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LECTURE 4 Investment under uncertainty, real options  Derivatives valuation approach. Example:  Copper mine  Strategic options. Examples:  Copper mine with shutdown option  Valuing Vacant Land  Valuation of an option to delay  Ratio comparison approach  Additional Definitions ECOM051 Business Finance, Lecture 4 (Dr Giles Spungin, G.Spungin@qmul.ac.uk, www.excalibur24.com, QMUL©2010-11) 1 Discounted cash flow methods ignore opportunities (strategic options, indirect cash flows) created by investment project. Strategic options exist whenever management has any flexibility regarding the implementation of a project. Options to change the scale of a project (downsize, expand), abandon it, or …show more content…

Forward to buy 25k £0 Cashflow at Y1 Cashflow at Y2 25k  p1  £0.10 50k  p2  £0.10 25k  p1  £0.65 £0 £0 50k  p2  £0.60 £25k 0.65-0.10 £0 £0 £50k 0.60-0.10 25k  p1  £0.10 50k  p2  £0.10 copper in Year 1 Forward to buy 50k £0 copper in Year 2 with £25k 0.65-0.10 1+0.05 maturity in Year 1 Buy ZCB with face value £25k(0.65-0.10) with £50k 0.60-0.10 1+0.062 maturity in Year 2 Buy ZCB with face value £50k(0.60-0.10) TOTAL £35,345 ECOM051 Business Finance, Lecture 4 (Dr Giles Spungin, G.Spungin@qmul.ac.uk, www.excalibur24.com, QMUL©2010-11) 7 Strategic options DEFINITION: strategic options are opportunities that arise from undertaking a project. These opportunities are usually missed in the direct cash flow forecasts, as they are not easily identifiable. An option to delay the start of a project, or a mine with shutdown option is examples of such strategic options. In case of the latter, we employ a binomial tree approach. Copper mine with shutdown option The mine will be closed down if the cost of extraction is greater than copper price. EXAMPLE: Suppose that a copper mine will produce 75mln pounds of copper one year from now if economic conditions ECOM051 Business Finance, Lecture 4 (Dr Giles Spungin, G.Spungin@qmul.ac.uk, www.excalibur24.com,

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