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Real Options and Monte Carlo Modeling for New Product Development

24 March 2003 Michael J. Sanislo, P.E.

Agenda

Valuation Process Overview Case Study


Discounted Cash Flow Decision Tree

Real Options Introduction


Application to case

Monte Carlo Simulation Q&A

Real Options and Monte Carlo Modeling For New Product Development 25 March 2003

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High Energy Consulting New Product Development Financial Modeling


financial modeling step objectives
Identify value drivers and relative contributions to total uncertainty in the financial model; set goals for reducing uncertainty in the Development stage; in this stage, risks will also be categorized as market risk or project specific risk

Discounted Cash Flow Model Sensitivity and Uncertainty Analysis

Monte Carlo Model: NPV, IRR, market share

Create probability distributions for model assumptions: Model the risk profile for the opportunity

Identify Real Options embedded in the project

Determine quantifiable options embedded in the opportunity, including options for deferral, abandonment, growth, flexibility, and timing; Create a decision tree

Estimate value of successive NPD stages

Develop estimates for the economic value determined by discounted cash flow and strategic value determined by real options; create budget for the Development stage

Reduce uncertainty in primary value drivers

Reduced risk in valuation estimate; identification of market, (non-diversifiable) risk and project-specific (diversifiable) risk

Measure the value created during Development Portfolio Optimization

Assess product development process efficiency; demonstrate value created by the NPD team during the subject phase, Determine optimal portfolio investments

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Limitations of DCF for New Product Development Decisions

Implicitly assumes only one investment decision Not applicable for comparing competing projects with different risks or scale Value of learning or managerial flexibility is not quantified Discount rate incorrectly includes market risk and unique risk

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Risks

Project Specific (Unique) Risk


Unique to the opportunity in question Usually decline over the course of a well-managed project Can be diversified High values reduce DCF Value

Market (Systematic) Risk


Risks affect all competitors in the market Can increase or decrease during the project Cannot be diversified High market risk increases the value of real options

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Valuation in Successive New Product Development Phases

Idea Generation

Feasibility Assessment

Development

Piloting

Launch

Project-Specific Risk

100%

80%

50%

30%

Real Option Value, relative to DCF

High

High

Low

Discounted Cash Flow Value

Negative

Negative

Positive

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New Product Development Costs

100 85%
Cumulative Percent of Cost

95%

80 60 40 20

70%

Life-Cycle Cost Determination Up to 85% of Product Costs are Committed During Design and Development

35% 22%

Cost-Reduction Opportunities
Source: DARPA Rapid Design Exploration and Optimization (RaDEO) Project

Idea

Validation

Design

Development

Mfg.

Support

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Case Study

A food company has completed a business plan for a delicious, non-fat yogurt smoothie, aimed at busy professionals who often dont have time to eat, but are still health-conscious and desire tasty, healthy alternatives to vending-machine food. Market research indicates strong evidence of customer demand and willingness to pay for the product, and the next major investment needed before entering a regional market is $1 Million, to be used for the creation of a production process to manufacture the product in high volumes. The development of the production process is expected to take one year, and a regional rollout can be completed in two years, at a cost of $5 Million, if the process design and implementation is successful. If the regional rollout succeeds, a national market launch can be completed during the fourth year. The full market launch is expected to cost $66 Million over the next four years. The company would like to determine if the current $1 Million investment is prudent, given the size of the opportunity, the proposed staging of investments, and the project and market risks. The company would also like to quantify the value of managerial flexibility embedded in the opportunity.

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Case Example Starting Point

Ideation

Analysis 2

Experiment 3

Business Plan 4

Development 5 Gate 4 Decision:

Test Market Launch 6

U.S. Market Launch

Completed stages and gates

Should we invest $1,000,000 in the next stage of product development, resulting in the creation of a production process for a new beverage?

