Real Options - Coca Cola Amatil

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INTRODUCTION This essay will discuss the concept of real options and their application in the capital budgeting exercise. We will describe a real option and its valuation using commonly used pricing formulae. We will then try and estimate project uncertainty, also known as volatility. Once we’ve estimated volatility we will demonstrate obtaining this estimate using ASX listed company, the Coca Cola Amatil Group. REAL OPTIONS AND THEIR INCORPORATION WITHIN CAPITAL BUDGETING A real option is a form of derivative, similar to a forward contract, but with a couple of important differences. A real option infers the right, but not an obligation, to buy an underlying real asset. The holder of a real option will compare the market value of the asset in question, along with the agreed exchange value on the option and can then decide whether to exercise that option or tear it up. This flexibility can come at considerable cost, which we will examine in the next section. The process of capital budgeting focuses on the incremental increase in cash flows associated with an investment decision or investment project. These cash flows are commonly analysed using a combination of analysis techniques such as Discounted Cash Flows, NPV, IRR and Profitability Index as well as Payback, Accounting Return on Investment and Discounted payback (Freeman and Hobbes, 1991, p37). In comparison with NPV, a most commonly used technique; real options consider multiple decision pathways, all of which aren’t necessarily apparent or available at the time of the initial decision. In essence, the NPV calculation does not value managements flexibility, so underestimates the value of a project. (Leslie & Michaels, 1997, p11) Examples of real options and the flexibilities they afford include • Option to abandon • Option to wait and see • Option to delay • Option to expand •

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