The Entrepreneur’s Process of Designing and Evaluating
Financial Contracts by Simulation
Model the venture and the
Include a structure embedded real options
and a contractual framework for allocating
of cash flow to each party.
Specify the assumptions and
uncertainties, including terms for
exercising the options:
Use a specific contract structure and terms
and assumptions for exercising the real
options. Assumptions should reflect the
effects of the contract on information or
Revise the model to Run the simulation: Revise the model to
consider alternative Generate estimates of each party’s consider alternative
mutually exclusive expected total and conditional cash flows financial contract
real options. and corresponding standard deviations. assumptions.
Value the expected cash flows:
Use the appropriate valuation models to
value the claims of each party.
Holding the allocation of financial claims
constant, search for the option-exercise
decisions that result in highest value:
Exclude option exercise assumptions that
are dominated by others.
Search for the allocation of financial
claims that results in highest value:
Also, exclude any structures of contract
terms that would not offer sufficient
returns to attract outside investment.
The result is the entrepreneur’s
Created on 2/1/2007 12:24:00 PM