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First Rough Financial Model


Market size: First year sales: Sales grow th rate, years 2-5: Sales grow th rate, years 6-10: Terminal Value grow th rate: Cost of goods sold grow th rate: Operating expenses/sales ratio: Capital investment: Unrecoverable launch costs: Discount rate: Tax rate: Year Sales Cost of goods sold Net Sales Total operating expenses EBITDA Taxes Capital + Launch Cost Operating cash flow NPV, Years 1-10: NPV, including terminal value: IRR: Value of underlying security ($60.0) ($60.0) $0.64 $53.92 22.92% $113.92 $4.0 $5.6 $7.7 $10.6 $14.3 $15.8 $17.5 $19.4 $21.4 $23.7 $197.52 $53.28 $150.0 $12.0 30.0% 10.0% 2.0% 5.0% 20.0% $40.0 $20.0 14% 40% Terminal 1 $12.0 $3.0 $9.0 $2.4 $6.6 $2.6 2 $15.6 $3.2 $12.5 $3.1 $9.3 $3.7 3 $20.3 $3.3 $17.0 $4.1 $12.9 $5.2 4 $26.4 $3.5 $22.9 $5.3 $17.6 $7.0 5 $34.3 $3.6 $30.6 $6.9 $23.8 $9.5 6 $37.7 $3.8 $33.9 $7.5 $26.3 $10.5 7 $41.5 $4.0 $37.5 $8.3 $29.2 $11.7 8 $45.6 $4.2 $41.4 $9.1 $32.3 $12.9 9 $50.2 $4.4 $45.7 $10.0 $35.7 $14.3 10 $55.2 $4.7 $50.5 $11.0 $39.5 $15.8 Value all dollar amounts are in millions

Market Share
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003

8.0%

10.4%

13.5%

17.6%

22.8%

25.1%

27.6%

30.4%

33.5%

36.8%

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Gate 4 Financial Model, Staged Investments


Market size: Year 5 sales: Sales grow th, years 6-9: Sales grow th, years 10-14: Terminal Value grow th: COGS grow th rate: Op Ex/Sales ratio: Production process costs: Regional phase costs: U.S. market launch costs: Discount rate: Risk-free rate: Tax rate: Year Sales Cost of goods sold Net Sales Total operating expenses EBITDA Taxes Product Development Costs Operating cash flow PV (cash flow s, 14%) PV (investment, 5%) NPV Underlying security $8.94 $63.57 ($0.95) $0.00 ($4.32) ($49.36) ($1.0) ($1.0) ($5.0) ($5.0) $150.0 $12.0 30.0% 10.0% 2.0% 5.0% 20.0% $1.0 $5.0 $60.0 14% 5% 40% 0 1 2 3 4 $6.0 $4.0 $2.0 $2.0 $0.0 $0.0 ($60.0) ($60.0) $4.0 $2.06 $5.6 $2.55 $7.7 $3.10 $10.6 $3.71 $14.3 $4.39 $15.8 $4.26 $17.5 $4.14 $19.4 $4.02 $21.4 $3.90 $23.7 $197.52 $3.79 $27.67 5 $12.0 $3.0 $9.0 $2.4 $6.6 $2.6 6 $15.6 $3.2 $12.5 $3.1 $9.3 $3.7 7 $20.3 $3.3 $17.0 $4.1 $12.9 $5.2 8 $26.4 $3.5 $22.9 $5.3 $17.6 $7.0 9 $34.3 $3.6 $30.6 $6.9 $23.8 $9.5 10 $37.7 $3.8 $33.9 $7.5 $26.3 $10.5 11 $41.5 $4.0 $37.5 $8.3 $29.2 $11.7 12 $45.6 $4.2 $41.4 $9.1 $32.3 $12.9 13 $50.2 $4.4 $45.7 $10.0 $35.7 $14.3 14 $55.2 $4.7 $50.5 $11.0 $39.5 $15.8 Terminal Value 15 all dollar amounts are in millions

Market Share

8.0%

10.4%

13.5%

17.6%

22.8%

25.1%

27.6%

30.4%

33.5%

36.8%

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Staged Investments, Decision Tree Valuation Approach


4
go

Develop production process Cost: ($1.0 M) PV: ($0.95 M)

5
50%, go

Launch in a test market Cost: ($5.00 M) PV: ($4.32 M)

