delay in the expansion from 2.5g to 3g wireless networks: a real options approach dr. fotios...

Delay in the Expansion from 2.5G to 3G Wireless Networks: A Real Options Approach

Dr. Fotios Harmantzis (Speaker) & P. Tanguturi

Assist. Professor, Stevens Institute of TechnologyDirector, Real Options Group (ROG)

PerfEcTNet Research Group

Outlook of Presentation

• Introduction and Problem• Parameters and Assumptions• Numerical Results• Analysis

– Study the effect of key parameters• Investment cost, Volatility, Expansion Factor

• Conclusion• References

15th Biennial International Telecommunications Conference 2004


Introduction and Problem

• Facts:– The cellular market has seen an unprecedented growth in subscribers and is still

growing.

– The services have emerged from basic voice services to text messaging and data services.

– Need for high speed data services have been promised by 3rd Generation (3G) wireless networks even before actual implementation.

– It’s a known fact that operators in Europe paid exorbitant prices for 3G spectrum in auctions.

– Revenues to respective governments have ranged from 20 Euros per capita to 650 Euros per capita.

– Notion among the operators was to own as much as spectrum as they can, no matter how much it costs them.

– Operators face this daunting task to evolve their infrastructure cost effectively



Cont..

• Problem– The requirement of network architecture that supports new bandwidth intensive service is

demanding and costly.

– Due to high price paid for spectrum there has been delay in the introduction of the services.

– Operators are posed with certain questions:• What will be the cost of deployment of network?

• How are the investment costs going to be recovered?

• How and when to release applications that will drive the market?

– The fact is that future is uncertain.

• Solution– Uncertainties related with high-technology investment are better managed by valuing

flexibility rather than static valuation i.e., NPV.

– We propose the use of Real Options approach to valuate investment decisions, help in decision making process, and identify which factors affect the decision making process.



Objective

• Company considers expanding or delay expansion of a 2.5G network to the next generation of networks, the 3G, using real options approach



Approach to Problem

• Step 1: Parameters and Assumptions

• Step 2: Capital Budgeting– Investment cost break down

• Step 3: Use of Option pricing framework to value the option– Option to Expand



Parameters and Assumptions

• New York Metro market for analysis.

• Scenarios– Scenario A: Company has acquired the spectrum to upgrade

from 2.5G to 3G– Scenario B: Company has not acquired the spectrum to

rollout 3G network yet.



Parameters and Assumptions (Cont.)

• So – Present value of the company forms the underlying asset for our derivative

• K - Present value of Investment cost – Capital Expenditure (CapEx)– Scenario A: It is the capital expenditure required to upgrade the network– Scenario B: It is the sum of capital expenditure and license cost (assumed to be

$6350.00m)

• T - 5 Years• Volatility (σ) – 18% annually, 5 years historical price movements of stock

price of company.• Risk Free Interest (rf) – 3.12%, 5 Years US Treasury Bond Rate• Expansion Factor (E) – Post-expansion growth factor of the company



Investment Cost Break Down

Year Year 1 Year 2 Year 3 Year 4 Year 5

Initial Cell Sites 512 626 720 828 953

New Cell Sites 166 94 108 124 143

CapEx

(in million)

$167.76m $54.49m $67.14m $71.92m $87.44m

CapEx = No of cell sites * Cell site construction cost * Base station equipment* Antenna* Switch* Radios* Integration

Present Value of Investment cost

•Scenario A (excludes license cost) : $286.00m

•Scenario B (including spectrum cost): $6,636.00m

(discounted using WACC = 20% for the time of the project)



Parameters revisited

• So – Present value of the company – $27,761m

• K - Present value of Investment cost – Scenario A: $286m (excludes license cost)– Scenario B: $6,636m (CapEx + License cost)

