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FIN 468: Intermediate Corporate Finance

Topic 12–Real Options

Larry Schrenk, Instructor

Topics

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What is a real option?

Real options exist when managers can influence the size and risk of a project’s cash flows by taking different actions during the project’s life in response to changing market conditions.

Alert managers always look for real options in projects.

Smarter managers try to create real options.

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Introduction to Real Options

Alternative, yet complementary, approach to DCF-based Capital Budgeting.

Many corporate investments (especially “strategic” ones) have embedded options.

Overlooking these options can lead to under-valuing investment projects.

Using Real Options approach can improve project management as well as valuations.

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Types of Real Options

Abandonment Contraction

Temporary suspension Permanent

Switch / Transition Change Product Mix Change Input Mix Technical Obsolescence

Wait / Timing Resolve Uncertainty Identify Demand

Expansion Existing Products New Geographic Markets

Growth New Products R&D

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What is a Real Option?

Traditional discounted cashflow approaches (such as the NPV rule) cannot properly capture management’s flexibility to adapt and revise later decisions in response to unexpected market developments. Traditional approaches assume an expected scenario of cashflows and presume management’s passive commitment to a certain static operating strategy.

The real world is characterized by change, uncertainty and competitive interactions => As new information arrives and uncertainty about market

conditions is resolved, management may have valuable flexibility to alter its initial operating strategy in order to capitalize on favorable future opportunities or to react so as to mitigate losses.

This managerial operating flexibility is like financial options, and is known as Strategic Options, or Real Options.

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Source of value in an option

Financial Options:A call option gives the owner the right, with no obligation, to acquire the underlying asset by paying a prespecified amount (the exercise price, X) on or before the maturity date.

Value of a Call Option on theMaturity Date

Stock Price on the Maturity Date

Source of value in an option: The asymmetry from having the right but not the obligation to exercise the option.

X

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Different types of real options

Occurring naturally. Example: Option to defer a capital investment.

Planned for and created. Example: Option to invest in a new technology-

based service/product, as the result of a successful R&D effort.

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Traditional Approaches To Dealing with Uncertainty and Complexity in Capital Budgeting - 1

Sensitivity Analysis

Considers effect on the NPV of varying one variable at a time. Useful in identifying key drivers in a project.Indicates how large the forecast error on a key driver can be tolerated, before the project becomes unacceptable.

Pro: Easy to implement and understand.

Con: Ignores interdependencies among variables (at a point in time), and over time.

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Traditional Approaches To Dealing with Uncertainty and Complexity in Capital Budgeting - 2

Simulation Steps:

1. Equations specify relationships among variables. 2. Specify probability distribution of underlying variables. 3. Random draws from distributions; compute NPV. 4. Repeat steps 1, 2, and 3 many times.

Pro: Takes into account interdependencies among variables.

Cons: A. Difficult to interpret a distribution of NPVs. Traditional view of NPV as

"increase in shareholder wealth from accepting the project" not applicable.

Solution: Use simulation to assess the distribution of the net cashflows.

B. Problems in specifying interdependencies in step 1. C. Cannot handle well asymmetries in the distributions introduced by

management's flexibility to revise its prior operating strategy as more information about project cashflows becomes available over time: Real Options.

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Traditional Approaches To Dealing with Uncertainty and Complexity in Capital Budgeting - 3

Decision tree analysis

Helps structure the managerial decision problem by mapping out feasible managerial alternatives in response to future events.

Pro: Forces management to recognize its implied operating strategy and the interdependencies between the initial and subsequent decisions.

Cons: A. Number of different paths on the tree increases

geometrically. B. Choice of discount rate: Risk of project may change over

time. (Options based approach circumvents the discount rate problem by constructing a riskfree hedge.)

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Traditional Approaches To Dealing with Uncertainty and Complexity in Capital Budgeting - 4

Traditional capital budgeting procedures cannot properly capture management’s flexibility to adapt and revise later decisions in response to unexpected regulatory/technological/market developments.

The real option techniques can conceptualize and value managerial flexibility to alter its initial operating strategy in order to capitalize on favorable future opportunities or to react so as to mitigate losses.

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Example of Real Options The SuperCom Project:

A large telecommunications company faces an opportunity to invest in an R&D project that will revolutionize the way consumers use telephones, internet, and TV.

Real Options in the SuperCom Project

R&D Stage Commercialization Stage

0 (Years) 3 5 7 T = 15

I1

Ic

Defer( up to 1 year)

IE

I3

ExpandSwitch Use

(Abandon for salvage) Contract( save Ic )

I2

Abandon(forgo I2)

I1: Required investment in the R&D project.

I2: Required investment in the commercial-scale plant, marketing, and distribution - if the R&D effort is successful, and if market conditions are favorable..

I3: Final investment in the project; can be decreased by Ic if the market is weak.

IE: Flexibility in the design of the production process allows for output expansion with an outlay of IE.

V: Gross present value of the completed project’s expected operating cashflows.

