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A capital investment project that generates new opportunities is more valuable than one that doesn't. A flexible project, one that does not commit management to a fixed operating strategy is more valuable than an inflexible one. When a project is flexible or generates new opportunities for the company, it is said to contain real options.
In this assignment, you are to discuss the budgeting implications of different option strategies and the cost-benefit issues associated with such decisions.
- Why might recognizing a real option raise but not lower a project's net present value (NPV) as found in a traditional analysis?
- Why do we tend to underestimate NPV when we ignore the option to abandon?
- What do you suggest as a cost-effective approach to capital budgeting analysis when a project contains real options.
Write a one-page memo in which you explain the answers to any two of the three questions.
Explanation & Answer
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How to Budget with Real Options
When budgeting, it is important to consider all options so that the most relevant estimates
can be arrived at. This means that newer, and better accounting models have to be employed in
coming up with these estimates. For example, when accounting for cashflows, and the potential
value of a capital project, the traditional method of doing so, by determining the Net present
va...
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