Real Options Analysis - Crazy

A Crazy presentation on Real Options Analysis!!

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Closed Caption:

oh hello my name is dr. uma and i'm here
to talk to you today about some
financial decision-making tools that you
can use in your business in particular
real options analysis my volunteer and I
will bring you step-by-step through the
whole process of making these decisions
are you ready to win no you
let's begin my friend let's start by
talking about why manager should use
some of these decision-making tools
available to them as technology managers
you should use decision-making tools for
choices about your business for example
npv do npv is harshil and personality
that's exactly right
net present value calculates the value
of a project against the possibility of
investing that money somewhere else at
an established interest or discount rate
if a project has a positive net present
value is financially beneficial to
undertake that project if a project has
a negative net present value it is not
financially beneficial the downfall of
net present value is that it fails to
take into account the probability that a
project will or won't succeed net
present value only accounts for the most
likely scenario which is overly
simplistic because of its simplicity
managers risks foregoing possible
profitable opportunities and risk the
success of your business but isn't
optional the best tool in both
situations you're the best volunteer
I've ever had partial did not a day goes
by where I don't use real options
analysis in my line of work real options
analysis is a tool that can be used to
overcome the limitations of discounted
cash flow analysis or net present value
real options provide the right but not
the obligation to make a future
investment because research projects
developed through different phases or
stages a manager has the option of
whether or not to continue investing
money based on the success of the
research project maintaining the option
gives the manager the possibility of
abandoning ship
if the project is not reaching its goals
in this way a manager can mitigate the
risk of supporting a project wholesale
from start to finish
essentially by using options a manager
limits decision-making to information
that is actually known in this way a
manager can avoid spending money on
infeasible projects so in- ending is
real options on it is like marriage
manages costly to ruin and the
significant investment time and the
future of happiness or misery is
uncertain so i guess one must entered
with a lot of caution
courtship is equivalent of expertise or
R&D investment even if the expected
return is not high at least it gives you
the opportunity to see if it works out
or see our relationship is going
so am i right back on by with this
compassion to think i'm right well that
examples ok the mines better people use
real options all the time just as
pharmaceutical salesman who old city
right
675
okay that sounds good
crystal on one second
do what
do what you look seriously get out of my
face among get them anyways Marshall
let's give them an example of real world
real options analysis what do you say i
don't want to do this how do you like
you
great come on over here I'll show you
let's say you've got a new product and
you want to invest 12 million dollars in
research and development and when you do
that you've got a thirty percent chance
of an excellent outcome the sixty
percent chance of a good outcome a ten
percent chance of a poor outcome now
regardless of whatever the outcome is
going to cost you 30 million dollars to
put on an investment in product
development so should you decide to
invest that 30 million dollars there if
you've got an excellent product there's
an eighty percent chance that you'll
make a hundred twenty million dollars in
revenue if you invest in 30 mount 30
million dollars in a good product
there's seventy percent chance that
you'll get 20 million dollars if you
invest 30 million dollars in a poor
product there is a nineties percent
chance that you will lose a hundred and
twenty million dollars in revenue
now let's do the real analysis options
real options analysis rather so let's
say you've decided that you're going to
invest 12 million dollars here you've
got a choice if the outcome is excellent
then you can invest more because that's
what the option says you've got the
option to invest more money if the
outcome is in fact good you can decide
i'm not going to invest more money
because i want only excellent options
and you can decide that you're not going
to fund the project any further and
you've only lost 12 million dollars now
let's say you decide to invest in the
excellent project and you've invested 30
million dollars human you've decided to
do that and now what you've done is
you've made the choice to get an eight
percent chance of a hundred twenty
million dollars or twenty percent chance
of 30 million dollars by eliminating the
rest of these possibilities you
eliminate the possibility of losing a
hundred and twenty million dollars of
losing 30 million dollars of making only
20 million dollars
of making a only thirty percent chance
of 40 million dollars so you mitigate
your risk to these two possible outcomes
by using real options analysis which is
significantly more sure than all eight
of these options to understand what I'm
saying harshal yeah I do
good now we race that bored what get to
it now let's do the mathematics of this
fascinating problem let's calculate the
net present value for the most probable
outcome in this research and development
project we initially invest 12 million
dollars and then an additional 30
million dollars to that we add the net
present value of the revenue for a total
net present value of negative 22.8 four
million now if we do the net present
value and weigh in the probabilities we
again take the initial 12 million dollar
investment the second 30 million dollar
investment and we calculate through this
gnarly mess the different probability
weights of each individual outcome and
we get a negative 10.8 million neither
one of these options is desirable in
terms of net present value now if we do
a real options analysis again we start
with 12 million dollar investment we
calculate the net present value of the
year to investment but then we calculate
only the desirable outcome that we can
choose based on our real option and when
we do that we get a positive net present
value of 4 million . 36 so this is all
to say that when you're calculating net
present value just for the most likely
outcome and with the probabilities of
the different possibilities we get a
negative net present value so we
wouldn't want to invest however when we
take into account with real options that
we can choose our most desirable outcome
we can then come up with a positive net
present value and we'll go ahead and
invest in the project
and we're done as you can see these
strategic tools can be very helpful for
managers making decisions about how to
invest in research and development
projects but don't take my word for it
net present value and real options
analysis are great ways for your company
to gain a competitive advantage
well we want to thank you for watching
and purchasing this very expensive video
i hope you had as much fun as harshly
and I did good luck in your future
endeavors
because me and the moon
baby come on