Real Options Thinking

1
Real Options Thinking

• IOM580
• Hiroshi Ochiumi

2
Traditional NPV Analysis

• Discounts future cash flows to their present
  value.
• In 1970, 57 of large corporations were using NPV
  calculations to determine the profitability of
  major investment decisions.
• In 1980, 86
• Today, NPV is the standard.
• It took corporate America 20 years to replace
  payback with NPV.

3
Traditional NPV Analysis

• Sophisticated versions can handle
• Uncertainties
• Contingent decisions
• Varying discount rate

4
Example Regressive Insurance Co.

• Regressive has the opportunity to purchase a
  license to sell insurance in China. The cost of
  this license is 10 million.
• Need to pay an additional 50 million to develop
  the market.
• 20 chance of a huge success profit of 100
  million.
• 80 chance of failure loss of 70 million
• NPV - 96, reject the project.
• Really?

5
NPV undervalues investments when..

• There are options embedded in the investments to
• Delay or defer making the investment
• Abandon a project (for a price)
• Scale back a project
• Expand a project into a new market or products
• Extend the life of a project
• Switch between two modes of operation
• Depending on the outcomes at early stages.

6
Real Options

• Flexibilities have values.
• We should be paying a premium on NPV estimates.
• A bad investment (according to NPV) can actually
  be a good one.

7
Bidding for a lease on Government-owned coal lands

• Estimated
• Future price of coal
• Quantity of coal in the ground
• Extraction costs
• Consider the value of option to defer, and bid
  more aggressively.

8
Airbus told customers..

• The value of being able to change the size of the
  aircraft within a family (and other
  configurations) up to 12 months before delivery
• Airbus can negotiate more effectively.

9
Real Options Analysis

• Oil Field Development
• Major RD
• New Product Development under Uncertainty
• Breakthrough type
• Pharmaceutical Research

10
Early Adopters

• Airbus valuing delivery options
• Apple exit decision for pc business
• Enron new product development
• Exxon oil exploration
• HP production and distribution
• Smith Nephew funding research

11
When Managerial Flexibility is Valuable

• High Uncertainty about the Future
• Likely to receive new information over time
• High Room for Managerial Flexibility
• Allows management to respond appropriately to
  this new information
• NPV without flexibility is near zero
• The greater the volatility, the greater the value
  of the flexibility (option)

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How to Compute the Value of Flexibility

• Fairly Complex
• Stochastic Differential Equation
• Black-Scholes