Give an example in business for each of the following real options with clear ex

Question

Give an example in business for each of the following real options with clear explanations. If you manage to put some numbers in your examples and sketch how you may value such optionality the better but not required.

The option to expand if the immediate investment project succeeds.

The option to wait (and learn) before investing.

The option to shrink or abandon a project.

please refer to references to reflect each of the three options in business investments, and provide sample case for each. In addition provide a numerical example in pricing the option, similar to the example I have in the attachment

Suppose that you are offered partnership in a business that requires $200,000 initial investment with the following possible outcomes. Outcome 1: $100,000 annual cash inflow, perpetual Outcome 2: $50,000 annual loss, perpetual P(outcome 1) - 0.8 P(outcome 2) - 0.2

Explanation / Answer

investment is $400000

outcome:-1 $200000 annual cashflow perpetual (p= 0.7)

outcome 2:- $100000 annual loss, perpetual (p=0.3)

opportunity cost is 18%

1.WHETHER TO ACCEPT PROJECT OR NOT

(200000/18% - 400000 ) * 0.7 + (-100000/18% - 400000) * 0.3

= 497777 - 286667 = $211110

Since NPV Is +ve accept the project.

WAIT TO LEARN BEFORE INVESTING.

assuming no change in opportunity cost

Since there is no change in opportunity cost and cash flows are perpetual there is no hurry in investing. so its always better to wait and study about the investment.

ABANDON

Offered option to abandon afer 3years

NPVabandon = -100000/1.18 - 100000/1.182  - 100000/1.183 - 400000

= -84745-71818-60863 = -617426

expected NPV with option

497777$ - 0.3*617426 = 312550

value of option

312550 - 211110

= $101440

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