Epsilon Archive for Student Projects

Abstract

This paper investigates the impact of real options on the value of a particular business
entity. Theoretically, the paper benefits from use of an option pricing model which is
based on a two-state (binomial) framework. This model provides an intuitive appeal
by visually showing the evolution of the value of a business in terms of discrete time
intervals. In contrast to majority of similar studies, this paper utilizes an extended
version of the binomial framework that combines both volatility and drift (in actual
expression, it is substituted by risk-free rate).
Empirically, the analysis is supported by financial data from Ukrainian steel-making
company Metals and Polymers Ltd. Properties of production process, as well as
institutional environment, enable to detect two business opportunities examined by
means of the theoretical model selected. These opportunities are option to expand and
option to abandon. The potential of the company in terms of profitability is estimated
using conventional NPV analysis, with no options included. This estimation is then
enhanced by implementing the options chosen.
To account for different economic scenarios, some independent variables are taken
fixed while others are loosen to float in the imposed intervals. Among the variables,
changeable (floating) ones are rate of corporate tax, rate of volatility and discount rate.
It is shown that in the presence of options the value of the company is significantly
higher than without them. Moreover, its value is subject to noticeable fluctuations
depending on alterations in the changeable variables.