6
60%, go

Launch in the U.S. market Cost: ($60.00 M) PV Cost: (49.36 M) PV Cash Fl: $63.57 M NPV: $14.21 M

30% X (($0.95 M)+($4.32 M)+$14.21 M) = 30% X $8.94 M =

$2.68 M

50%, abandon

1 year

2 years

40%, abandon

abandon

1 year
20% X (($0.95 M)+($4.32 M)) = 20% X ($5.27 M) =

($1.05 M)

50% X ($0.95 M) =

($0.48 M)

The decision to invest would be easier if we knew the value of each stage The value of managerial flexibility is not yet quantified Success probabilities apply to unique risks only The case is marginally attractive

Total Expected Value = $2.68 M+($1.05 M)+($0.48 M) =

$1.15 M

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Financial Option Definition

A contract conveying the right, but not the obligation, to buy or sell designated securities or commodities at a specified price during a stipulated period.
Call option a contract to buy Put option a contract to sell A European option gives the owner of the option contract the right to buy the designated securities only on the expiration date for the option. An American option gives the owner of the option contract the right to buy the designated securities at any time before the expiration date.

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Value of the Option

There are several methods for estimating the value of a financial option (such as a stock option), but the most commonly used is the Black-Scholes1 equation, which expresses the value as a function of six variables:

1. 2. 3. 4. 5. 6.

The stock price The exercise price (or, strike price) The risk-free rate of return The volatility of the underlying security The time to expiration The dividend yield

Fischer Black and Myron Scholes of the MIT Sloan School of Management developed the original option valuation model using five variables. The dividend yield variable was added by Robert Merton in 1975. Fischer Black and Robert Merton won the Nobel Prize in Economics for their work on the option valuation model in 1997. Fischer Black, who died in 1995, was mentioned in the award citation.

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Real Options

Stewart Myers of the Massachusetts Institute of Technology observed that the Black-Scholes model could be used to value investment opportunities in real markets-the markets for products and services. Today, this technique is commonly used in industries such as:
Oil and Gas Exploration Pharmaceuticals Chemicals Semiconductors

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General Electric June 03 Call Option Pricing Example

General Electric Call Option Example


Inputs Stock Price ($): Uncertainty (%): Exercise Price ($): Time To Expiry (years): Div idends ($): Risk-free Interest Rate (%): $28.00 Stock Price 27.82% Volatility from Chicago Board of Options Exchange $27.50 The present v alue of the cost of dev eloping the new product 0.2685 The option is v alid for 98 days between 24 March 2003 and 30 June 2003 $0.76 Annual div idends 3.98% 10 year treasury yield

Outputs d 1: N(d 1): d 2: N(d 2): Value of the option: All data as of 24 March, 2003 0.220646468 0.587316105 0.076491614 0.530486076 $1.89

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Example Cisco Systems Call Options

Cisco Systems Call Option Values (March 12, 2001)


$7.00

Call Price (value of the option, $/share)

$6.00

Cisco Systems Stock Price: $20.63


$5.00

Strike Price (X) $17.50

$4.00

$20.00 $25.00

$3.00

$27.50 $30.00

$2.00

$1.00

$0.00 Nov-00

Jan-01

Feb-01

Apr-01

Jun-01

Jul-01

Sep-01

Nov-01

Dec-01

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Correspondence in the Valuation Models

Real Options Value for NPD


Present Value of the cash flows from the project Required new investment, unrecoverable NPD cost Length of time until decision must be made Time value of money Risk of the expected returns Annual cost of preserving the option S X t rf

Call Option Value


Stock price Exercise price Time to expiration Risk-free rate of return Variance of returns on stock Dividend Yield

2
D

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Option Payoff Diagram and the NPD Process

Value of the Option to Delay Launch, Generic New Product Development Example
payoff and call option v alue
$300,000 uncertainty = 100% uncertainty = 50% uncertainty = 30%

$200,000 Stage 2 Analysis

Stage 6 Launch Stage 3 Pilot Stage 5 Design

$100,000

Stage 4 Business Plan

$0 $300,000 $400,000 $500,000 $600,000 $700,000 $800,000

Present Value of the Project Cash Flows

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Valuation Matrix Using the Black-Scholes Call Option Method

