binomial(model(in(( real(op/ons(analysis(
TRANSCRIPT
![Page 1: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/1.jpg)
Binomial Model in Real Op/ons Analysis
Jenny Zhou Opera/ons Research
November 21, 2008
![Page 2: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/2.jpg)
November 21, 2008 Jenny Zhou 2
Problems with tradi/onal capital budge/ng methods mo/vate ROA
Invest!
Abandon!
Invest!
Net present value The binomial model
Real op/ons analysis (ROA)
![Page 3: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/3.jpg)
November 21, 2008 Jenny Zhou 3
I inves/gate the applica/on of the binomial model in valuing real op/ons
Real Op/ons
Binomial model in ROA example
Assessment of ROA
![Page 4: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/4.jpg)
November 21, 2008 Jenny Zhou 4
Assessment of ROA
I inves/gate the applica/on of the binomial model in valuing real op/ons
Real Op/ons
Binomial model in ROA example
![Page 5: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/5.jpg)
November 21, 2008 Jenny Zhou 5
A real op/on is the right (not obliga/on) to undertake some business decision �
• Types of real op/ons include – Op/on to invest – Op/on to wait – Op/on to expand – Op/on to contract
![Page 6: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/6.jpg)
November 21, 2008 Jenny Zhou 6
A real op/on is the right (not obliga/on) to undertake some business decision � GM’s plant development project
GM wants to build a factory that produces fuel efficient cars. The project costs $60 million immediately for permits, which take a year. At the end of the year, GM could invest $400 million to complete the design phase. Once the design phase is over, GM has a two-‐year window during which it can invest the $800 million needed to build the plant.
Ques5on
Which types of real op/ons can you iden/fy?
![Page 7: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/7.jpg)
November 21, 2008 Jenny Zhou 7
A real op/on is the right (not obliga/on) to undertake some business decision � GM’s plant development project
GM wants to build a factory that produces fuel efficient cars. The project costs $60 million immediately for permits, which take a year. At the end of the year, GM could invest $400 million to complete the design phase. Once the design phase is over, GM has a two-‐year window during which it can invest the $800 million needed to build the plant.
We can iden/fy the following real op/ons in this project – GM has an op/on to invest $400 million in Year 1
– GM has the op/on to wait in Year 2. – GM has the op/on to invest $800 million in Year 3
![Page 8: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/8.jpg)
November 21, 2008 Jenny Zhou 8
Assessment of ROA
I inves/gate the applica/on of the binomial model in valuing real op/ons
Real Op/ons
Binomial model in ROA example
![Page 9: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/9.jpg)
November 21, 2008 Jenny Zhou 9
Recall the three step process of the binomial model
0
1
-1
2
0
-2
3
1
-1
-3
Yr 1 Yr 2 Yr 0 Yr 3
Step 1
Construct a tree describing all possible states
#H-#T
![Page 10: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/10.jpg)
November 21, 2008 Jenny Zhou 10
Recall the three step process of the binomial model
0
1
-1
2
0
-2
3
1
-1
-3
Yr 1 Yr 2 Yr 0 Yr 3
Step 2
Make decisions at the end nodes of the tree
Accept!
Accept!
Decline!
Decline!
$300
$100
$0
$0
Decision rule
$100(#H-#T) > 0 Accept
Otherwise Decline
![Page 11: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/11.jpg)
November 21, 2008 Jenny Zhou 11
Recall the three step process of the binomial model
0
1
-1
2
0
-2
3
1
-1
-3
Yr 1 Yr 2 Yr 0 Yr 3
Step 3
Calculate value of game at each earlier node
Accept!
Accept!
Decline!
Decline!
$300
$100
$0
$0
$182
$45
$0
$103
$21
$56
![Page 12: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/12.jpg)
November 21, 2008 Jenny Zhou 12
I will apply a similar three step process to evaluate GM’s plant development project� GM’s plant development project
GM wants to build a factory that produces fuel efficient cars. The project costs $60 million immediately for permits, which take a year. At the end of the year, the GM could invest $400 million to complete the design phase. Once the design phase is over, GM has a two-‐year window during which it can invest the $800 million needed to build the plant.
Ques5on
What is a possible source of uncertainty?
