Real Options

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Real Options
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Option Theory and Investment Decisions

• Traditional investment analysis uses the NPV rule
  to decide on investment projects
• The concept of net present value uses expected
  cash flows, discounted at a constant discount
  rate which is assumed to capture the risk of
  these cash flows
• Making investment decisions based on a projects
  NPV is equivalent to assuming that the firms
  managers have no ability to respond to
  uncertainty (no managerial flexibility)

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Option Theory and Investment Decisions

• Example Suppose that a firm will invest 600m
  over the next two years (250m this year and
  350m next year) to build a new factory with a
  life of 20 years
• Suppose that revenues from this factory will be
  80m starting 3 years from now and grow at 8
  annually and that the costs to run the factory
  will be 60m (also staring 3 years from now) and
  grow at 6
• Assume for simplicity that there are no working
  capital investments, no taxes, no salvage value,
  and that the firm will use straight-line
  depreciation starting two years from now

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Option Theory and Investment Decisions

• If the firms WACC is 10, this projects NPV is
  -1.44m so we reject the project
• The above analysis may fail to capture some
  aspects of the project
• The initial investment takes place in stages and
  can be abandoned at each
• If the project goes well, perhaps it can be
  expanded or extended
• If it goes bad, perhaps it can be scaled back or
  sold at a floor price
• Perhaps there is the option to delay building the
  factory for some time

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Option Theory and Investment Decisions

• Example Suppose that you are given the choice to
  put 1 in a toy bank that guarantees 1.05 a year
  later with certainty
• This offer is good for only one year
• Alternatively, interest rates in a real bank are
  currently at 10
• How much is the toy bank offer worth?

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Option Theory and Investment Decisions

• Real options are options that give the right to
  make decisions on a capital investment project
• Real options are American options
• A limitation of traditional investment analysis
  is that it is static, meaning that it does not do
  a good job capturing the value of options
  embedded in a project
• One can go as far as arguing that the NPV rule
  systematically undervalues every project

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Option Theory and Investment Decisions

• These options add value to a project and may
  change a projects NPV from negative (under
  traditional analysis) into positive
• Projects value NPV Value of option

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Types of Real Options

• Option to delay a project (Deferral option)
• Option to expand or to extend a project
• Option to abandon a project
• Option to contract a project
• Option to scale back a project
• Switching options
• Compound options
• Rainbow options

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The Option to Delay a Project

• If a firm has exclusive rights to a project or a
  product for a specific period, it can delay
  taking the project or introducing the product
  until a later date
• A project that has a negative NPV today may have
  a positive NPV at some future date
• The reason is that expected cash flows and the
  discount rate may change through time, meaning
  there are changes in the business environment

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The Option to Delay a Project

• This resembles a call option (deferral option)
  where
• The underlying asset is the project
• The strike price is the investment needed to take
  the project
• The life of the option is the period that the
  firm can delay undertaking the project
• The value of the option increases with the
  volatility in the business environment

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The Option to Delay a Project
NPV of project
Initial investment
PV of cash flows from accepting the project
Loss of rights to the project
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The Option to Expand a Project or Take Other
Projects

• Taking a project today may allow a firm to expand
  the project or consider taking other projects in
  the future
• The value of this option may change the NPV of a
  project
• These call options are called strategic options
• Example Honda, Toyota, GM, Ford are investing in
  cars with hybrid engines, which, despite current
  losses, gives them the option to gain
  technological and production expertise to produce
  an eco-car profitably in the future

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The Option to Abandon a Project

• A firm may have the option to abandon a project
  if the cash flows from the project do not match
  the firms expectations
• If abandoning the project allows the firm to save
  itself from further losses, then this put option
  increases the value of the project and makes it
  more attractive
• Firms try to build such options in the contracts
  signed with other parties involved in a project

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Other Types of Real Options

• Switching Real Options are portfolios of call and
  put options that allow their owner to switch at a
  fixed cost between two modes of operation
• Example the option to shut down a manufacturing
  plant when demand is low and reopen it when
  demand picks up (General Motors assembly plants)
• Compound real options are options on options
  typically found in phased investment projects

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Other Types of Real Options

• Example The decision to build a chemical plant
  may involve three phases a design phase, an
  engineering phase and construction
• At each phase, the firm has the option to stop or
  defer the project
• Thus, each phase is an option that depends on the
  earlier exercise of another option
• Rainbow options are options driven by multiple
  sources of uncertainty (e.g., exploration and
  development)

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Value of Real Options

• The value of real options depends on
• Expected present value of cash flows from project
• Exercise price (Investment Outlay)
• Time to expiration (Time to defer)
• Uncertainty (volatility) of projects present
  value
• Risk-free rate

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Value of Managerial Flexibility
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Decision Trees

• Decision Tree Analysis is useful for applying
  binomial pricing methods to (real) options
• Decision trees are used to analyze projects that
  involve sequential decisions
• If the decision made today affects the decision
  that we are able to make tomorrow, then we should
  analyze tomorrows decision before we act today

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Decision Trees

• Example Suppose that Delta Airlines is
  considering offering shuttle service between
  Champaign and Cincinnati for two years
• Future demand for this service is uncertain and
  the company must make a decision today of what
  type of plane to buy
• Suppose that there is a 60 chance that demand
  for this service will be high and 40 chance that
  it will be low after the service is initiated
• If demand is high, there is a 75 chance that
  subsequent demand will also be high

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Decision Trees

• However, if demand is low, the chance of
  subsequent demand being high drops to 25
• The firm has two choices of planes to purchase
• A small jet costs 1.5m and can handle large
  capacity
• A prop plane costs 0.25m, but it cannot fully
  handle capacity
• Operating costs are higher for the jet plane
• If demand is high in the first year, the firm
  might consider buying another prop plane before
  the second year for 0.25m
• The projects decision tree looks as follows

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High (.75) 2000
High (.6) 2000
Decision Tree For Delta
Low (.25) 300
High (.25) 2000
Purchase Jet -1500
Low (.4) 300
Low (.75) 300
High (.75) 1500
Expand (-250)
Low (.25) 400
High (.75) 1000
Purchase Prop -250
Dont expand
High (.6) 1000
Low (.25) 500
High (.25) 1000
Low (.4) 500
Low (.75) 500
Decision node
Chance node