Finance Option Pricing Application

Question: Discuss about the Finance for Option Pricing Application. Answer: Real Options Real option gives the holder the right to buy or sell the underlying assets on or before the date of expiration of that specific option. The payoffs of the real options must be contingent. The real option has the significant economic value when there is competition restriction in the contingency event and the presence of exclusivity makes the real option most valuable. There are three determinants of the real option value. They are value of the underlying assets, variance in that value and expected dividend on that assets. Black and Sholes model is an important aspect in this regard. Option Pricing Application Being static and not having any good job capturing ability are the limitations of traditional investment. There are three kind of options that can make an investment a bad investment and they are the option to delay, to take advantage of other opportunities and option to abandon. In the option to delay, the NPV is negative and the IRR is less than the hurdle rate. An unacceptable project can be made acceptable with the help of option to abandon. However, this needs to be weighted off against the abandonment value. Option Pricing Application in Capital Structure Decision Design of securities is the most direct application of the option pricing in capital structure. Valuation o flexibility is the other application of option pricing. In order to have the option of taking the future projects, a firm uses to maintain large cash balances and excess debts. The external debt capacity becomes useful when the external reinvestment needs exceeds the firms internal investment needs. The firms value will be increase than the present value if excess return is earned by the investment. The value of flexibility will be greater at the time of more unpredictable investment needs. Option Pricing Application in Valuation A troubled firms equity can be considered as the call option to liquidate the firm. The amount of equity in a firm is a residual claim. At the time of liquidation of the firm, the equity shareholders get the leftover of the firm after paying all the debts and financial claims of the others. There are two claim holders in a firm and they are the debt and the equity. Acquisition As per the financial managers, the long term benefits of the merger and acquisition cannot be seen by the market. Acquisition firms have more trouble creating value than the internal investment firms. The structurally wrong factors of acquisition are supported by the mistakes. There are seven mistakes or sins in the process of acquisition. They are Transference of Risk, Subsidies of Debt, Auto-Pilot Control, Elusive Synergy, Relativity, and Verdict first and Trail afterwards and its not the fault. Value Enhancement There are four ways to create or enhance the value. They are I) the increase in the cash flow by the existing assets, II) the increase in the expected growth rate in these cash flows, III) the extension in the high growth period to allow more years of high growth and IV) the reduction in the cost of capital.