• T - 5 Years• Volatility (σ) – 18% annually, 5 years historical price

movements of stock price of company.• Risk Free Interest (rf) – 3.12%, 5 Years US Treasury Bond Rate• Expansion Factor (E) – Post-expansion growth factor of the

company



Option to Expand

• Binomial Method

Sof

S0ufu

S0u2

fuu

S0udfud

S0dfd

S0d2

fd

p

p

p

1-p

1-p

1-p

T0

dt dt

Step 1 Step 2

])1([ durdt fppfef

du

dap

dteu

dted

rdtea



Valuation

Scenario A Scenario B

Traditional Approach

(No growth assumptions)

NPV = $27,475m NPV = $21,125m

Option to Expand Option to Expand= $27,822.54m

Static Valuation = $27,752.61m

(Expansion Factor of 1%)

Extra Premium = $69.93m (0.02%)

Option to Expand=$27,768.74m

Static Valuation = $23,901.10m

(Expansion Factor = 10%)

Extra Premium = $3867.64m (16%)



Analysis

Effect of Expansion Factor to Option Value (both scenarios)

$25,000.00

$26,000.00

$27,000.00

$28,000.00

$29,000.00

$30,000.00

$31,000.00

$32,000.00

$33,000.00

$34,000.00

Expansion Factor

Valu

e o

f O

pti

on

(M

illio

ns)

Value of Option W/OLicense Cost (Scenario A)

Value of Options W/License Cost (Scenario B)

Expansion is favored at E = 1.026; Value = $28,238.10

Expansion is Favored at E = 1.098, Value = $27,763.24



Analysis (Cont.)

$27,650.00

$27,700.00

$27,750.00

$27,800.00

$27,850.00

$27,900.00

$27,950.00

$28,000.00

5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80

Volatility (%)

Valu

e o

f O

pti

on

(M

illio

ns)


Value of Option W/Lincese Cost (Scenario B)

Effect of Volatility to Option Value (both scenarios): Expansion Factor 1%



Analysis (Cont.)

Scenario A Scenario BEffect of Volatility to Option Value (both scenarios): Expansion Factor 20%

$33,055.00

$33,060.00

$33,065.00

$33,070.00

$33,075.00

$33,080.00

$33,085.00

$33,090.00

$33,095.00

5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80

Volatility (%)

Valu

e o

f O

pti

on

(M

illio

ns)


$26,000.00

$27,000.00

$28,000.00

$29,000.00

$30,000.00

$31,000.00

$32,000.00

5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80

Volatility (%)

Va

lue

of

Op

tio

n (

Mill

ion

s)

Value of Options W/License Cost (Scenario B)



Conclusion

• Path to 3G depends not only on purchasing the spectrum but also on other factors such as expansion factor, volatility and investment cost.

• When expansion factor is varied our analysis suggest that Option value is high when the investment cost is low.

• When investment cost are high, it requires at least 10 fold increase in the company’s value to expand.

• When investment cost is low, it is other way round, even a small expansion factor can lead to exercising the option.

• With low investment cost and high volatilities it is a good decision to expand.

• It is important to understand that the success of 3G will be largely based on market both penetration and business models.



Critique

• Selection of input parameters and assumptions– The volatility factor used to measure change in the

value of underlying asset is difficult to estimate in reality.

– We considered capital cost as the investment cost, it can be extended to include operational expenditure.

– For the underlying asset we can use present value of future cash flows (i.e., the revenues) instead of current value of the company.



Future Work

• Enhancing the cash flow estimate

• Consideration for operational expenditure, marketing cost, and revenues.

• There can be several other Options embedded which can be explored by further study on the topic.



Thank You

Dr. Fotios HarmantzisVenkata Praveen, Tanguturi

PerfEcTNet Research GroupTelecommunications Management

Stevens Institute of TechnologyHoboken, NJ 07030

{fharmant, vtangutu}@stevens.eduhttp://www.stevens.edu/perfectnet



delay in the expansion from 2.5g to 3g wireless networks: a real options approach dr. fotios...

Documents

g spectrum

g network

g wireless networks

problem parameters

g scenario b

assumptions step

problem step

use of real options