Options

1
Options

• Last session The 5 steps
• This lecture Options
• workshop
• presentation 12.4
• Midstage reports and exam form
• Next

2
CMK.20 Options

• If investors were riskneutral we could discount
  risky cashflow using the riskfree rate, but they
  are not !
• Hence risky inflows minus certain outflows (NPV)
  does not work
• if you use risk-adjusted probabilities you can
  discount using the risk free rate, alternatively
  discount using a risk adjusted interest rate, but
• NPV assumes constant risk i.e. a passive
  management in a static world !

3
CMK.20 Options

• Decision Tree Analysis decides AFTER information
  is received (ctr. event tree) but what discount
  rate to use ?
• there is no single, constant discount rate
  because it changes with time (info) and
  underlying conditions (risk)
• Options are truely dymanic and find their
  discount rate in a comparable security
• the risk on an option on an underlying risky
  asset is always greater than the risk on the
  asset
• hence DTA uses too low an interest rate giving
  too high value estimates

4
CMK.20 Options

• Options takes care of flexibility and of
  uncertainty that is gradually solved over time.
  They presume decisiontaking in the future,
  contingent on the arrival of new information and
  learning, not now - based on expectations of
  future informations
• operating real option is the value of flexibility
• growth option is the value of sequential
  interdependency
• there are asset options and liability options
  e.g.

5
CMK.20 Options

• Options to
• abandon (put) resale /liquidation value
• defer (call) development costs
• expand (call) expansion costs
• contract (put) contraction costs
• switch (putts and calls) restruc Shutdown c.
• non ordinary equity
• lease
• Of value when
• uncertainty is high
• adaptiveness is high see exh.20.1

6
CMK.20 Options

• Exhibit 20.4
• NPV -6,5 - without flexibility
• DTA 23,4 - with flexibility
• the value of the option can be approximated to
  the diff. 29,6
• the true optionvalue calculated on a twinn
  security gives an option value of 20,9 6,5
  27,4

7
6 optionvalue drivers
8
CMK.20 Options

• Event tree (no flexibility) models the evolution
  of uncertainty in the different possible NPV
  events over time. Use expected values risk
  adjusted interest rates OR risk adjusted
  probabilities risk free rate
• Decision tree (with flexibility) have decision
  nodes added and hence improves the positive
  value path in the event tree
• 4 steps in option evaluation(exh.20.10)
• base case without uncertainty and flexibility,
  using DCF
• event tree with uncertainty, but still no flex.
  (use objective probabilities and WACC)
• use flexibility in a decision tree analysis
• calculate option value (evt.using option risk
  rate)

9
Luehrman Investment opportunities

• The correspondance between project
  characteristics and the option value drivers
  shows us, that deferral has two value elements
  to be included
• earning the timevalue of money on the postponed
  exercise price X, (X-PV(X))
• the world may change/ is uncertain
• ad1. NPV S-X where S is stock value
• modifiedNPV S-X(X-PV(X))S-PV(X)
• converted to a ratio to handle it easier
  NPVqS/PV(X)
• ad2. Measure uncertainty by assessing probability
  and let the option-pricing model quantify the
  value. The measure is cumulative variance in
  returns but we utilize the square root of this
  called cumulative volatility

10
Luehrman Investment opportunities

• These two metrics combine the 5 option variables
  into two dimensions (see p.55) called Option
  space
• Option space is priced via a table (see p.56)
• How to do in 7 steps (p.58)

11
Luehrman Strategy as options

• Use the two option value metrics ( NPVq and
  cumulative volatility) to locate the project in
  the option space to obtain the effect of
  uncertainty and active decision making
• The tomato garden metaphor divides the garden in
  6 regions, giving us 6 possible actions instead
  of just two (invest/ not invest) - also taking
  the likelihood of the projekcts future attraction
  into consideration.
• Never (6) and Now (1) combined with sure, maybe,
  and probable. (se p.94).
• This is a dynamic approach where time moves the
  opportunity upwarrd and to the left, and active
  management can move it back

12
Kasanen Trigeorgis

• Strategic investment planning
• how to design proper controls consistent with the
  value-max strategy
• to create and manage a collection of
  opportunities giving a growth path (strategic
  investment mix)- controlled via ROA and growth.
• 3 strategic sources of value
• flexibility (operating real options)
• synergy between projects
• sequential project interdependencies (growth
  options)