An Analysis Of This Project In A Real Options Context Differ From A More Traditional Npv

2. How does an analysis of this project in a real options context differ from a more traditional NPV valuation? How would you model this using a more traditional discounted cash flow framework? What elements would it fail to capture? Could you capture the real options aspect of the project using this approach? How?

The traditional NPV valuation method looks at the potential future free cash flows of the asset and quantifies and discounts the free cash flows to a present value. The cost of implementing, acquiring or developing the asset is then deducted from the present value of the free cash flows to generate Net Present Value. The free cash flows are discounted at firm specified hurdle rate or weighted average cost of capital or risk adjusted

In case of DCF method, the bidder has to decide, at the time of making the bid, to whether develop the property or not based on the discounted future cash flow expectations. The main difference between real options and DCF is the discounting of risk. The real options method adjusts risk for the uncertainty present in cash flows while the DCF method adjusts at overall level of net cash flows of the project. In case of real option, the bidder decides about the development of the property on the basis of development cost and future cash inflows after the development of the property at end of year 2. However, in the case of DCF, the bidder must decide on the basis of development costs and future cash inflows at the time of making the bid. At the end of year 2 of exploration phase, if the return is expected to meet the property owner’s requirements, the owner will exercise the real option and will develop the property. However, if the expected return fails to meet requirements of the owner, the owner will simply return the property to the government. On the other hand, in case of DCF, at the end of exploration phase in year 2, whether the expected return meets the owner’s requirements or not, the owner is obliged to develop the property as committed at the

DCF undervalues everything because of its simplifying assumptions. DCF ignores the options to extend, contract, expand or defer investment decisions, since all expected cash flows are pre-committed. The method excludes the management flexibility that is present in real options. The method also ignores the strategic value of projects i.e. the benefit of expanding to new markets or development of new technology etc. DCF does not consider the changing risk profile over time. DCF treats investors are passive, one time commitment and hence misses on the options embedded in investment