Lecture 6 Real Options Basics

8/2/2019 Lecture 6 Real Options Basics

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Copyright 2007 Pearson Addison-Wesley. All rights reserved. 22-3

A simple example

Assume Megan is financing part of her MBA education byrunning a small business. She purchases goods on eBayand resells them at swap meets.

Swap meets typically charge her $500 in advance to setup her small booth. Ignoring the cost of the booth, if shegoes to every meet, her average profit on the goods thatshe sells is $1100 per meet.


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Megans Choices


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Effect of the Weather on Megans Options


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Megans Decision Tree When She Can Observe the Weather Before

She Makes the Decision to Go to the Meet


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Real Options

If Megan commits to go regardless of the

weather, her expected profit is $1100.

0.75

$1500 + 0.25

($100) = $1100

However, if she goes only when the weather is

good, her expected profit is $1125.

0.75 $1500 + 0.25 $0 = $1125

The value of the real option is the difference, $25.


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Real option

The real option approach is the extension of

financial option theory to options on real assets

There is a great value in breaking up large projects

in stages taken in uncertain markets Uncertainty creates opportunities (NPV >0)

Many strategic investments create subsequent

opportunities that may be taken

The investment opportunity can be viewed as a

stream of cash flow plus a set of options.


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RO assumptions

There is uncertainty

Management has flexibility

Flexibility strategies are credible and executable

Management is rational in executing strategies

Important concepts

Market risk; It is correlated with the general movements of the economy and

industry this uncertainty is exogenous to the decision. Incentive to defer

investments.

Private risk; Endogenous to the decision. It can be resolved by making aninvestment in exploration a learning option. It gives incentive to divide the

investment stage forward.

9


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Four classes of real options

Option to expand

Option to abandon

Option to defer

Option to vary output/input and production methods


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Option to Defer

A company holds lease on valuable land or

resources

Wait to see ifoutput prices justify

constructing a building or a plant

Important for resource extraction, real estate

development, farming, forest management

etc.


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Option to abandon

If market conditions decline severely,

management can abandon current operation

permanently and realize resale value and other

assets in secondary markets Important for capital-intensive industries (airlines,

railroads) financial services, and new product

introduction


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Option to expand

An early investment (R&D) may be a link (aprerequisite) in a chain of interrelated projects,

opening up future growth opportunities

Important for infrastructure-based industries(high-tech), multiple product industries,

multinational operations, FDI.


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Option to change input/output and production process

If prices or demand change, management canchange the output mix of facility (productflexibility)

Alternatively, the same outputs can beproduced using different types of inputs(process flexibility).

Important for consumer electronics, toys,machine parts, autos, electric power,chemicals, crop switching, etc


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Common Embedded Real Options

Option to defer

Time-to-build option (Staged investment)

Option to alter operating scale (e.g. to expand; to

contrast; to shut down and restart)

Option to abandon

Option to switch (e.g. outputs or inputs)

Growth options Multiple interacting options


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When to use real options

When there is a contingent investment decision

When uncertainty is large enough to wait for more

information and to make flexibility a consideration

When the value depends highly on future growthand future prices

When there will be project updates and strategy

corrections


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Options Call Option

Gives the buyer of the option the right to buy the underlying asset

at a fixed price.

Put Option

Gives the buyer of the option the right to sell the underlying asset

at a fixed price

Exercise price (Strike price)

The price the holder of an option has the right to sell/buy a

specified quantity of an underlying asset (share)

Share price

The value of the underlying share

Value of option

The price one pays for the option.


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In the money and out of the

money

A call option is in the money if share price isabove exercise price

A call option is out-of-money if the shareprice is below the exercise price. The price isdefined by future expectations on changes in

share price.

