Welcome everyone to a fifth week of our corporate finance course. We've done a great job in the previous four weeks in analyzing investment projects. We studied the cash flows, we talked about risk, we've applied the universal NPV criterion. At the end of last week, we have come up with the way the average cost of capital formula, and it seems that we are close to be all set. However, there is one important thing that we haven't talked about before but that plays a crucial role in the correct analysis of investment projects. What is this? Well, we have to deal with change. Now, what do we mean by change? Because change is, to an extent, a buzzword, too. Well, I'll put it here, change. When we talked about investment portfolios, we said that investors hold some portfolios of stocks, bonds, and other instruments, and they just move together with the market. So this is sort of a passive approach. When however, you talk about management of investment projects in a company, you take a more active approach and you can change something when the project unfolds. What is this? Well, first of all, I will point this out that this is sort of active management. Now, what else? Remember, we talked at the very beginning of this course about the fact that when we put the time, a moment now or zero that is moving, we said that that value arise from the future. And even if we wait for some time, then still, there is going to be a lot of unknown in the future, and we will never be able to wait long enough to remove this uncertainty. However, information does arrive when the time goes by and some of this information may not only be important but crucial in our measures in this active management. So, I will put it, information arrival. And taken together, that leads us to the following idea. Well, what if in this process of the project management, when the new information arrives, we have the choice of changing something? Well, when this is taken to the extreme, let's say, we have the choice to stop the project altogether or we have the choice to enlarge the project. So, all this leads us to the idea of some benefits of making decisions in the future. Let me give you an example. Let's say, you started to build a plant and six months have passed. And well, you may not stop building this plant. It seems to be a very bad decision because if you stop building it, let's say, you started to just build the building itself, and then you just started to order equipment. So, you clearly cannot produce a penny of cash flow with this unfinished land. But what if six months from now, you will have learned that the product that you planned to produce at this plant is going to be obsolete by the time you will have completed the plan? So, you will not generate anything but losses. In this case, you can see that proceeding or being, let's say, stubborn with finishing this plant building may be a very bad idea. You may, well, write off these losses, but if you have the ability to stop that at this point in time, that's a very important and potentially valuable option. Now having said all that, I produced or pronounced the word option for the first time but all that leads us to this fundamental idea of an option. That, as many believe, is the key idea of modern finance. Now, when we hear the word option, most immediately, the people start talking about listed options and trade it at the Chicago Board of Options Exchange, for example. And then immediately, they may recall some of the very advanced math formulas that they used in the option valuation and that they know that this is sort of really something very much difficult and that requires advanced math background. Now, we will deal with options only to the extent we need to understand them and understand how people value them in the application to real investment projects. I will say a few words about some other areas where options play the key role, but we are limited with our ability to proceed with really very much advanced approach that requires this very hard math. Now, in general, I have to say right now that in option valuation there is a dilemma. There are two ways. One is sort of a more journalistic way, a more descriptive way in which we just talk about how all that works and do not produce any valuation formula. The other approach is to proceed with advanced math, and then on this path, we clearly are sort of stuck because that requires a dense background. Now, I will try to avoid these two pools but instead, we will use some math when it is absolutely required. We will not go that far away and when we will see where that leads, we will then go in a little bit more descriptive way. So that way, we will be able to kill two birds with one stone namely, we will come up with some understanding and also some way of how we can lead, how we can get a number and not only just the idea of that. This is in general valuable or not. So from now on, I will wrap up this introductory episode and starting with the next one, we will talk about options in some more detail just because, like I said, this is not only the most important idea in modern finance but also because we will see how that contributes to the value of investment projects.