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Example of Real Options in the Supercom Project - 1

Option to Defer InvestmentCongress is currently debating the viability and the process by which to allocate or auction the airwaves that are crucial to the commercial success of SuperCom. Our lobbyist in Washington advises us that the debate would be resolved within a year. We could initiate the R&D project immediately, or wait a year to see what Congress does. The option to defer investing in the R&D project is similar to a call option whose value is max (V - I1, 0).

Option to ExpandGiven an initial design choice, management may deliberately favor a more expensive technology for the built-in flexibility to expand production/sales if and when it becomes desirable. If the market’s response to SuperCom is better than expected, management can accelerate the rate or expand the scale of production by x% by incurring a follow-on cost IE. The option to expand has value max (xV - IE, 0).

The option to expand also applies to complementary markets: Investing in SuperCom in a new geographical area allows for the possibility to expand to other similar markets; for example besides local and long-distance tele-communication, the market for telephone-via-internet could be explored in the new geographical area.

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Example of Strategic Options in the Supercom Project - 2 Option to Default during Staged Construction ( Time-to-Build-Option)

Investing in the R&D project, or investing I1, provides the opportunity to invest in the commercial stage by investing I2 or to abandon the project if the R&D and initial test-marketing is unsatisfactory.

Option to ContractIf the market does not respond to SuperCom as expected, management can reduce the scale of operations by c%, thereby saving Ic of the planned investment outlays. This option to mitigate loss has value max (Ic - cV, 0).

Option to Abandon for Salvage ValueIf SuperCom does significantly worse than expected in the market, management may choose to abandon the project permanently in exchange for its salvage value: the resale value of the capital equipment, license, etc. for A. This flexibility to abandon the project has value max (V, A).

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Defer

Expand or contract

Abandon

Switch inputs or outputs

Grow

To wait before taking an action until more is known or timing is expected to be more favorable

To increase or decrease the scale of an operation in response to demand

To discontinue an operation and liquidate the assets

To commit investment in stages giving rise to a series of valuations and abandonment options

To alter the mix of inputs or outputs of a production process in response to market prices

Stage investment

To expand the scope of activities to capitalize on new perceived opportunities

ExamplesDescriptionOption

Adding or subtracting to a service offering, or adding memory to a computer

When to introduce a new product, or replace an existing piece of equipment

Discontinuation of a research project, or product/service line

Staging of research and development projects or financial commitments to a new venture

The output mix of telephony/internet/cellular services

Extension of brand names to new products or marketing through existing distribution channels

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Stock Options

A call option on a stock is the right to buy a share of stock at a pre-specified price (exercise price) within a specified time period (time to maturity).

Thus, a call on Sprint with an exercise price of $22.50 and an expiration date of May 19, 2006 traded at a price of $2.15 at close on Feb. 22, 2006.

The closing price of the stock on that day was $23.80, so if the call had been exercised right away, it would have resulted in a loss. Still the option has value because the stock price might well go up before May 19, 2006.

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Call option

$22.50

Value of Sprint stock at option maturity

Value of call option at option maturity

$27.50

$5.00

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Real options A real option is similar to a stock option. The

primary difference is that the real option is not traded on a market and, often,

The underlying asset may not be traded on a market, either.

Thus, a patent grants the owner an option because s/he has the sole right for a certain amount of time (time to maturity) to develop a product based on the patented idea by investing the necessary capital (exercise price).

The patent may or may not be traded; The underlying asset in this case, is the product

based on the patent. In this case, the underlying asset is not traded, either.

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Importance of Real Options

Real options are pervasive; for example, flexibility usually implies a real option.

Real options have a big effect on firm value where the firm is growing and/or has unique assets.

Real options capture effects that DCF doesn’t. DCF analysis alone misestimates the value of an asset.

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Using real options in M&A

Estimate the value of optionality. The right to take action, the triggering of

which is contingent on some other event. Structure critical thinking about

company values and/or deal design. Even if valuing the options is difficult,

thinking of the transaction in terms of real options can help qualitatively.

Guide negotiation and problem-solving. Helps in deal negotiation and in coming

up with solutions to impasses.

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How to identify an option

An option is a right regarding some other asset or good; can you identify it?

Options give the owner a special right that others do not have. Is this right exclusive to you?

The value of an option derives from the value of an uncertain underlying asset. What is the contingency or uncertainty in this case?

Options are valuable, and are costly to acquire. Was the right costly to acquire?

An option has a finite life.

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Options and opportunities

Option OpportunityThe underlying asset can be identified and is separate from the option

The focus of the opportunity can be identified, but is indistinguishable from the right.

Whether you would exercise the right before expiration is uncertain. The sources of uncertainty are identifiable. The value of the right is contingent.

The value of the opportunity is the value of the underlying asset. Whether you will exploit the opportunity depends on whether the NPV > 0.

Options are exclusive rights. Opportunities are not exclusive rights.Resources are deployed to gain the option

Opportunities are free.

The life of the option is finite and identifiable

Opportunities are often not time constrained

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Example of option Right to start up a business under an

exclusive fast-food franchise that you purchased, that expires within three years unless you own one or more outlets and that requires further spending to exercise. You are the exclusive franchisee in your territory. Whether and where you exercise the right is contingent on the results of a market survey, on zoning rulings by government, and on actions by competitors.

