| Summary: | This dissertation discusses the application of real options theory in estimate of intrinsic value of a small high-growth software company which has great uncertainties on the strategic project. Traditionally, discounted cash flow (DCF) models are most commonly used in capital budgeting. However, it is argued that DCF models fail to account for the managers' ability to alter the course of investment over time responding to the new information, thus they are likely to underestimate strategic investment. By introducing real option theory and option pricing models, it becomes intuitive to use real options analysis to calculate a project's embedded option value.
Besides the application in capital budgeting, the real options analysis could also be used in the company valuation. By identifying the real options embedded on the strategic investment and adding the real options values to the firm's NPV value without flexibility, the intrinsic value of a company can be revealed. This dissertation adopts a case study methodology and demonstrates how real options analysis is used to investigate the value of a target company TMIC, a software company in the Forbes Global List of "The 200 Best Small Companies". In conclusion, real option analysis has not been accurate enough in valuing companies; but they provide a better approach than DCF valuation.
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