NPV? Decision Trees? Real Options?

EST581

F. Phillips

A running example• An opportunity requires an investment of $10,000 now, with an assured first-year cash flow of $6,000. The second-year cash flow is uncertain with a 50-50 chance of either a $15,000 gain or a $5,000 loss. • The project can be abandoned at the end of the first year if new information uncovered during this period suggests that the second-year payoff will not be favorable. • Dropping the project at that time involves no salvage value or penalty. • The cost of capital is 10%.

Decision tree for the example

QuickTime™ and a decompressor

are needed to see this picture.

NPV for the example

NPV = -$10,000 + 6,000/1.10 + 5,000/(1.10)2 = -$413

• Negative NPV => Do not make this investment.

Traditional method of adding a “risk premium” to the discount rate:

If risk premium = 5%

Then

Risk-adjusted NPV = -$10K + $6K/1.15 + $5K/(1.15)2 = -$1,001.89

Much worse than before. Notice the formula applies the risk premiummany times - thus • overstating the project risk, and• causing management to reject some good projects.

The NPV didn’t let us use the option of abandoning the project after we got the

additional information. What if it did allow it?

NPV(ABANDON) = -$10,000 + 6,000/1.10NPV(KEEP) = -$10,000 + 6,000/1.10 + 15,000/(1.10)2

NPV(OPTION) = 0.5*NPV(KEEP) + 0.5*NPV(ABANDON) = $1,600. => Make the investment.

Traditional DCF analyses may understate the attractiveness of new product market ventures which typically have high levels of uncertainty associated with early time periods.

Why decision trees are more flexible than NPV

NPV- Pro’s and Con’s• Pros

– Simple and understandable– Easily compare alternative projects/investments– Thus, easy to implement in companies

• Cons– Can’t allow for contingencies– Tends to overstate risks– Can’t address concerns of multiple constituents

Decision Trees: Pro’s and Con’s• Pros

– Allows for contingent actions

– More realistic choice of projects or investments

– Adaptable to concerns of (small # of) constituents.

• Cons– Only good for discrete choices

– More complex than NPV

– Requires more organizational buy-in than NPV.

– Thus, most uses are personal or entrepreneurial.

Options.

Hmm, they sound good.

Let’s learn more about them.

• Option - A right to make a decision in the future• Elements of an option

– An underlying asset– Exercise price (strike price)– Expiration date– European or American form

• Basic options– Call option– Put option

• Financial options• Real options• Complex options

– Contingencies - Option created by some earlier action– Interdependencies - Options with interdependent values

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

An Introduction to Options

Example of a financial option

Value

of Asset

Value of Underlying Asset

Underlying Asset

E

ExpirationValue

Call beforeExpiration

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

The Structure of a Call Option

Buy a Call Write a Call

Loss

Gain

Gain

Loss

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Realized Returns on Options

Simple (Financial) Options: Features

• A bet on the rise or fall of a single stock.

• The option may be:

• To buy a certain number of shares at a certain price and certain date (“put”)

• To sell a certain number of shares at a certain price and certain date (“call”)

• The bet is made by one investor or fund manager.

• I.e., rather simple.

• Simple Financial Options • Put• Call

• Complex Options (Rainbow Options)A single option linked to two or more underlying assets. In order for

the option to pay off, all the underlying assets must move in the intended direction. (www.investopedia.com)

• Real Options

Adapted from ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Kinds of Continuous Options

The Black-Scholes Option Pricing Model

This will notbe on the exam.

Terminology• “Real option” refers to treating a contingent operations

management decision using the same reasoning as for a financial option.

• (Kind of implies that finance isn’t real, ha ha.)• Some people call decision trees a real option technique.

However,• In this class we reserve the term “real options” for analysis

of situations where choice variables (time, money, etc.) are continuous rather than discrete.– Analyzed with variations of the Black-Scholes formula.– Can give some good approximate solutions, but...– ... Assumptions of B-S model do not always hold in operational

situations.

• Opportunities to alter input sourcing, change output mix, or redirect exports to new markets are common in settings of

• multiple markets

• with fluctuating currency values.

• Example: With the devaluation of SE Asian currencies in 1997, Japanese automakers shifted subsidiaries in Thailand and Indonesia

• from production of autos for the local markets

• to production of parts for developed-country markets.

• This flexibility is a major rationale for value creation via the “multinational corporation” model.

Complex Enterprise Decisions

• Defer - Investing now eliminates the option to defer (learning).

• Expand - An option to defer part of the scale of investment.

• Contract - The flexibility to reduce the rate of output.

• Abandon - Stop investing, and liquidate existing assets.

• Staging - Substitute a series of small investments for one large.

• Switching - Re-deploy resources or change inputs (terminate).

• Change Scope - Expand or contract scope.

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Real Options - Some Examples

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4

Extending brand names to new products or marketing through existing distribution channels

Defer

Expand or contract

Abandon

Switch inputs or outputs

Grow

To wait before taking an action until more is known or timing is expected to be more favorable

To increase or decrease the scale of a operation in response to demand

To discontinue an operation and liquidate the assets

To commit investment in stages giving rise to a series of valuations and abandonment options

To alter the mix of inputs or outputs of a production process in response to market prices

Stage investment

To expand the scope of activities to capitalize on new perceived opportunities

ExamplesDescriptionOption

Adding or subtracting to the daily flights on an airline route or adding memory to a computer

When to harvest a stand of trees, introduce a new product, or replace an existing piece of equipment

Discontinuing a research project, closing a store, or resigning from current employment

Staging of research and development projects or financial commitments to a new venture

The output mix of refined crude oil products or substituting coal for natural gas to produce electricity

Examples: More Detail

So, why is NPV still so widely (and exclusively) used?

Survey of High Tech ExecsSurvey Scores: “Reasons Why Your Company Does Not Use the ‘Options’ Method of Valuing Projects or the Decision Analysis Approach (DAA)”

• Perfect information for project evaluations at future points is rarely available (or difficult to obtain). 74 • Operations executives do not like to discontinue their own projects at a future point of evaluation. 70 • All possible ‘options’ cannot be anticipated. 69 • More convenient to obtain complete project funding now, rather than compete for partial funding with other projects in the future. 65 65 • Conservative decision making avoids choosing ‘options’ or alternatives that involve large downside risks. 59 • Existence of entry and exit barriers will not permit project expansion or discontinuance based on DAA. 58 •Employee turnover/re-adjustment problems makes future project expansion/discontinuance difficult. 54 • Process of evaluating a project at each future decision point may incur higher costs. 52 • Project valuation is generally performed by financial rather than operations executives. 52 • DAA is more complex than ROI/NPV. 49

DiscussThe acquisition of a fleet of buses (for example) has

one value to the acquiring company if later decisions about maintenance are made in a certain way, e.g., if the oil is changed at certain intervals,

and a different lifetime value if the oil is changed less frequently or not at all.

If the return on fleet acquisition is allowed to depend on reliable mechanics changing the oil regularly, why are other kinds of project selections made without depending on reliable executives to make the subsequent decisions that maximize the project’s value?

Sources for this lecture

FDI and New Venture Strategy:

Real Option / Strategic Decision Trees Analysis

Compiled by Ted Fu

July 1, 2002

Adapted from

Luenberger: Investment Science

Smith: Entrepreneurial Finance

Click: International Financial Management

Ted Fu

The Evolution of Decision Analysis

By

Ali AbbasAli Abbasaliabbas@stanford.edu

Lecturer

Department of Management Science and Engineering

Stanford University

F. Phillips, Market-Oriented Technology ManagementSpringer, 2001.