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This book aims to introduce readers to the fascinating world of real options and its applications in corporate finance problems. I start with simple models to introduce the basic math and then consider problems which add realistic features. Throughout, I provide guidance on how to actually implement the models in Excel^TM using Visual Programming for Applications (VBA). I start with the simple option to decide on the timing of investment which was introduced in the literature by McDonald and Siegel (1986). This model is without any financing considerations. I then focus on a model introduced by Leland (1994) which analyzes capital structure (financing) decisions and the option of equity holders to time default. This model, does not however consider an investment option. Then, the two frameworks are combined to study the option to invest and the optimal financing of the option to investment. This model is essentially the model analyzed by Mauer and Sarkar (2005). I show how they have also analyzed agency conflicts arising from equity holders choice of investment timing that does not cater for debt holders’ interests. The book also provides an introduction to pricing within finite horizon models using the binomial tree.

I aim to extend future extensions of the book generalizing the previous mentioned frameworks to consider two stages of investments and lumpy financing, consider the interesting implications of priority rules of debt and agency considerations between the claimholders (see Hackbarth and Mauer, 2012). I also plan to introduce readers to compound options using binomial trees. The plan is also to add models with multiple stochastic variables and introduce readers to simulation in option pricing.

References

Hackbarth, D., & Mauer, D. C. (2012). Optimal priority structure, capital structure, and investment. The Review of Financial Studies, 25(3), 747-796.

Leland, H. E. (1994). Corporate debt value, bond covenants, and optimal capital structure. The journal of finance, 49(4), 1213-1252.

McDonald, R., & Siegel, D. (1986). The value of waiting to invest. The quarterly journal of economics, 101(4), 707-727.

Mauer, D. C., & Sarkar, S. (2005). Real options, agency conflicts, and optimal capital structure. Journal of banking & Finance, 29(6), 1405-1428.

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