Real Options & Decision Making by Ramabhadran S. Thirumalai

Real Options & Decision Making

Ramabhadran S. Thirumalai

Indian School of Business

Agile Carnival, ChandigarhMay 8, 2016

Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up

Agenda

1 IntroductionCapital BudgetingOption Types

2 Real Options

3 Option to Defer

4 Option to Abandon

5 A Four-Step Process

6 Wrap-Up

Ram Thirumalai Real Options

Agile Carnival 2 / 16


A capital budgeting example• XYZ Pharma Ltd. is looking to make an additional R&D

investment of |10 billion for a cure to cancer.

• If the additional investment results in a breakthrough cure(probability of 0.05), the future net inflows are worth |200billion at the end of year 1.

• If the additional investment fails (probability of 0.95), thefuture net inflows are worth zero at the end of year 1.

• The discount rate is 30%.

• Traditional capital budgeting would say:

NPV =0.05× 200 + 0

1.30− 10 = −2 billion⇒ Reject the

project.




A capital budgeting example . . . 2

• However, since this has significant implications for the healthof its citizens, the government agrees to pay the company |20billion if the additional investment fails.

• Does this change the decision?

• NPV =0.05× 200 + 0.95× 20

1.30− 10 = 12.31 billion⇒

Accept the project.

• Value of option = 12.31−−2 = 14.31 billion.







• NPV =0.05× 200 + 0.95× 20

1.30− 10 = 12.31 billion⇒

Accept the project.








• NPV =0.05× 200 + 0.95× 20

1.30− 10 = 12.31 billion⇒

Accept the project.





Options contract

• Option: It gives the holder the right to trade the underlyingasset at a stated price (called the exercise or strike price).

I Right to buy: call.I Right to sell: put.

• Option in the previous example: call or put? It is a put as itgives the company the right to “sell” the project to thegovernment and receive the guaranteed amount if theadditional investment is a failure.

• Can be viewed as insurance contracts.




Options contract



• Option in the previous example: call or put?

It is a put as itgives the company the right to “sell” the project to thegovernment and receive the guaranteed amount if theadditional investment is a failure.





Options contract








Options contract








Why real options?• Traditional valuation assumes that there is no uncertainty in cash

flows and projects are irreversible.• Ignoring options will lead to incorrect valuation and hence wrong

decisions.• The decision to invest is an option itself, which need not be

decided right away.I For example, project may be unattractive if price drops by 10% in a year’s

time but may be lucrative if price increases by 5% in a year’s time. Sowait for a year (to resolve uncertainty in price) before deciding to acceptor reject the project.

• Flexibility is valuable and cannot be ignored.

• Definition: A real option is an alternative or choice that isavailable or becomes available with a business investmentopportunity.




Why real options?• Traditional valuation assumes that there is no uncertainty in cash

flows and projects are irreversible.• Ignoring options will lead to incorrect valuation and hence wrong

decisions.• The decision to invest is an option itself, which need not be

decided right away.I For example, project may be unattractive if price drops by 10% in a year’s

time but may be lucrative if price increases by 5% in a year’s time. Sowait for a year (to resolve uncertainty in price) before deciding to acceptor reject the project.

• Flexibility is valuable and cannot be ignored.• Definition: A real option is an alternative or choice that is

available or becomes available with a business investmentopportunity.




Why real options? . . . 2

• Common examples of real options (from “Real Options” by LenosTrigeorgis):

I Option to defer: company holds a lease on or an option to buy valuableland. Typical in oil extraction, mining and real-estate industries.

I Staged investment: each stage may be viewed as an option on thesubsequent stages. Typical in start-up, R&D-intensive andenergy-generating industries.

I Option to alter operating scale: expand, contract, shutdown and restart.Typical in consumer goods, mining and fashion apparel industries.

I Option to abandon: sell all capital assets. Typical in capital-intensiveindustries.

I Option to switch: change output mix or produce same output usingdifferent inputs. Typical in toy industries, automobile.

I Even football clubs have real options: whether to hire players from school,when to fire them, when to promote them to second team and full team.



























































Option to defer

• Decide right now whether to precommit to a project that willcost $115 million next year.

• This produces cash flows of $170 million or $65 million, with aprobability of 0.50 each.