NPV Quotient (S/PV(X))


lower values lower values

1.0

higher values

Cumulative Volatility (

Call option value increases In these directions

higher values

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Real Options applied to Case Study

Model the Regional Launch Phase as a 2-year call option to invest $60 Million in the
National Launch Phase

Model the Production Process Development Phase as a 1-year call option to invest $5
Million in the Regional Launch Phase

Develop a Production Process


PV, Costs: ($1.0 M) PV, Benefits:: $ 2.98 M

Launch in a Regional Market


Strike Price: $5.0 M Stock Price: $ 10.95 M Volatility: 40% Time to expiry: 1 year Risk-free rate: 5% Gross Option value:$5.95 M Success probability: 50% Net Option value: $2.98 M

Launch in the U.S. Market


Strike Price: $60 M Stock Price: $ 63.57 M Volatility: 40% Time to expiry: 2 years Risk-free rate: 5% Gross Option value:$18.26 M Success probability: 60% Net Option value: $10.95 M

NPV: $1.98 M

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Sensitivity Analysis, Volatility Parameter


Volatility
Develop a Production Process Launch in a Regional Market
Strike Price: $5.0 M Stock Price: $ 9.12 M Volatility: 30% Time to expiry: 1 year Risk-free rate: 5% Gross Option value:$4.37 M Success probability: 50% Net Option value: $2.19 M

Launch in the U.S. Market


Strike Price: $60 M Stock Price: $ 63.57 M Volatility: 30% Time to expiry: 2 years Risk-free rate: 5% Gross Option value:$15.21 M Success probability: 60% Net Option value: $9.12 M

30%
PV, Costs: ($1.0 M) PV, Benefits:: $ 2.19 M

NPV: $1.19 M
Develop a Production Process

Launch in a Regional Market


Strike Price: $5.0 M Stock Price: $ 10.95 M Volatility: 40% Time to expiry: 1 year Risk-free rate: 5% Gross Option value:$5.95 M Success probability: 50% Net Option value: $2.98 M

Launch in the U.S. Market


Strike Price: $60 M Stock Price: $ 63.57 M Volatility: 40% Time to expiry: 2 years Risk-free rate: 5% Gross Option value:$18.26 M Success probability: 60% Net Option value: $10.95 M

40%
PV, Costs: ($1.0 M) PV, Benefits:: $ 2.98 M

NPV: $1.98 M
Develop a Production Process

Launch in a Regional Market


Strike Price: $5.0 M Stock Price: $ 12.79 M Volatility: 50% Time to expiry: 1 year Risk-free rate: 5% Gross Option value:$8.07 M Success probability: 50% Net Option value: $4.03 M

Launch in the U.S. Market


Strike Price: $60 M Stock Price: $ 63.57 M Volatility: 50% Time to expiry: 2 years Risk-free rate: 5% Gross Option value:$21.31 M Success probability: 60% Net Option value: $12.79 M

50%
PV, Costs: ($1.0 M) PV, Benefits:: $ 4.03 M

NPV: $3.03 M

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Modeling the Option Value with the Black-Scholes Method

Inputs Stock Price ($, millions): Volatility (%): Exercise Price ($, millions): Time To Expiry (years): Div idends ($): Risk-free Interest Rate (%): $63.57 The present v alue of the cash flows, or, the v alue of the underlying security 30% The standard dev iation in the present v alue of the project cash flows $60.00 The unrecov erable costs of launching the product in a national market 2.0 The period for which this inv estment opportunity is v alid; proposed delay period for decision $0 The estimated annual cost of preserv ing the option (technical expertise, product dev elopers) 5.00% Two year treasury security yield

Outputs d 1: N(d 1): d 2: N(d 2): Gross Value of the Option: Probability of success: Net Value of the Option: 0.584063363 0.720411205 0.159799294 0.563480421 $15.21 60% $9.12

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Value Drivers for the Option to Delay Launch

Stock Price:

