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

By Lenos Trigeorgis | Go to book overview

addition, the binomial examples of involuntary bankruptcy show how the original CCM may undervalue debt because it neglects the legal protection given to bondholders by the bankruptcy law.

To include all the important features of the bankruptcy law, three further extensions of the CCM model are needed. The first is a more accurate treatment of the bankruptcy criteria. First, one should model the net worth criterion for bankruptcy as a book-value--based constraint, rather than as the market-value constraint used here and in the original CCM. This distinction will lead to a two-state variable problem.

Second, one should include the cash flow criterion for bankruptcy. This extension would help to capture short-run considerations, surprises, and unanticipated losses to debtholders. This extension again would require a two-state variable model of the firm. The value of the firm would continue to be a state variable and would represent the long-run viability of the enterprise. The second state variable would be the amount of cash available to meet current obligations and would permit more careful distinctions between bankruptcy filings made for strategic reasons and those made as a result of financial distress. While the former may represent unanticipated losses for debtholders, the latter can be better anticipated because they arise from deterioration in the long-run prospects of the firm.

A third extension could allow interest rates to be stochastic. We have noted earlier in this chapter that interest-rate risk can contribute to default risk. The interaction of default risk and interest-rate risk needs to be more fully explored and will depend on the costs of recontracting outstanding debt.

Finally, any of these extensions will require improvements in the computational method. While all would add important features to the model and may improve the accuracy of the estimates of bond values, considerable effort must be expended to make them computationally tractable. These methods hold the promise to better capture the default options of leveraged firms.


ACKNOWLEDGMENTS

We would like to thank Zvi Bodie for many helpful discussions and Daniel Raff and Timothy Bresnahan for suggesting some of the figures. We have received helpful comments from participants at the 1992 American Law and Economics Conference, and especially from three anonymous referees and from the editor, Lenos Trigeorgis.

-318-

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Real Options in Capital Investment: Models, Strategies, and Applications
Table of contents

Table of contents

  • 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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