# Real Options in Capital Investment: Models, Strategies, and Applications

By Lenos Trigeorgis | Go to book overview

values both European and American calls and puts as special cases. The general valuation formula was also applied to valuing the timing option in investment theory.

The forgoing analysis may be extended to allow for imperfect capital markets, stochastic interest rates, and discrete dividends. Furthermore, the formula for the American exchange option can be used to value certain financial options, such as options in exchange offers or options embedded in convertible or commodity-linked bonds.

ACKNOWLEDGMENTS

A slightly longer version of this chapter appeared as the second essay in my Ph.D. dissertation, "Essays on Exchange" ( University of California at Los Angeles). I would like to thank the following individuals for their comments and support: Warren Bailey, Jim Brandon, Michael Brennan, Tom Copeland, Dan Galai, Bob Geske, Mark Grinblatt, David Hirshleifer, Craig Holden, Eduardo Schwartz, Erik Sirri, Sheridan Titman, Walt Torous, Brett Trueman, and the participants of the UCLA finance workshop. They are not responsible for any errors. Financial support was provided by a fellowship from the Social Sciences and Humanities Research Council of Canada, a John M. Olin scholarship, and an Allstate Dissertation Fellowship.

NOTES
1.
Merton ( 1973) also showed that the risk-free rate, r, need not appear in the Black-Scholes formula if the present value of the exercise price is replaced by the price of a zero-coupon bond paying the exercise price at expiration.
2.
A function f(x1, x2) is linearly homogeneous if f(λx1,λx2) = λ f(x1, x2) for any λ > 0.
3.
See the Appendix of Geske and Johnson ( 1984) for a derivation of this formula. The formulas for E1, E2, and E3 are given by Equations (6.2), (6.9), and (6.11), respectively.
4.
To express the formula in the Geske-Johnson ( 1984) notation, make the following substitutions in Equation (6.14): X = V, S = D, , and use the identities given by Equation (6.5) in section 6.2.

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Real Options in Capital Investment: Models, Strategies, and Applications

• Title Page iii
• Contents v
• Tables and Figures ix
• Preface xiii
• Chapter 1 Real Options: An Overview 1
• Introduction 1
• Acknowledgments 28
• Notes 28
• Part I Real Options and Alternative Valuation Paradigms 29
• Chapter 2 Methods for Evaluating Capital Investment Decisions Under Uncertainty 31
• Introduction 31
• Conclusion 44
• Notes 45
• Chapter 3 Merging Finance Theory and Decision Analysis 47
• Introduction 47
• Summary and Conclusion 65
• Acknowledgments 66
• Notes 66
• Chapter 4 The Strategic Capital Budgeting Process: A Review of Theories and Practice 69
• Introduction 69
• Conclusions 84
• Acknowledgments 86
• Notes 86
• Part II General Exchange or Switching Options and Options Interdependencies 87
• Chapter 5 The Value of Flexibility: A General Model of Real Options 89
• Introduction 89
• Concluding Remarks 105
• Acknowledgments 105
• Notes 106
• Chapter 6 The Valuation of American Exchange Options with Application to Real Options 109
• Introduction 109
• Conclusion 119
• Acknowledgments 120
• Notes 120
• Chapter 7 Operating Flexibilities in Capital Budgeting: Substitutability and Complementarity in Real Options 121
• Introduction 121
• Conclusion 130
• Acknowledgments 131
• Notes 131
• Part III Strategy, Infrastructure, and Foreign Investment Options 133
• Chapter 8 The Value of Options in Strategic Acquisitions 135
• Introduction 135
• Implications and Conclusions 147
• Acknowledgments 148
• Notes 148
• Chapter 9 Corporate Governance, Long-term Investment Orientation, and Real Options in Japan 151
• Introduction 151
• Implications and Conclusions 158
• Notes 160
• Chapter 10 Volatile Exchange Rates and the Multinational Firm: Entry, Exit, and Capacity Options 163
• Introduction 163
• Conclusions 178
• Acknowledgments 180
• Notes 180
• Part IV Mean Reversion/ Alternative Formulations in Natural Resources, Shipping, and Start - Up Ventures 183
• Chapter 11 The Effects of Reversion on Commodity Projects of Different Length 185
• Introduction 185
• Conclusions and Extensions 199
• Appendix 201
• Acknowledgments 204
• Notes 204
• Chapter 12 Contingent Claims Evaluation of Mean-Reverting Cash Flows in Shipping 207
• Introduction 207
• Conclusions 216
• Appendix 217
• Acknowledgments 218
• Notes 218
• Chapter 13 Valuing Start-Up Venture Growth Options 221
• Introduction 221
• Conclusion 236
• Appendix 237
• Acknowledgments 238
• Notes 238
• Part V Other Applications: Pollution Compliance, Land Development, Flexible Manufacturing, and Financial Default 241
• Chapter 14 Investment in Pollution Compliance Options: The Case of Georgia Power 243
• Introduction 243
• Notes 262
• Chapter 15 Optimal Land Development 265
• Introduction 265
• Conclusions and Extensions 277
• Appendix 278
• Acknowledgments 279
• Notes 279
• Chapter 16 Multiproduct Manufacturing with Stochastic Input Prices and Output Yield Uncertainty 281
• Introduction 281
• Conclusion 298
• Appendix 300
• Notes 301
• Chapter 17 Default Risk in the Contingent Claims Model of Debt 303
• Introduction 303
• Conclusions and Extensions 317
• Acknowledgments 318
• Notes 319
• Bibliography 323
• Author Index 347
• Subject Index 351
• About the Editor and Contributors 357
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