31.20%

Uncertainty

5.98%

Time To Expiry

4.87%

Exercise Price

21.76%

Risk-free Interest Rate

1.97%
% change in option value for a 10% change in value driver

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Valuation Matrix Using the Black-Scholes Call Option Method

NPV Quotient (S/PV(X))


0 0
t

1.0 Invest never

2.0 Invest now

Cumulative Volatility (

Probably never
NP V=

Probably soon

Maybe never 0.5

Maybe later

Source: Timothy Leuhrman, Strategy as a Portfolio of Real Options, Harvard Business Review, Sept.-Oct 1998

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Valuation Matrix Using the Black-Scholes Call Option Method

NPV Quotient (S/PV(X))


0 0
t

1.0 Invest never Invest now


Production process

2.0 1

Cumulative Volatility (

Regional launch

Probably never 0.5

National launch

Probably soon

NP V=

Maybe never 1.0

Maybe later

Source: Timothy Leuhrman, Strategy as a Portfolio of Real Options, Harvard Business Review, Sept.-Oct 1998

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Use of Real Options for Energy Services Product Development

Xcel Energy uses Real Options to estimate the strategic value of initiatives in our new product portfolio, and to plan investments in product development resources, market research, pilots and market trials. By using real options with a structured new product development process, this technique is invaluable for estimating the appropriate investments in successive development phases, and to ensure that we risk only the amount of money justified by the sum of the economic value derived from discounted cash flow analysis and the strategic value derived from real options analysis.

Doug Jaeger Vice President of Sales and Marketing Xcel Energy Corporation

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Monte Carlo Simulation Example


Low Market size: First year sales: Sales grow th rate, years 2-5: Sales grow th rate, years 6-10: Terminal Value grow th rate: Cost of goods sold grow th rate: Operating expenses/sales ratio: Capital investment: Unrecoverable launch costs: Discount rate: Tax rate: Year Sales Cost of goods sold Net Sales Total operating expenses EBITDA Taxes Capital + Launch Cost Operating cash flow NPV, Years 1-10: NPV, including terminal value: IRR: Value of underlying security ($60.0) ($60.0) $0.64 $53.92 22.92% $113.92 $4.0 $5.6 $7.7 $10.6 $14.3 $15.8 $17.5 $19.4 $21.4 $23.7 $197.52 $53.28 $150.0 $12.0 30.0% 10.0% 2.0% 5.0% 20.0% $40.0 $20.0 14% 40% Terminal 1 $12.0 $3.0 $9.0 $2.4 $6.6 $2.6 2 $15.6 $3.2 $12.5 $3.1 $9.3 $3.7 3 $20.3 $3.3 $17.0 $4.1 $12.9 $5.2 4 $26.4 $3.5 $22.9 $5.3 $17.6 $7.0 5 $34.3 $3.6 $30.6 $6.9 $23.8 $9.5 6 $37.7 $3.8 $33.9 $7.5 $26.3 $10.5 7 $41.5 $4.0 $37.5 $8.3 $29.2 $11.7 8 $45.6 $4.2 $41.4 $9.1 $32.3 $12.9 9 $50.2 $4.4 $45.7 $10.0 $35.7 $14.3 10 $55.2 $4.7 $50.5 $11.0 $39.5 $15.8 Value $10.0 10% 0% 1.5% 3% 18% $38.0 $18.0 $14.0 triangular 50% triangular 20% triangular 2.5% lognormal 7% triangular 22% normal $42.0 uniform $22.0 triangular High Distribution all dollar amounts are in millions

Market Share
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003

8.0%

10.4%

13.5%

17.6%

22.8%

25.1%

27.6%

30.4%

33.5%

36.8%

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Simulation Results
Market Share Frequency Distribution
140 120 100
Frequency

Probability that the market share in year 10 is at least 30%: 0.74

80 60 40 20 0 13%

Median: 37.6%% Standard Deviation: 12.7%

18%

24%

29%

35%

40%

45%

51%

56%

62%

67%

72%

Market Share

Internal Rate of Return


140 120
Frequency

Median: 23.35% Standard Deviation: 4.88% Uncertainty, for Black-Scholes Equation: 4.88%/23.35% =

100 80 60 40 20 0 11% 14% 17% 20% 23% 26% 29% 32% 35%

21%

Internal Rate of Return

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What can I use for the estimate of volatility?

