Getting Started

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Chapter 1

• Getting Started

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Chap 1 --- Getting Started

• We take value creation as a companys objective,
  through its investments in real assets.
• On the make-or-break investments that are
  strategic in nature.
• We want it to be a useful tool that shows how to
  use Real Options Analysis ( ROA ) in enough
  detail that todays managers, most of whom are
  familiar with the use of a personal computer, can
  work through a problem from start to finish and
  fully understand the results.

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• Estimating the NPV without flexibility,
• Modeling the uncertainties that drive the
  value of the investment,
• Putting decision nodes into the event tree that
  is built to reflect the uncertainties, and
• Valuing the real options using a replicating
  portfolio approach

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An analogy - Getting from here to there

• Turnpike theorem, which says that its preferable
  to go a little out of your way to take advantage
  of higher speed paths.
• Using your expected route no detours, no
  traffic jams, no bad weather no ability to
  respond to uncertainty.
• There are at least five different types of
  managerial flexibility to respond to
  uncertainties.

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Definition of a real option

• A real option is the right, but not the
  obligation, to take an action ( e.g., deferring,
  expanding, contracting, or abandoning ) at a
  predetermined cost called the exercise price, for
  a predetermined period of time the life of the
  option.
• We would go so far as to say that NPV
  systematically undervalues every project.
• 1. The value of the underlying risky asset,
  a project, investment,
• or acquisition.
• 2. The exercise price.
• 3. The time to expiration of the option.
• 4. The standard deviation of the value of
  the underlying risky
• asset.
• 5. The risk-free rate of interest over the
  life of the option.
• The sixth variable is the dividends that may
  be paid out by the underlying asset the cash
  outflows or inflows over its life.

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• It seems that Thales read the tea leaves and
  interpreted them as forecasting a bountiful olive
  harvest that year.

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• The underlying risky asset was the rental value
  of the olive presses.
• The driving cause of the uncertainty was the
  variability of the olive harvest, but the actual
  variable of interest ( the underlying risky asset
  ) was the standard derivation of the value of the
  rental fee on the olive presses.
• The exercise price was the normal rental rate, a
  value that had been written into the contract.
• The risk-free rate was, presumably, an observable
  market rate.
• And the time to maturity was the time until the
  olive harvest.
• The value of the option was the money that Thales
  paid to the owners of the presses his lifes
  savings.

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• You have the opportunity to buy a toy bank that
  allows you to put in a dollar today and
  guarantees you 1.05 with absolute certainty a
  year later if you do. The offer is good for one
  year. However, interest rates at real bank are 10
  percent right now. How much is the toy bank worth?

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Real options dictionary

• A call option where the price of the underlying
  is above the exercise price so that an immediate
  profit could be made by exercising the option is
  said to be in-the-money.
• Conversely, if the price of the underlying is
  below the exercise price the option is
  out-of-the-money.
• Options that can be exercise only on their
  maturity date are called European options. Those
  that can be exercised any time during their life
  are called American options.
• There are also boundary conditions called caps
  and floors that bound the value of the underlying.

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Taxonomy of real options

• Real options are classified primarily by the type
  of flexibility that they offer.
• For example, an option is just what it seems to
  be - the right, but not the obligation to invest
  in a project at a later date.
• A deferral option is an American call option
  found in most projects where one has the right to
  delay the start of a project. Its exercise price
  is the money invested in getting the project
  started.
• The option to abandon a project for a fixed price
  ( even that price decrease through time ) is
  formally an American put.
• So is the option to contract ( scale back ) by
  selling a fraction of it for a fixed price.

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• The option to expand a project by paying more to
  scale up the operations is an exercise price is
  also an American call.
• Switching options are portfolios of American call
  and put options that allow their owner to switch
  at a fixed cost ( or costs ) between two modes of
  operations.
• There are also options on options, called
  compound options. Phased investments fit into
  this category.
• Options that are driven by multiple sources of
  uncertainty are called rainbow options.
• Most real options are affected by uncertainty
  regarding the price of a unit of output, the
  quantity that might be sold, and by uncertain
  interest rates that affect the present value of
  the project.
• Many real-world applications require modeling as
  compound rainbow options.

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Real options are everywhere war stories

• First, isnt the option value of managerial
  flexibility always positive and consequently
  isnt the use of real option just an attempt to
  justify projects that should be turned down?
• First, the appropriate mind-set is to recognize
  that the net present value technique
  systematically undervalues everything because it
  fails to capture the value of flexibility.
• And second, while the value of flexibility is
  always positive, the price that you have to pay
  for it often exceeds its value.

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• The second question is, when is the use of real
  options likely to change the answer a lot?
• Real options have the greatest value when three
  factors come together.
• When there is high uncertainty and when managers
  have flexibility to respond to it, real options
  are important. But the value of real options
  relative to NPV is large when the NPV is close to
  zero, in the gray area.
• If the NPV is high, then most options that
  provide additional flexibility will have a very
  low probability of being exercised, and therefore
  have low relative value.
• If the NPV is extremely negative, no amount of
  optionality can rescue the project.

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Deferral call option

• Having a deferral option, allowing them to
  postpone their development decision until the
  price of coal increased enough to make them
  relatively certain that they could recover their
  development costs before the price turned around
  and fell again.
• Node that this example illustrates a fundamental
  difference between NPV and ROA that will be
  discussed in detail later on.
• Real options analysis combines them into a single
  present value a go or no go decision today
  with a decision rule about when to develop the
  lease.

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American put option a cancelable operating lease

• The lease could be canceled either redelivery or
  for a period of time after delivery of the
  aircraft a walk-away option.
• If he stopped offering the cancellation feature.
• Subsequently, we segmented the market into
  categories based on the variability of estimated
  operating income, which in turn depends on the
  variability of passenger revenue miles.
• The jet engine manufacturer decided to stop
  offering the cancellation feature to these
  airlines where the value of the cancellation
  feature was greatest, preferring to lose their
  business to competitors.

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Opening and closing mines switching options

• Switching options are the right to close an
  operation that is currently open by paying fixed
  shutdown costs and the right to open it later for
  a different fixed cost to a common type of
  option, actually a portfolio of puts and calls.
• Application of switching options in mining. Not
  only does the real options approach reveal the
  added value from the ability to close then reopen
  the mine, but it also provides rules of thumb
  about when to do so.
• Real options approaches to this problem show that
  the flexibility to shut down and reopen adds
  value to the mine, adds more value if the
  switching costs are low, and tells the mining
  company exactly what trigger prices to use for
  optimal operation.

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Phased investment in a chemical plant a
compound option

• A real option approach viewed the project as a
  series of compound options each option
  depending on the exercise of those that preceded
  it.
• Thus Phase II is a call option that is contingent
  on Phase I.
• Many executive decisions are made in phase
  without recommitment to undertake all phases
  regardless of how uncertainties that drive the
  value of the project might evolve.

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Exploration and developmentA compound rainbow
option

• Compound rainbow options are perhaps the most
  realistic and the most complex real options that
  we will show you how to value.
• But they cover a wide and important class of
  decision In addition to exploration and
  development, they are useful for research and
  development, and new product development
  decisions.

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• The speed and capacity of personal computers have
  advanced so rapidly that only recently have
  managers had at their disposal enough
  easy-to-access computer power to bring realism
  and transparency to the table.
• Now we realize that real options can be applied
  to almost any situation where it is possible to
  estimate the understand and to value real options
  for many realistic applications including those
  that are compound options and that have multiple
  sources of uncertainty.

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Conclusion

• Real options analysis values the flexibility to
  respond to uncertain events net present value
  techniques do not and consequently undervalue
  everything.