![Page 13: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/13.jpg)
November 21, 2008 Jenny Zhou 13
I will apply a similar three step process to evaluate GM’s plant development project� GM’s plant development project
GM wants to build a factory that produces fuel efficient cars. The project costs $60 million immediately for permits, which take a year. At the end of the year, GM could invest $400 million to complete the design phase. Once the design phase is over, GM has a two-‐year window during which it can invest the $800 million needed to build the plant.
One source of uncertainty is the possible future values of the plant under plausible market scenarios.
![Page 14: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/14.jpg)
November 21, 2008 Jenny Zhou 14
Assume plant is worth $1 billion if it existed today and moves +20% or -‐16.7%
1000
1200
833
1440
1000
694
1728
1200
833
579
Yr 1 Yr 2 Yr 0 Yr 3
Step 1
Construct a tree describing all possible plant values
Plant values (in $millions)
![Page 15: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/15.jpg)
November 21, 2008 Jenny Zhou 15
In year 3, GM has an op/on to invest $800 million to construct the plant
Yr 1 Yr 2 Yr 0 Yr 3
Step 2
Make decisions at the end nodes of the tree
1000
1200
833
1440
1000
694
1728
1200
833
579
Project values (in $millions)
Invest 800
Invest 800
Invest 800
Abandon
928
400
33
0
Decision rule
If value of plant > 800 invest
Otherwise abandon
![Page 16: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/16.jpg)
November 21, 2008 Jenny Zhou 16
In year 2, GM has the op/on to wait (or invest $800 million)
Yr 1 Yr 2 Yr 0 Yr 3
Step 2
Make decisions at the end nodes of the tree
1000
1200
833
1440
1000
694
1728
1200
833
579
Project values (in $millions)
Invest 800
Invest 800
Invest 800
Abandon
928
400
33
0
Step 2.5
Calculate value of project at each earlier node and make decisions
699
259
21
![Page 17: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/17.jpg)
November 21, 2008 Jenny Zhou 17
In year 2, GM has the op/on to wait (or invest $800 million)
Yr 1 Yr 2 Yr 0 Yr 3
Step 2
Make decisions at the end nodes of the tree
1000
1200
833
1440
1000
694
1728
1200
833
579
Project values (in $millions)
Invest 800
Invest 800
Invest 800
Abandon
928
400
33
0
Step 2.5
Calculate value of project at each earlier node and make decisions
699
259
21
Decision rule
Value of project from waiting >
(value of plant – 800) wait
Otherwise invest $800 million in Yr 2
![Page 18: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/18.jpg)
November 21, 2008 Jenny Zhou 18
In year 2, GM has the op/on to wait (or invest $800 million)
Yr 1 Yr 2 Yr 0 Yr 3
Step 2
Make decisions at the end nodes of the tree
1000
1200
833
1440
1000
694
1728
1200
833
579
Project values (in $millions)
Invest 800
Invest 800
Invest 800
Abandon
928
400
33
0
Step 2.5
Calculate value of project at each earlier node and make decisions
wait
wait
wait Decision rule
Value of project from waiting >
(value of plant – 800) wait
Otherwise invest $800 million in Yr 2
699
259
21
![Page 19: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/19.jpg)
November 21, 2008 Jenny Zhou 19
In year 1, GM has the op/on to invest $400 million to complete the design phase
Yr 1 Yr 2 Yr 0 Yr 3
Step 2
Make decisions at the end nodes of the tree
1000
1200
833
1440
1000
694
1728
1200
833
579
Project values (in $millions)
Invest 800
Invest 800
Invest 800
Abandon
928
400
33
0
Step 2.5
Calculate value of project at each earlier node and make decisions
699
259
21
wait
wait
wait
514
168
![Page 20: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/20.jpg)
November 21, 2008 Jenny Zhou 20
In year 1, GM has the op/on to invest $400 million to complete the design phase
Yr 1 Yr 2 Yr 0 Yr 3
Step 2
Make decisions at the end nodes of the tree
1000
1200
833
1440
1000
694
1728
1200
833
579
Project values (in $millions)
Invest 800
Invest 800
Invest 800
Abandon
928
400
33
0
Step 2.5
Calculate value of project at each earlier node and make decisions
699
259
21
wait
wait
wait
514
168 Decision rule
Value of project > 400
invest 400
Otherwise abandon
