A Pragmatic Guide to Real Options

201 Pages·2014·1.329 MB·English

by  Tom Arnold

A Pragmatic Guide to

Real Options
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A Pragmatic Guide to

Real Options
Tom Arnold
a pragmatic guide to real options
Copyright © Tom Arnold, 2014.
All rights reserved.
First published in 2014 by
PALGRAVE MACMILLAN®
in the United States—a division of St. Martin’s Press LLC,
175 Fifth Avenue, New York, NY 10010.
Where this book is distributed in the UK, Europe and the rest of the world,
this is by Palgrave Macmillan, a division of Macmillan Publishers Limited,
registered in England, company number 785998, of Houndmills,
Basingstoke, Hampshire RG21 6XS.
Palgrave Macmillan is the global academic imprint of the above companies
and has companies and representatives throughout the world.
Palgrave® and Macmillan® are registered trademarks in the United States,
the United Kingdom, Europe and other countries.
ISBN: 978–1–137–39148–3
Library of Congress Cataloging-in-Publication Data
Arnold, Tom.
A pragmatic guide to real options / by Tom Arnold.
pages cm
Includes bibliographical references and index.
1. Real options (Finance) I. Title.
HG6042.A76 2014
332.63—dc23 2014022096
A catalogue record of the book is available from the British Library.
Design by Newgen Knowledge Works (P) Ltd., Chennai, India.
First edition: December 2014
10 9 8 7 6 5 4 3 2 1
Printed in the United States of America.
To the three people who have made my life interesting:
Cindy, Andrew, and Claire;
and to the two people for whom I have, hopefully,
made life interesting: Jane and John
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Contents

List of Tables ix
Preface xiii
1 How Net Present Value Is Implemented 1
2 Making Decisions Sequential 15
3 Option Terminology and an Introduction to
Binomial Trees 33
4 Binomial Trees, Risk-Neutral Pricing, and
American Style Options 53
5 Applying Real Option Analysis with
NPV-Embedded Binomial Trees 85
6 Applying More Real Options Analysis into
an NPV-Embedded Binomial Tree 117
7 Implementing an NPV-Embedded Binomial Tree
from an NPV Analysis 145
8 Real Option Analysis and the Black-Scholes Model 167
Index 183
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Tables
Tables
Tables

1.1 Timeline 9
1.2 Timeline with Visual Discounting 10
2.1 Nonsequential and Sequential Dice Game Results 17
2.2 P robability Distribution of X 22
2.3 Probability Distribution of Second Die Roll 22
2.4 D eviations from Mean of X 23
2.5 Probability Distribution of X, Y, and Z 25
2.6 D eviations from Mean of X, Y, and Z 26
2.7 Probability Distribution of X and Q 29
2.8 Probability Distribution of X and H 30
2.9 Deviations from Mean of X and H 31
3.1 First Stage of a Three-Stage Binomial Tree 44
3.2 Second Stage of a Three-Stage Binomial Tree 45
3.3 All Stages of a Three-Stage Binomial Tree 46
3.4 Three-Stage Binomial Tree with Probability
Distribution 47
3.5 Probability Distribution of Future Stock Price and
Call Option Value (Strike Price of $50.00) 48
3.6 Probability Distribution of Future Stock Price and
Put Option Value (Strike Price of $50.00) 49
4.1 All Stages of a Four-Stage Binomial Tree 57
4.2 Four-Stage Binomial Tree with Probability
Distribution 58
4.3 Building Four-Stage Contract Binomial Tree (Part 1) 59
4.4 Building Four-Stage Contract Binomial Tree (Part 2) 62
4.5 Building Four-Stage Contract Binomial Tree (Part 3) 64
4.6 Building Four-Stage Contract Binomial Tree (Part 4) 65