Chapter 22
Real Options
I. Chapter Outline
The following chapter outline is correlated to the PowerPoint Lecture Slides. The PowerPoint slides
are referenced in bold. Alternative Examples to selected textbook examples are also available in the
PowerPoint Lecture Slides and are also referenced in bold.
22.1 Real Versus Financial Options (Slide 7)
22.2 Decision Tree Analysis (Slides 8–10)
• Figure 22.1 United’s Investment without Real Options (Slide 11)
• Representing Uncertainty (Slides 12–16)
• Figure 22.2 Representing Uncertainty (Slide 13)
22.3 The Option to Delay: Investment as a Call Option (Slide 20)
• An Investment Option (Slides 21–31)
• Figure 22.4 Electric Car Dealership Investment Opportunity (Slide 22)
• Table 22.1 Black-Scholes Option Value Parameters for Evaluating a Real Option to Invest
(Slide 26)
• Figure 22.5 The Decision to Invest in the Dealership (Slide 32)
• Factors Affecting the Timing of Investment (Slides 33–34)
• Global Financial Crisis: Uncertainty, Investment, and the Option to Delay
22.4 Growth and Abandonment Options (Slide 45)
• Valuing Growth Potential (Slides 46–57)
• Figure 22.6 StartUp’s Decision to Invest in the Drug (Slide 50)
• The Option to Expand (Slides 58–65)
• Figure 22.7 Staged Investment Opportunity (Slide 59)
• Interview with Scott Mathews
22.5 Investments with Different Lives (Slides 77–78)
– Standalone NPV of Each Design (Slides 79–80)
94 Berk/DeMarzo • Corporate Finance, Fourth Edition, Global Edition
– No Replacement (Slide 81)
– Replacement at the Same Terms (Slide 82)
22.6 Optimally Staging Investments (Slide 89)
• An Example: Eclectic Motors (Slides 90–92)
• Table 22.2 Required Time, Cost, and Likelihood of Success for Eclectic’s Project (Slide
91)
– Mutually Dependent Investments (Slide 93)
– Investment Scale (Slides 94–95)
– Investment Time and Risk (Slides 96–97)
– A General Rule (Slides 98–99)
22.7 Rules of Thumb (Slide 107)
• The Profitability Index Rule (Slide 108)
• The Hurdle Rate Rule (Slides 109–110, 115)
22.8 Key Insights from Real Options (Slides 116–117)
• Out-of-the-Money Real Options Have Value (Slide 116)
• In-the-Money Real Options Need Not Be Exercised Immediately (Slide 116)
• Waiting Is Valuable (Slide 116)
II. Learning Objectives
22-2 Draw decision trees to represent alternative decisions and potential outcomes in an uncertain
economy.
22-4 Illustrate how, given the option to wait, an investment that currently has a negative NPV can
have a positive value.
22-7 Discuss the situation in which equivalent annual benefit method results in optimal decision
©2017 Pearson Education, Ltd.
22-9 Define and use the profitability index and the hurdle rate rules of thumb.
III. Chapter Overview
The chapter begins with a description of the capital budgeting decision of the pharmaceutical
company Amgen. There is no single methodology to evaluate real investment options. Here they
22.1 Real Versus Financial Options
The difference between a real option and a financial option is that real options, and the underlying
22.2 Decision Tree Analysis
For this section of the text, the authors describe a project under consideration by United Studios,
22.1 shows the decision tree if the studio produces both movies at once. The NPV of the decision to
make the movie is positive. However, there is significant uncertainty about the actual outcome.
22.3 The Option to Delay: Investment as a Call Option
This section considers an option to open an electric car dealership immediately or in exactly one year.
If you do neither, you lose the right to open the dealership. The decision tree is shown in Figure 22.4.
$1.2 million for the contract and wait until next year to build the dealership. Table 22.1 shows the
inputs to the Black-Scholes model.
Whether it is optimal to invest today will depend on the magnitude of lost profits compared to the
©2017 Pearson Education, Ltd.
22.4 Growth and Abandonment Options
This section introduces another example, StartUp Incorporated, whose only asset is a patent on a new
drug. If produced, it will generate certain profits of $1 million per year for the life of the patent,
which is 17 years. The NPV of this project is negative. However, if interest rates decrease, the NPV
22.5 Investments with Different Lives
Consider an opportunity to replace a machine with one of two designs. The first design has a five–
year life, and the second machine has a 10-year life. The NPV of the longer-lived machine is higher.
22.6 Optimally Staging Investments
The text next addresses the staging problem for mutually dependent investments. In the case where
development of a product happens in multiple stages, each stage must be evaluated based on its scale,
22.7 Rules of Thumb
This section discusses two rules of thumb for capital budgeting: the profitability index rule and the
hurdle rate rule. The profitability index rule sets a different benchmark (rather than zero) for the
©2017 Pearson Education, Ltd.
22.8 Key Insights from Real Options
The chapter closes with this restatement of the rules that have been developed. The authors highlight
IV. Spreadsheet Solutions in Excel
The following Problems for Chapter 22 have spreadsheet versions of the problems available: 2, 8, and
18.
These spreadsheets can be downloaded from the Instructor’s Resource Center at: