Category: Modern comic book investing
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asset strategies and funds of funds. The report targets the core business of asset owners and asset managers, namely, their investment activities. Many people are familiar with the idea of angel investors from the television show which has annual revenues of about $ billion. (C) To promote policies and practices conducive to economic freedom and private sector development. (D) To attract foreign direct investment capital to. INVESTING IN SHARES FOR BEGINNERS PDF VIEWER
Many investment returns are based on continuous compounding which grows a bit faster than annual compounding. For situations involving continuous compounding, use The Rule of is used to figure out how long it will take for an investment to triple in value. It follows the same process as the Rule of As with the Rule of 72, the Rule of is an approximation.
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Feel free to learn more at www. If the asset rises in value, the net payoff from investing increases. If the value declines, the company can decide not to invest and will lose only what it has spent to obtain the investment opportunity.
As long as there are some contingencies under which the company would prefer not to invest, that is, when there is some probability that the investment would result in a loss, the opportunity to delay the decision—and thus to keep the option alive—has value. The question, then, is when to exercise the option.
The choice of the most appropriate time is the essence of the optimal investment decision. Recognizing that an investment opportunity is like a financial call option can help managers understand the crucial role uncertainty plays in the timing of capital investment decisions. With a financial call option, the more volatile the price of the stock on which the option is written, the more valuable the option and the greater the incentive to wait and keep the option alive rather than exercise it.
Recognizing that an investment opportunity is like a financial call option clarifies the role of uncertainty. The same goes for capital investment opportunities. The greater the uncertainty over the potential profitability of the investment, the greater the value of the opportunity and the greater the incentive to wait and to keep the opportunity alive rather than exercise it by investing at once.
Of course, uncertainty also plays a role in the conventional NPV rule—the fact that a risk is nondiversifiable creates an uncertainty that is added on to the discount rate used to compute present values. But in the option view of investment, uncertainty is far more important and fundamental. A small increase in uncertainty nondiversifiable or otherwise can lead managers to delay some investments those that involve the exercising of options, such as the construction of a factory.
In addition to understanding the role of irreversibility and uncertainty, it is also important to understand how companies obtain their investment opportunities their options to invest in the first place. Sometimes investment opportunities result from patents or from ownership of land or natural resources.
In such cases, the opportunities are probably the result of earlier investments. Such resources enable the company to undertake in a productive way investments that individuals or other companies cannot undertake. Irreversibility and Uncertainty in Everyday Life The decisions that individuals face in their personal lives do not typically involve billions of dollars. In many cases, the highest costs and the biggest benefits are emotional. Examples of large-scale mistakes are legendary.
In the s, many bright students chose physics as an exciting and rewarding career, only to find that a surplus of physicists developed in the s. The option view suggests appropriate caution. First, it suggests proceeding in steps. As one acquires that information and gathers more data about the likely career prospects in medicine versus, say, chemical engineering, one can gradually fine-tune decisions about the appropriate direction. Second, one should not take the final and irreversible plunge into a very specialized line unless the rate of return to the investment is sufficiently greater than the cost, with high enough rewards to justify killing the option of flexibility.
Marriage is another decision that can be analyzed in the same manner. It is costly to reverse, and there is significant uncertainty about future happiness or misery. Therefore, one should enter into it with due caution and only when the expected return is sufficiently high. The criteria should become stiffer as the social costs of separation increase: for example, in some religions or cultures. Even if the expected return is not very high, one should be willing to undertake courtship because it creates a valuable option—namely the opportunity but not the obligation to follow up or not to, according to the information revealed by the initial steps.
Regardless of where a company gets its options to invest, the options are valuable. Indeed, a substantial part of the market value of most companies can be attributed to their options to invest and grow in the future, as opposed to the capital they already have in place. That is particularly true for companies in very volatile and unpredictable industries, such as electronics, telecommunications, and biotechnology. Most of the economic and financial theory of investment has focused on how companies should and do exercise their options to invest.
But managers also need to understand how their companies can obtain investment opportunities in the first place. To illustrate the implications of the option theory of investment and the problems inherent in the traditional net present value rule, let us work through the process of making a capital investment decision at a hypothetical pharmaceutical company.
Suppose that you are the CEO of a company considering the development and production of a new drug. Both the costs and the revenues from the venture are highly uncertain. You realize that later, if you decide to continue the project, additional money will have to be invested in a production facility.
To focus on the question of how uncertainty and option values modify the usual NPV analysis and to keep the example simple, we will also assume that the time frame is short enough that the usual discounting to reflect the time value of money can be ignored.
First, let us analyze the problem by using a simple NPV approach. The expected value i. So the conventional thinking would kill the project at the outset. After learning about the cost, you would be able to make a decision to go ahead and continue the project or to drop it.
In the other two cases, however, you will proceed. You can exercise it selectively when doing so is to your advantage, and you can let it lapse when exercising it would be unprofitable. Now let us reintroduce the notion of uncertainty with regard to the expected revenue.
But suppose you can postpone the production decision until you have found out the true market potential. By waiting, you can choose to go ahead only if the revenue is high, and you can avoid the loss-making case where the revenue turns out to be low. Here the opportunity to proceed with production is like a call option. Making a go-or-no-go decision amounts to exercising that option. If you can identify some eventualities that would cause you to rethink a go-ahead decision such as a drop in market demand for your product , then the ability to wait and avoid those eventualities is valuable: The option has a time value or a holding premium.
Instead, you should wait until the option is deeper in the money—that is, until the net present value of going ahead is large enough to offset the loss of the value of the option. In this example, we have intentionally left out any explicit cost of waiting. But you can easily include potential waiting costs in the calculation.
The reason is that the option itself is valuable. You can exercise an option selectively when the action is to your advantage, or you can let it lapse when such a course would be unprofitable. Again, the extra value gain depends on the sizes and the probabilities of the losses you are able to avoid. It is even possible to put the revenue uncertainty and the cost uncertainty together. All of the numbers in this pharmaceutical example were chosen to facilitate simple calculations.
But the basic ideas represented in the case can be applied in a variety of real-life situations. And insofar as there is a positive probability that production would be unprofitable, building the plant rather than waiting exercises an option. The option theory of investing also has clear implications for companies attempting to raise capital. If financial market participants understand the nature of the options correctly, they will place greater value on the investments that create options, and they will be more hesitant to finance those that exercise options.
It is interesting to note that this is exactly what has been going on recently in the biotechnology industry as it has progressed from searching for several new products to trying to exploit the few it has found. But we believe that, to a large extent, the market is making an astute differentiation between the creation of options and the exercising of options. As companies in a broad range of industries are learning, opportunities to apply option theory to investments are numerous.
Below are a few examples to illustrate the kinds of insight that the options theory of investment can provide. Investments in Oil Reserves. Nowhere is the idea of investments as options better illustrated than in the context of decisions to acquire and exploit deposits of natural resources. A company that buys deposits is buying an asset that it can develop immediately or later, depending on market conditions.
The asset, then, is an option—an opportunity to choose the future development timetable of the deposit. A company can speed up production when the price is high, and it can slow it down or suspend it altogether when the price is low. The U. The sums involved are huge—an individual oil company can easily bid hundreds of millions of dollars. It should not be surprising, then, that unless a company understands how to value an undeveloped oil reserve as an option, it may overpay, or it may lose some very valuable tracts to rival bidders.
Depending on the current price of oil, the expected rate of change of the price, and the cost of developing the reserve, he might construct a scenario for the timing of development and hence the timing and size of the future cash flows from production. He would then value the reserve by discounting these numbers and adding them together. Because oil price uncertainty is not completely diversifiable, the greater the perceived volatility of oil prices, the higher the discount rate that he would use; the higher the discount rate, the lower the estimated value of the undeveloped reserve.
But that would grossly underestimate the value of the reserve. And note that, just as options are more valuable when there is more uncertainty about future contingencies, the oil reserve is more valuable when the price of oil is more volatile. The result would be just the opposite of what a standard NPV calculation would tell us: In contrast to the standard calculation, which says that greater uncertainty over oil prices should lead to less investment in undeveloped oil reserves, option theory tells us it should lead to more.
By treating an undeveloped oil reserve as an option, we can value it correctly, and we can also determine when is the best time to invest in the development of the reserve. Developing the reserve is like exercising a call option, and the exercise price is the cost of development. The greater the uncertainty over oil prices, the longer an oil company should hold undeveloped reserves and keep alive its option to develop them. Scale Versus Flexibility in Utility Planning. The option view of investment can also help companies value flexibility in their capacity expansion plans.
Should a company commit itself to a large amount of production capacity, or should it retain flexibility by investing slowly and keeping its options for growth open? Although many businesses confront the problem, it is particularly important for electric utilities, whose expansion plans must balance the advantages of building large-scale plants with the advantages of investing slowly and maintaining flexibility.
Economies of scale can be an important source of cost savings for companies. By building one large plant instead of two or three smaller ones, companies might be able to reduce their average unit cost while increasing profitability. Perhaps companies should respond to growth opportunities by bunching their investments—that is, investing in new capacity only infrequently but adding large and efficient plants each time. But what should managers do when demand growth is uncertain, as it often is?
When the growth of demand is uncertain, there is a trade-off between scale economies and the flexibility that is gained by investing more frequently in small additions to capacity as they are needed. Electric utilities typically find that it is much cheaper per unit of capacity to build large coal-fired power plants than it is to add capacity in small amounts. But at the same time, utilities face considerable uncertainty about how fast demand will grow and what the fuel to generate the electricity will cost.
Adding capacity in small amounts gives the utility flexibility, but it is also more costly. As a result, knowing how to value the flexibility becomes very important. The options approach is well suited to the purpose. The utility faces uncertainty over demand growth and over the relative prices of coal and oil in the future.
Even if a straightforward NPV calculation favors the large coal-fired plant, that does not mean that it is the more economical alternative. The reason is that if it were to invest in the coal-fired plant, the utility would commit itself to a large amount of capacity and to a particular fuel. In so doing, it would give up its options to grow more slowly should demand grow more slowly than expected or to grow with at least some of the added capacity fueled by oil should oil prices, at some future date, fall relative to coal prices.
By valuing the options using option-pricing techniques, the utility can assess the importance of the flexibility that small oil-fired generators would provide. Utilities are finding that the value of flexibility can be large and that standard NPV methods that ignore flexibility can be extremely misleading. A number of utilities have begun to use option-pricing techniques for long-term capacity planning.
Among other things, the company has used option-pricing techniques to show that an investment in the repowering of a hydroelectric plant should be delayed, even though the conventional NPV calculation for the project is positive.
It has also used the approach to value contract provisions for the purchase of electric capacity and to determine when to retire a generating unit. Commodity prices are notorious for their volatility. Copper prices, for example, have been known to double or drop by half in the space of several months. Why are copper prices so volatile, and how should producers decide whether to open new mines and refineries or to close old ones in response to price changes?
The options approach to investment helps provide answers to such questions. Investment and disinvestment in the copper industry involve large sunk costs. Building a new copper mine, smelter, or refinery involves a large-scale commitment of financial resources. Given the volatility of copper prices, managers understand that there is value to waiting for more information before committing resources, even if the current price of copper is relatively high.
As we showed in the earlier pharmaceutical example, a positive NPV is not sufficient to justify investment. The price of copper and, correspondingly, the NPV of a new copper mine must be high enough to cover the opportunity cost of giving up the option to wait. The same is true with disinvestment.
Once a mine, smelter, or refinery is closed, it cannot be reopened easily. As a result, managers will keep these facilities open even if they are losing money at current prices. They recognize that by closing a facility, they incur an opportunity cost of giving up the option to wait for higher future prices.
Thus many copper mines built during the s, when copper prices were high, were kept open during the mids, when copper prices fell to their lowest levels in real terms since the Great Depression. Given the large sunk costs involved in building or closing copper-producing facilities and given the volatility of copper prices, it is essential to account for option value when making investment decisions.
In reality, copper prices must rise far above the point of positive NPV to justify building new facilities and fall far below average variable cost to justify closing down existing facilities. Outside observers might see that approach as a form of myopia. We believe, however, that it reflects a rational response to option value. Understanding option value and its implications for irreversible investment in the copper industry can also help us understand why copper prices are so volatile in the first place.
Corporate inertia in building and closing down facilities feeds back into prices. Suppose that the demand for copper rises in response to higher-than-average GNP growth, causing the price of copper to rise. Knowing that the price might fall later, producers typically wait rather than respond immediately with new additions to capacity.
Since greater supply is not readily forthcoming, the pressure of demand translates into rapid increases in price. Similarly, during downturns in demand, as mines remain open to preserve their options, the price collapses. Recent history has illustrated this phenomenon: The reluctance of producers to close mines during the mids, when demand was weak, allowed the price to fall even more than it would have otherwise.
Thus the reaction of producers to price volatility in turn sustains the magnitude of price volatility, and any underlying fluctuations of demands or costs will appear in an exaggerated way as price fluctuations. The economic environment in which most companies must now operate is far more volatile and unpredictable than it was 20 years ago—in part because of growing globalization of markets coupled with increases in exchange-rate fluctuations, in part because of more rapid technology-induced changes in the marketplace.
Whatever its cause, however, uncertainty requires that managers become much more sophisticated in the ways they assess and account for risk. Ultimately, options create flexibility, and, in an uncertain world, the ability to value and use flexibility is critical. More readily than conventional calculations suggest, managers should make decisions that increase flexibility. Choices that reduce flexibility by exercising options and committing resources to irreversible uses construction of specific plants and equipment, advertising of particular products will be valued less than their conventional NPV.
Such choices should be made more hesitantly—and subjected to stiffer hurdle rates than the cost of capital—or delayed until circumstances are exceptionally favorable. The bottom line for managers is that learning how to apply the net present value rule is not sufficient. To make intelligent investment choices, managers need to consider the value of keeping their options open.
For an overview of financial options and their valuation, see John C. Stoll and Robert E.
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