Question

Explain Discounted Cash Flow (DCF) method of project evaluation. Explain how real options can be lorated into project evaluation.

Answer 1

Discounted cash flow method estimates the future cash flows from a project and uses a discounting rate to arrive at the net present value of the project. It discount rate usually is the opportunity cost of the project or cost of capital/ equity. The inflows of the project are discounted and deducted from the present out flow to arrive the net present value. If the NPV is positive the project must be accepted and if it is negative it must be rejected.

Real options in investment decisions is allowing the use of decision tree, a binominal analysis or Black Scholes model in project evaluation. It considers the use of options such as postponement of the project, abandon the project , expansion of a project , the wait option, the option to switch and the costs related with the same. It is complementary to NPV analysis.