• The alternative is to wait until the end of the year to decide.

• Risk-free rate is 8% and the discount rate is 17.5% for theproject.




Option to defer . . . 2

• NPV =0.5× 170 + 0.5× 65

1 + 0.175− 115

1.08= −6.48 million.

• Reject the project.

• Alternatively, if you wait a year, the uncertainty is resolved.I If “good” state occurs, payoff = max (170− 115, 0) = 55.I If “bad” state occurs, payoff = max (65− 115, 0) = 0.I You will invest only in the “good” state. This is a simple call option.

I NPV =0.5× 55 + 0.5× 0

1 + 0.175= 23.40.

I Value of option to defer = 23.40−−6.48 = 29.88 million.





• NPV =0.5× 170 + 0.5× 65

1 + 0.175− 115

1.08= −6.48 million.

• Reject the project.• Alternatively, if you wait a year, the uncertainty is resolved.

I If “good” state occurs, payoff = max (170− 115, 0) = 55.I If “bad” state occurs, payoff = max (65− 115, 0) = 0.I You will invest only in the “good” state. This is a simple call option.

I NPV =0.5× 55 + 0.5× 0

1 + 0.175= 23.40.






• NPV =0.5× 170 + 0.5× 65

1 + 0.175− 115

1.08= −6.48 million.

• Reject the project.• Alternatively, if you wait a year, the uncertainty is resolved.

I If “good” state occurs, payoff = max (170− 115, 0) = 55.I If “bad” state occurs, payoff = max (65− 115, 0) = 0.I You will invest only in the “good” state. This is a simple call option.

I NPV =0.5× 55 + 0.5× 0

1 + 0.175= 23.40.





Option to abandon: An example• A company is looking at a new project.• The current investment for the project is |550 million.• If the project succeeds, the project will generate |150 million in

annual cash flows in perpetuity.• If the project fails, the project will generate |50 million in

annual cash flows in perpetuity.• Success and failure are equally likely.• The management has the option to terminate the project at

the end of the first year and sell all equipment and assets for|400 million.

• What is the value of this option to the company?• What type of an option is this: call or put?• A discount rate of 20 percent is appropriate for all cash flows.




Example . . . 2

• First step: what is the NPV without the option to abandon?

• If the project is a success,NPV = −550 + 150/0.20 = 200 million

• If the project is a failure,NPV = −550 + 50/0.20 = −300 million

• Expected NPV = 0.5× 200 + 0.5×−300 = −50 million




Example . . . 2








Example . . . 2








Example . . . 2








Example . . . 3

• Now assume that the abandonment option exists.

• Payoff at end of year 1 if project is a success =max (400, 150/0.20) = 750 million

• NPV at time 0 if project is a success =−550 + (750 + 150) / (1 + 0.20) = 200 million

• Payoff at end of year 1 if project is a failure =max (400, 50/0.20) = 400 million

• NPV at time 0 if project is a failure =−550 + (400 + 50) / (1 + 0.20) = −175 million

• Expected NPV = 0.5× 200 + 0.5×−175 = 12.5 million

• Value of option = 12.5− (−50) = 62.5 million




Example . . . 3











Example . . . 3











Example . . . 3











Example . . . 4

• This is a put option because the company has the right to sellits assets if the project is a failure.




A four-step process

• Compute base case NPV without flexibility using traditionaldiscounted cash flow methodology.

• Model the uncertainties using trees.I This is NOT a decision tree.I This step allows you to get a better understanding of the

uncertainties that drive the value of the project through time.I In other words, you build a tree that shows how the project value (of

base case) evolves over time.I Using a Monte Carlo simulation will help in building this tree.




A four-step process . . . 2

• Identify the managerial flexibilities and incorporate them in thetree built in the previous step.

I Now the tree is a decision tree.

• Value the real option.I Most difficult step!




Wrap-up

• Real options are valuable and cannot be ignored.

• Factoring them could change the decision to accept/reject theproject.

• These options are valuable only if they help resolve uncertainty.

• These options have positive value i.e., including them in NPVcalculations will increase NPV.



Economy & Finance

Real Options & Decision Making by Ramabhadran S. Thirumalai