List of Figures p. xix
Acknowledgments p. xxv
Preface p. xxvii
Theory p. 1
Chapter Summaries p. 3
A New Paradigm? p. 3
Traditional Valuation Approaches p. 4
Real Options Analysis p. 5
The Real Options Process p. 6
Real Options, Financial Options, Monte Carlo Simulation, and Optimization p. 7
A New Paradigm? p. 9
Introduction p. 9
A Paradigm Shift p. 9
Expansion and Compound Options: The Case of the Operating System p. 11
Expansion Options: The Case of the e-Business Initiative p. 13
Expansion and Sequential Options: The Case of the Pharmaceutical R&D p. 15
Expansion and Switching Options: The Case of the Oil and Gas Exploration and Production p. 17
Abandonment Options: The Case of the Manufacturer p. 19
Expansion and Barrier Options: The Case of the Lost Venture Capitalist p. 20
Compound Expansion Options: The Case of the Internet Start-Up p. 23
The Real Options Solution p. 24
Issues to Consider p. 24
Industry Leaders Embracing Real Options p. 26
What the Experts Are Saying p. 28
Summary p. 30
Chapter 1 Questions p. 31
The Timken Company on Real Options in R&D and Manufacturing p. 33
Schlumberger on Real Options in Oil and Gas p. 36
Intellectual Property Economics on Real Options in Patent and Intangible Valuation p. 42
Gemplus on Real Options in High-Tech R&D p. 45
Sprint on Real Options in Telecommunications p. 49
Traditional Valuation Approaches p. 55
Introduction p. 55
The Traditional Views p. 55
Practical Issues Using Traditional Valuation Methodologies p. 57
Summary p. 66
Chapter 2 Questions p. 66
Financial Statement Analysis p. 67
Discount Rate versus Risk-Free Rate p. 74
Real Options Analysis p. 77
Introduction p. 77
The Fundamental Essence of Real Options p. 77
The Basics of Real Options p. 79
A Simplified Example of Real Options in Action p. 79
Advanced Approaches to Real Options p. 81
Why Are Real Options Important? p. 82
Comparing Traditional Approaches with Options p. 85
Summary p. 92
Chapter 3 Questions p. 92
The Real Options Process p. 93
Introduction p. 93
Critical Steps in Performing Real Options Analysis p. 93
Summary p. 96
Chapter 4 Questions p. 98
Real Options, Financial Options, Monte Carlo Simulation, and Optimization p. 99
Introduction p. 99
Real Options versus Financial Options p. 99
Monte Carlo Simulation p. 102
Summary p. 107
Chapter 5 Questions p. 109
Financial Options p. 111
Simulation p. 114
Forecasting p. 124
Optimization p. 126
Application p. 133
Chapter Summaries p. 135
Behind the Scenes p. 135
Real Options Models p. 136
Advanced Options Problems p. 136
Real Options Analysis Toolkit Software (CD-ROM) p. 137
Results Interpretation and Presentation p. 137
Behind the Scenes p. 139
Introduction p. 139
Real Options: Behind the Scenes p. 139
Binomial Lattices p. 143
The Look and Feel of Uncertainty p. 146
A Firm's Real Options Provide Value in the Face of Uncertainty p. 149
Binomial Lattices as a Discrete Simulation of Uncertainty p. 151
Granularity Leads to Precision p. 154
An Intuitive Look at the Binomial Equations p. 158
Frolicking in a Risk-Neutral World p. 163
Summary p. 168
Chapter 6 Questions p. 168
Real Options Models p. 171
Introduction p. 171
Option to Abandon p. 171
Option to Expand p. 175
Option to Contract p. 178
Option to Choose p. 181
Compound Options p. 185
Changing Strikes p. 188
Changing Volatility p. 189
Sequential Compound Option p. 191
Extension to the Binomial Models p. 194
Summary p. 195
Chapter 7 Questions p. 195
Volatility Estimates p. 197
Black-Scholes in Action p. 203
Binomial Path-Dependent and Market-Replicating Portfolios p. 205
Single-State Static Binomial Example p. 210
Sensitivity Analysis with Delta, Gamma, Rho, Theta, Vega, and Xi p. 215
Reality Checks p. 220
Applying Monte Carlo Simulation to Solve Real Options p. 223
Trinomial Lattices p. 230
Non-Recombining Lattices p. 232
Advanced Options Problems p. 241
Introduction p. 241
The Advanced Problems p. 241
Decision Trees p. 242
Exit and Abandonment Options p. 245
Compound Options p. 246
Timing Options p. 247
Solving Timing Options Calculated Using Stochastic Optimization p. 247
Switching Options p. 252
Summary p. 256
Chapter 8 Questions p. 256
Stochastic Processes p. 257
Differential Equations for a Deterministic Case p. 260
Exotic Options Formulae p. 263
Real Options Analysis Toolkit Software (CD-ROM) p. 277
Introduction p. 277
Introduction to the Real Options Analysis Toolkit Software CD-ROM p. 277
Creating and Solving a Customized Option Using the Software p. 281
Advanced Real Options Models in the Software p. 285
Summary p. 291
Chapter 9 Exercises p. 291
Real Options Analysis Toolkit's Function Description for Excel p. 293
Getting Started with Crystal Ball Monte Carlo Simulation p. 305
Resource Optimization Using Crystal Ball's Opt-quest Software p. 312
Results Interpretation and Presentation p. 317
Introduction p. 317
Comparing Real Options Analysis with Traditional Financial Analysis p. 318
The Evaluation Process p. 321
Summary of the Results p. 324
Comparing across Different-Sized Projects p. 325
Comparing Risk and Return of Multiple Projects p. 326
Impact to Bottom Line p. 327
Critical Success Factors and Sensitivity Analysis p. 328
Risk Analysis and Simulation on NPV p. 329
Break-Even Analysis and Payback Periods p. 329
Discount Rate Analysis p. 331
Real Options Analysis Assumptions p. 332
Real Options Analysis p. 333
Real Options Risk Analysis p. 334
Summary p. 335
Chapter 10 Questions p. 335
Summary of Articles p. 337
Case Studies and Problems in Real Options p. 345
Answers to Chapter Questions p. 355
Endnotes p. 363
Index p. 371