![Page 21: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/21.jpg)
November 21, 2008 Jenny Zhou 21
In year 1, GM has the op/on to invest $400 million to complete the design phase
Yr 1 Yr 2 Yr 0 Yr 3
Step 2
Make decisions at the end nodes of the tree
1000
1200
833
1440
1000
694
1728
1200
833
579
Project values (in $millions)
Invest 800
Invest 800
Invest 800
Abandon
928
400
33
0
Step 2.5
Calculate value of project at each earlier node and make decisions
699
259
21
wait
wait
wait Decision rule
Value of project > 400
invest 400
Otherwise abandon
114
0
Invest 400
Abandon
![Page 22: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/22.jpg)
November 21, 2008 Jenny Zhou 22
In year 0, GM has the op/on to invest $60 million for permits and prepara/on
Yr 1 Yr 2 Yr 0 Yr 3
1000
1200
833
1440
1000
694
1728
1200
833
579
Project values (in $millions)
Invest 800
Invest 800
Invest 800
Abandon
928
400
33
0
699
259
21
wait
wait
wait
114
0
Invest 400
Abandon 71
Step 2.5
Calculate value of project at each earlier node and make decisions
![Page 23: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/23.jpg)
November 21, 2008 Jenny Zhou 23
In year 0, GM has the op/on to invest $60 million for permits and prepara/on
Yr 1 Yr 2 Yr 0 Yr 3
1000
1200
833
1440
1000
694
1728
1200
833
579
Project values (in $millions)
Invest 800
Invest 800
Invest 800
Abandon
928
400
33
0
699
259
21
wait
wait
wait
114
0
Invest 400
Abandon 71
Step 2.5
Calculate value of project at each earlier node and make decisions
Decision rule
Value of project > 60 invest
Otherwise Abandon
![Page 24: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/24.jpg)
November 21, 2008 Jenny Zhou 24
In year 0, GM has the op/on to invest $60 million for permits and prepara/on
Yr 1 Yr 2 Yr 0 Yr 3
1000
1200
833
1440
1000
694
1728
1200
833
579
Project values (in $millions)
Invest 800
Invest 800
Invest 800
Abandon
928
400
33
0
699
259
21
wait
wait
wait
114
0
Invest 400
Abandon 11
Step 2.5
Calculate value of project at each earlier node and make decisions
Decision rule
Value of project > 60 invest
Otherwise Abandon
Invest 60
![Page 25: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/25.jpg)
November 21, 2008 Jenny Zhou 25
Assessment of ROA
I inves/gate the applica/on of the binomial model in valuing real op/ons
Real Op/ons
Binomial model in ROA example
![Page 26: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/26.jpg)
November 21, 2008 Jenny Zhou 26
All models are simplified representa/ons of reality, and all involve assump/ons
ROA assumes that – the source of uncertainty can be modeled as a stochas/c process
– managers exercise their op/on rights in a /mely and ra/onal manner
![Page 27: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/27.jpg)
November 21, 2008 Jenny Zhou 27
The binomial model is very flexible, which allows it to model complex projects
The binomial model can reflect – Early decision points
– Mul/ple decisions – Changing vola/lity
![Page 28: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/28.jpg)
November 21, 2008 Jenny Zhou 28
Real op/ons analysis not only evaluates a project but also gives you a feasible plan
1000
1200
833
1440
1000
1728
1200
833
Project values (in $millions) Invest 800
Invest 800
Invest 800
928
400
33
699
259
wait
wait 114
0
Invest 400
Abandon 11
Invest 60
Yr 1 Yr 2 Yr 0 Yr 3
![Page 29: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/29.jpg)
November 21, 2008 Jenny Zhou 29
Real op/ons analysis typically gives higher return and lower risk than does NPV
prob
abili
ty d
ensi
ty
% returns
NPV Analysis
Real Op/ons Analysis
![Page 30: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/30.jpg)
November 21, 2008 Jenny Zhou 30
Assessment of ROA
Ques/ons?
Real Op/ons
Binomial model in ROA example
![Page 31: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/31.jpg)
Binomial Model in Real Op/ons Analysis �
Thank You!
![Page 32: Binomial(Model(in(( Real(Op/ons(Analysis(](https://reader034.vdocument.in/reader034/viewer/2022042101/62565ea376e2be305909f29d/html5/thumbnails/32.jpg)
November 21, 2008 Jenny Zhou 32
References
Microsoe PowerPoint 2003 Clip Art web collec/ons