors’ attitude to risk. Real option analysis can capture the value of this increased flexibility, which previous methods have not been able to, such as the option to defer, abandon, expand or default a project. These options can be exercised when new information arrives and therefore provide an opportunity to put a floor on project loss. Use of binomial option pricing model gives managers a whole range of possibilities in analyzing the flexibility and to value the uncertainty in their investments. In this thesis the disadvantages of net present value and decision…...

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