For the owner of a put the opposite holds


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19

B-S Valuation of a European Call

The Value of a European Call Option on a Stock:

2))(/ln(

1TXPVSd

Tdd

12 Where

andX = Exercise Price,T = Years to expiration,

= Annualized Standard Deviation of the Natural Logarithm of the Stock Return,

ln() = represents the natural logarithm

N(z) = the probability that a normally distributed variable with a mean of zero and variance of 1 is less than zX = Exercise Price,

T = Years to expiration,

= Annualized Standard Deviation of the Natural Logarithm of the Stock Return,

ln() = represents the natural logarithm

N(z) = the probability that a normally distributed variable with a mean of zero and variance of 1 is less than z

()(21

NXedSNcTrf


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How changes in option variables influence the

value of the option

Variable Changeinvariable

Change invalue for acall option

Change in valuefor a put option

Share Price (S) + + -Strike price (exerciseprice) (k)

+ - +

Years to maturity (t) + + +

Risk in underlyingasset () + + +

Risk free interest rate(rrf)

+ + -

Dividends + - +


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A common option A real option to

defer

A real option to

expand

The share price

S

the present value of

expected cashflow

from initiating the

project

The net present value

of the cash flow from

the original project

Strike price

k

The initial

investment

The initial

investment of the

expanding project

Years to maturity

t

The option expires

when the right to the

project lapse

The option expires

when the right to the

expanding project

lapse

Risk in underlying

asset

the variance (risk) in

the expected cash

flow

The variance in the

expected cash flow

from the expanding

project

The risk freeinterest rate

rrf

the risk free interestrate corresponding to

the length of the

option

the risk free interestrate corresponding to

the length of the

option

Dividends Cost of delay = the

cash flow that will be

lost because delaying

the project

Most often not

concidered


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Comments on different variables

The higher the variance the higher the value of the option

The value of an option in a stable business will be less than the value

of one in an environment where technology, competition and

markets are changing rapidly

When you give up your option to wait, you can no longer take

advantage of the volatility of the projects future value The arguments against NPV is that it is always a now or never

decision.

Investment made after the right to expire are assumed to deliver a

NPV of zero value, mainly because increased competition.


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Strategy and real option

Finance theory and traditional approaches to strategic planning maybe kept apart by differences in language and culture

Discounted cash flow analysis may have been misused, and

consequently not accepted, in strategic applications

Discounted cash flow analysis may fail in strategic applications even if

it is properly applied. Myers, Interfaces 14 Jan-Feb. 1984

smart managers

CAN REAL OPTION VALUATION BRIDGE THE CAP BETWEEN FINANCE

AND STRATEGY


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Options as a strategic tool

Waiting Does the opportunity materialize?

Given uncertainty managers are likely to make

small investments rather then a large, risky,investment.

Striking

To wait for the correct moment The arrival of the opportunity (the option is unfolded)

The expiration signal


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Downside risk and inertia

Options reduce downside risk

Sunk costs produces a pressure to hold on to old

investment

There is an optimal inertia

Conclusion:

Firms with bundles of options will grow

aggressively in upcoming markets and persistlonger in difficult markets


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Perceived environment uncertainty

The higher the environmental risk the higher

the value of an option

In high risk environment options are hold open

for a longer period

Conclusion:

Organization that hold options during instable

period and strike option in stable periods willshow superior long-term growth


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The size and timing of organisational

investments

Experience and learning

Small steps followed by a large strike

Conclusion:

Organizations that enter new business and

markets by linking investments, so that small

options are followed by a large strike will

perform better than those entering in discretesmall or large investments


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The size and timing of organisational

investments

Two signals (see earlier slide) The end of wait and see period The imminent closure of the option

Conclusion: The optimal strike is to wait for both signals:

that is when the opportunity has clearly arrived and the valueof waiting is at lowest

A final conclusion, linking options and strategy:Organizations entering new areas will achieve superior

growth and performance by striking small investments and tohold options open and follow with a large strike investmentupon both signals.


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Irreversible costs (sunk cost)

An investments economic life span is dependent

on the amount of irreversible costs included.

The abandon, and defer option will therefore beof high importance.

Example


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Investment as a Call Option

Assume you have negotiated a deal with a

major restaurant chain to open one of its

restaurants in your hometown.

The terms of the contract specify that you must

open the restaurant either immediately or in exactly

one year.

If you do neither, you lose the right to open the restaurant

at all.