Needs to be valued using real option analysis.

Why is Flexibility Valuable?

It allows one to do something or not do something when such an action adds

value or avoids loss of value

Flexibility Example

Consider a situation where you have two alternatives:

1. Commit right now to a project that will cost $115m in 1 year with certainty but which will produce an uncertain value – a 50-50 probability of either $170m (expected) or $65m (expected)

2. Wait the year before deciding to invest

NPV of Alternative 1

NPV of project based on committing now

= 0.5 x $170m + 0.5 x $65m - $115m _____________________ _____ 1.175 1.08= $100m - $106.5m= -$6.5m

where project cost of capital is 17.5% and risk free rate is 8%.

Therefore reject project. BUT flexibility of delaying decision not valued here so rejection may be wrong decision.

Decision Tree Approach - Alternative 2

t=0

Max[$170m-$115m,$0m] = $55m

Max[$65m-$115m,$0m] = $0m

q = 0.5

1-q = 0.5

t=1

Temptation: Value = (0.5 x $55m + 0.5 x $0m) / 1.175 = $23.4m (Compare with -$6.5m for Alternative 1)

Problem: What is the correct discount rate?

What is Solution?

Use option valuation methodology

Call option : right but not obligation to acquire something by paying predetermined price (exercise price) by or within predetermined time

Put option : right but not obligation to dispose of something for a predetermined price (exercise price) by or within predetermined time

Options

Pay-off diagrams : an option is exercised only if the option holder benefits

Call Option Value

Value of Underlying Asset

Exercise Price

Put Option Value

Value of Underlying Asset

Exercise Price

Call Option in Decision Tree

t=0

Max[$170m-$115m,$0m] = $55m

Max[$65m-$115m,$0m] = $0m

q = 0.5

1-q = 0.5

t=1

$115m $170m

$55m

Payoffs and Flexibility Benefit

State of nature

Payoffs without flexibility (decision made at t=0 to spend $115m at t=1)

Payoffs with flexibility (no decision made until t=1 whether to spend $115m) THESE ARE CALL OPTION PAYOFFS

Flexibility benefit

Up $170m-$115m = $55m Max[$170m-$115m,0] = $55m $0m

Down $65m-$115m = -$50m Max[$65m-$115m,0] = $0m $50m

Real Options

Option to defer commitment to project with defined start-up date until the last possible moment - deferral option based on European call option.

Option to start project within specified period by incurring cost of start-up - American call option.

Option to abandon project for a fixed price - American put. Option to expand project by paying defined amount to scale up operations

- American call. Option to contract (scale back) involvement in project by selling portion

of it at set price - American put. Option to extend life of project by expending specified amount -

European call option. Option to switch between two modes of operation (for example, on and

off) by paying fixed associated costs of so doing - portfolio of put and call options.

Compound options which permit flexibility in sequential developments. Rainbow options which permit multiple types of uncertainty.

Option Value Determinants

Variable Impact of Increase on Value of Call Option

Impact of Increase on Value of Put Option

Value of underlying asset

Positive Negative

Exercise price Negative Positive

Time to expiration Positive Positive

Volatility of asset value Positive Positive

Interest rate Positive Negative

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Investment Opportunities as Collections of Real Options

Justification of the options analogy.

Can the standard techniques of valuing options on the basis of a no-arbitrage equilibrium, using portfolios of traded securities to replicate the payoff to options, be justifiably applied to capital budgeting where projects may not be traded?Answer: Yes! The computation of NPV requires calculation (assumption) of a discount rate: The required return on an asset (that is traded in the capital markets) of similar risk as the project.

From a practical standpoint: Calculating real option values is non-trivial.

The Real Value in Real (Strategic) Options!

From option pricing theory we know that the value of a call option increases with Increase in variance of the underlying asset. Increase in the value of the underlying asset. Increase in the time to expiration. Increase in the riskfree rate. Decrease in the exercise price.

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Limitations of the options analogy1. Exclusiveness of Ownership and Competitive Interaction:Financial call option on a common stock is proprietary; only the owner can exercise it without worrying about competition for the underlying security. Some real options (patents, licenses) are also proprietary. Other real options are shared and can be exercised by any firm in the particular industry: Examples: Opportunity to penetrate a new geographic market.

Opportunity to introduce a new product unprotected by possible introduction of close substitutes.

2. Nontradability and Preemption:Financial call options are traded with minimal transaction costs. Real options are not generally traded. Non-tradability of real options may lead to its early exercise: A firm anticipating increase in industry demand - and hence subsequent competitive entry - may rush to expand its own production/sales capacity early to preempt competition. In the absence of such competition it might have preferred to wait for the uncertainty surrounding future demand to resolve itself.

3. Strategic Interdependencies and Option Compoundness:Financial call options are simple: their value derives entirely from the received shares of the stock. Some real options (such as, maintenance or standard replacement projects) are simple. Other real options are compound: R&D investments, Expansion into a new geographic market. Compound real options may have a more strategic impact on firm value, than simple real options, and are more complicated to analyze. Compound real options must be looked at not as independent projects but rather as links in a chain of interrelated projects, the earlier of which may be prerequisites for those to follow.