Real Options in Financial Management

Real options are opportunities embedded in projects or investments that are likely to exist and have a material economic impact on cash flow and risk. The recognition of real options in a project will result in the projects strategic net present value (NPV) to differ from its traditional NPV, as follows: Strategic NPV = Traditional NPV + Value of real options Abandonment Option This option allows executives or project owners to minimize or avoid monetary losses on projects that turn financially unsuccessful. A good financial modeler who explicitly recognizing the abandonment option when evaluating a project often increases the NPV. Flexibility Option The option to incorporate a greater degree of fluctuation flexibility into companys operations, especially manufacturing and production. It generally includes the opportunity to design the manufacturing & production process to accept multiple inputs.Use flexible manufacturing techniques and technologies to create a range of outputs by reconfiguring the same set of plant and equipment, and purchase and in capital industries, which have wide fluctuations in output demand and long lead times in building new capacity from. A financial modeling and analysis exercise that recognizes this option embedded in a capital expenditure should be able to increase the NPV of a project Timing Option The option to determine when various actions related to a project are implemented. This option recognizes the companys opportunity to delay acceptance of a project for one or more time periods, or to either accelerate or slow down the process of implementing a project in response to new information, or to discontinue a project in response to changes in the competitive general market conditions. As in the case of the other type of real options, the explicit recognition of timing opportunities in

a financial model can improve the NPV of a project that fails to recognize this option in an investment decision.

Black Scholes
The Black Scholes model is a mathematical model of a financial market containing certain derivative investment instruments. From the model, one can deduce the Black Scholes formula, which gives the price of European style options. The formula led to a boom in options trading and the creation of the Chicago Board Options Exchange. lt is widely used by options market participants Many empirical tests have shown the Black Scholes price is fairly close to the observed prices, although there are well-known discrepancies such as the option smirk The model was first articulated by Fischer Black and Myron Scholes in their 1973 paper, The Pricing of Options and Corporate Liabilities. They derived a partial differential equation, now called the Black Scholes equation, which governs the price of the option over time. The key idea behind the derivation was to perfectly hedge the option by buying and selling the underlying asset in just the right way and consequently "eliminate risk". This hedge is called delta hedging and is the basis of more complicated hedging strategies such as those engaged in by Wall Street investment banks. The hedge implies there is only one right price for the option and is given by the Black Scholes formula.

The Black Scholes model of the market for a particular stock makes the following explicit assumptions: There is no arbitrage opportunity, i.e. there is no way to make a riskless profit It is possible to borrow and lend cash at a known constant risk-free interest rate. It is possible to buy and sell any amount, even fractional, of stock this includes short selling The above transactions do not incur any fees or costs The stock price follows a geometric Brownian motion with constant drift and volatility. The underlying security does not pay a dividend.

Advantage: The main advantage of the Black Scholes model is calculate a very large number of option prices in a very short time
Statement of Cash Flows Links Balance Sheet and Income Statement elements to change in cash position. Undoes some accrual accounting adjustments underlying the income statement. Presents cash flows logically organized by source or type of activity generating the cash flows.

Two ways to prepare

Direct method: Start with cash collected from customers and cash paid for operating activities. Also shows reconciliation of net income to change in cash position as well. Indirect method: Start with net income, add back non cash expenses, adjust changes in assets and liabilities and end with net increase or decrease in cash. Non cash items depreciation, amortization is expenses that do not have to be paid to outside entities. Hence they are not a use of cash in the direct method. In the indirect method, depreciation has already been subtracted to compute net income, so we must add it back to compute cash from operations. Hence non cash items are informally called sources of cash. This does not mean more depreciation expense increases the cash balance. In general, increases in assets are a use of cash increases in current assets represents a use of cash in operations. operations. In general increases in liabilities are a source of cash increases in current liabilities represents a source of cash from operations. Decreases in current liabilities are uses of cash from operations. Decreases in current assets are sources of cash from