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Restaurant Investment Opportunity


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How much you should pay for this opportunity?

It will cost $5 million to open the restaurant, whether youopen it now or in one year.

If you open the restaurant immediately, you expect it togenerate $600,000 in free cash flow the first year.

Future cash flows are expected to grow at a rate of2% per year.

The cost of capital for this investment is 12%.


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If the restaurant were to open today, its value would be:

This would give an NPV of $1 million. $6 million $5 million = $1 million

Given the flexibility you have to delay opening for one year, whatshould you be willing to pay?

When should you open the restaurant?

$600,000$6 million

12% 2%V


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The payoff if you delay is equivalent to the payoff of a one-year European call

option on the restaurant with a strike price of $5 million.

Assume

The risk-free interest rate is 5%.

The volatility is 40%.

If you wait to open the restaurant you have an opportunity cost of

$600,000 (the free cash flow in the first year).

In terms of a financial option, the free cash flow is equivalent to a

dividend paid by a stock. The holder of a call option does notreceive the dividend until the option is exercised.


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Table


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The current value of the asset without the dividends

that will be missed is:

The present value of the cost to open the restaurant in

one year is:

$0.6 million

( ) $6 million $5.46 million1.12

x

S S PV Div

$5 million( ) $4.76 million

1.05PV K


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The current value of the call option to open the

restaurant is:

1

2 1

ln[ / ( )] ln(5.46 / 4.76)0.20 0.543

2 0.40

0.543 0.40 0.143

xS PV K T

d

T

d d T

1 2( ) ( ) ( )

($5.46 million) (0.706) ($4.76 million) (0.557)

$1.20 million

xC S N d PV K N d


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The value today from waiting to invest in the restaurant

next year (and only opening it if it is profitable to do so)

is $1.20 million.

This exceeds the NPV of $1 million from opening the

restaurant today. Thus, you are better off waiting to

invest, and the value of the contract is $1.20 million.


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What is the advantage of waiting in this case?

If you wait, you will learn more about the likely

success of the business.

Because the investment in the restaurant is not

yet committed, you can cancel your plans if the

popularity of the restaurant should decline. By

opening the restaurant today, you give up thisoption to walk away.


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Whether it is optimal to invest today or in one

year will depend on the magnitude of any lost

profits from the first year, compared to the

benefit of preserving your right to change yourdecision.


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Option to expand, a software example

Investment in a project called Blue Eye 1, a software application.

1982 1983 1984 1985 1986 1987

FCF -200 +60 +59 +195 +310 +125

(after tax)

Initial -250

investment

CF -450 60 59 195 310 125

K = 20%

NPV = -46.45 -$46


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Investing in Blue Eye 1 includes a call option to expand. It gives the opportunity to

make follow-on investment which could be extremely profitable. The option on the

second project Blue Eye 2 is therefore worth a lot.

Assume for Blue Eye 2:

1. It must be made after 3 years (1985)

2. It is double the scale of Blue Eye 1 and requires an initial investment of

$900 (exercise price)

3. Forecasted cash flow from Blue Eye 2 has a PV of $800 in 1985:(800/1.23 = $463 in 1985)

4. The future value of Blue Eye 2 is highly uncertain. The value evolves like

the companys stock price with a standard deviation of 35%.

5. The annual interest rate is 10% (risk free)


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The option value for Blue Eye 1 (the value of Blue Eye 2)

The opportunity to invest in Blue Eye 2 is a three year calloption on an asset worth $463 million with a $900 million

exercise price

59.53$6761767.04633739.0valueCall1767.0,3739.0

9279.0606.03216.0

3216.02/606.0606.0/685.0log

2///log

valueCall

6761.1

900)priceexercise(

21

12

1

21

3

dNdN

tdd

ttEXPVPd

EXPVdNPdN

PV



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The value for Blue Eye 1 with option to abandon equals

-$46.45 + $53.59 = $7.14

Invest in Blue Eye 1

Investing in Blue Eye 2 gives new options in Blue Eye 3 and

so on.

Documents

Lecture 6 Real Options Basics