Application of Real Option valuation Sample Clauses

Application of Real Option valuation. In this sector, we present examples to explain how the real options implement in the investment projects and how to help managers make right decisions. The following example is based on Xxx X.X Xxxx and Xxxxx Xxxxxxxxxx (2004). It is a classic example of real option which is valuing a research and development (R & D) program. Managers in that company have to decide whether to invest in this program, using real option theory. This program is described in details as follows. R & D program The R&D program involves two stages investment which are R&D and commercial projects. As can be seen from figure 2.12, the first capital outlay is $15 million in current year and there is $50 million at the end of year one. In addition, there is another investment which is $1200 million (I2) at the end of year two. This company will get pay off from year three to year six and the expected cash flows of four years are CF3=$200 million, CF4=$500 million, CF5=$700 million, CF6=$200 million respectively. Compare outlays with potential revenues, it seems that this company has a low return on investment. However, developing new technology may open up the company’s future growth opportunities and enhance its competition power in the market. 700 500 200 200 0 1 2 3 4 5 6 15 50 R & D Commercial Project 1200
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