General Mills Stock Price Volatility September 2001 - August 2002


60 February 6, 2002 General Mills revises 3Q01 earnings estimate from $0.40-$0.44/sh. to $0.27-$0.29/sh. due to Pillsbury/General Mills sales transition Stock price drops 10% S&P credit outlook revised from stable to negative

50

40

30

20

10

Sources: Chicago Board of Options Exchange, CBS Marketwatch.com 0 Sep-01

Oct-01

Nov-01

Dec-01

Jan-02

Feb-02

Mar-02

Apr-02

May-02

Jun-02

Jul-02

Aug-02

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Benefits for using Real Options and Monte Carlo Simulation for NPD Valuation

Valuable tool for estimating the value of each stage Portfolio optimization Separation of unique risk and market risk Tool for prioritizing activities in each stage Quantify R&D and Market Research expenditures Justify numerous small experiments to produce valuable information Maximize value by building flexibility into plans Resource allocation tool-quickly estimate the value of deferring or accelerating projects Become proficient at recognizing opportunities with high market risk and controllable unique risk

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Reading List

Books Martha Amram and Nalin Kulatika, Real Options: Managing Strategic Investment in an Uncertain World (Boston Mass.: Harvard Business School Publishing, 1998) Avinash K. Dixit and Robert S. Pinkyck, Investment Under Uncertainty (Princeton, N.J.: Princeton University Press, 1994) Lenos Trigeorigis, Real Options, Managerial Flexibility and Strategy in Resource Allocation (Cambridge, Mass.: MIT Press, 1996) F. Peter Boer, The Real Options Solution: Finding Total Value in a High-Risk World (New York, N.Y. John Wiley & Sons, Inc., 2002) Paul Wilmott, Paul Willmot on Quantitative Finance (West Sussex, England, John Wiley & Sons, Inc., 2000) Richard A. Brealey and Stewart Myers, Principles of Corporate Finance fifth edition (New York: McGraw-Hill, 1996) Journal and Magazine Articles Fischer Black and Myron Scholes The Pricing of Options and Corporate Liabilities Journal of Political Economy, May 9 1972 Timothy A. Luehrman, Whats It Worth A General Managers Guide to Valuation, Harvard Business Review May-June 1997 Timothy A. Luehrman, Investment Opportunities as Real Options: Getting Started on the Numbers, Harvard Business Review July-August 1998 Timothy A. Luehrman, Strategy as a Portfolio of Real Options Harvard Business Review September-October 1998 Timothy A. Leuhrman, Capital Projects as Real Options: An Introduction Harvard Business School Case Study 9-295-074 March 22, 1995 Avinash K. Dixit and Robert S. Pindyck, The Options Approach to Capital Investment Harvard Business Review May-June 1995 Keith J. Leslie and Max P. Michaels, The Real Power of Real Options The McKinsey Quarterly 1997 Number 3 Michael E. Edleson, Real Options: Valuing Managerial Flexibility Harvard Business School Case Study 9-294-109 June 4, 1999 Aswath Damodaran, The Promise and Peril of Real Options Stern School of Business web site, adamodar@stern.nyu.edu Michael J. Mauboussin Get Real: Using Real Options in Security Analysis Credit Suisse First Boston, 1999 F. Peter Boer Financial Management of R&D 2002 paper downloaded from www.tigerscientific.com F. Peter Boer Valuation of Techology Using Real Options paper downloaded from www.tigerscientific.com F. Peter Boer Traps, Pitfalls and Snares in the Valuation of Technology paper downloaded from www.tigerscientific.com Peter Coy Exploiting Uncertainty Business Week June 7, 1999 Thomas E. Copeland and Philip T. Keenan Making Real Options Real The McKinsey Quarterly 1998 Number 3 Thomas E. Copeland and Philip T. Keenan How Much is Flexibility Worth? The McKinsey Quarterly 1998 Number 2

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Q&A

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