investment decision techniques for long-term network planning: real options valuation sofie...
TRANSCRIPT
Investment decision Investment decision techniques for long-term techniques for long-term
network planning: network planning: Real Options ValuationReal Options Valuation
Sofie Verbrugge
Didier Colle, Mario Pickavet
GBOU Ghent University – IMEC – IBBT 2
Network planning processNetwork planning process
networkplanning
physical constraints
equipmentcost
existing network
technical constraintsnetwork
deployment plan
customerdemand
timeequ
ipm
ent
cost
old technology
new technology
timeto
tal t
raff
ic d
eman
d
Which investmentsshould be made
at which points in time ?
GBOU Ghent University – IMEC – IBBT 3
OutlineOutline
• Classical investment decision rules
• Real options valuation
• Network planning problems to be seen as investment decision problems
• Conclusions
GBOU Ghent University – IMEC – IBBT 4
ni
FC
)1(
Present value of future cash flowsPresent value of future cash flows
• Positive time value of money:– prefer receiving now– prefer spending later
• Discount future expenses to present values
where
C = current valueF = future expensei = interest raten = years into the future 0
20
40
60
80
100
120
now year 1 year 2 year 3 year 4 year 5
Current value of 100 euro to be spent in the future
GBOU Ghent University – IMEC – IBBT 5
Investment decisionsInvestment decisions
• “Should the investment be made or not?”• Consider all cash flows CF for the project
– Initial investment (-)– Additional revenues (+)
• Cash flows used:– Incremental, operational, after taxes, economical lifetime
2004 2005 2006 2007 2008 2009 2010
time- 200 +40 +40 +40 +40 +60 +0
Initial investment:
buy a machine
Annual revenue: sell produced goods End of the
project: resell the machine
GBOU Ghent University – IMEC – IBBT 6
Net Present ValueNet Present Value
• Definition– Present value of all cash flows in the investment project, discounted
using the minimum required return on investment
– r = minimum required return for considered project, grows with project risk (riskless project: interest earned on bank account)
• Objective– NPV >= 0
• Advantages– Takes into account all CFs– Takes into account timing– Takes into account size of the project
n
tt
t
r
CFNPV
0 )1(
GBOU Ghent University – IMEC – IBBT 7
OutlineOutline
• Classical investment decision rules
• Real options valuation
• Network planning problems to be seen as investment decision problems
• Conclusions
GBOU Ghent University – IMEC – IBBT 8
Real Options compared to NPVReal Options compared to NPV
• Net Present Value (NPV)– Discounts CFs using fixed discount rate– Evaluates now-or-newer investment decisions– For risky project: difficult to determine appropriate discount
rate
• Real Options Valuation (ROV)– Includes the options that may be present in an investment
project with uncertain parameters– Includes flexibility in decision process– Uses risk-free discount rate
• ROV is extension of NPV technique– Value of a project = NPV + value of the options
GBOU Ghent University – IMEC – IBBT 9
Origin: financial optionsOrigin: financial options
An option gives the buyer the right to buy or sell an asset for a predetermined exercise price over a limited time period.
– Right, not obligation– Asset: Asset for which the option holds, can be anything:
stocks, real estate, precious metals, …– Exercise price = strike price: Price for which option holder
can exercise the option, fixed over exercise time– Exercise date: option is no longer valid after this date
(remaining time = Time To Maturity)
GBOU Ghent University – IMEC – IBBT 10
TerminologyTerminology
• European option– can only be exercised on the exercise date
• American option– can be exercised till the exercise data
• Option price = option premium– Price to acquire the option, price to acquire to right
• Exercise price = strike price– Price for which option holder can exercise the option (fixed)
• Call option– option holder has right to buy the asset
• Put option– option holder has right to sell the asset
GBOU Ghent University – IMEC – IBBT 11
Value of call option on exercise dateValue of call option on exercise date
• Call option = right to buy (a stock)– Predetermined exercise price: X– Market value of the stock on exercise date: S
• On exercise date– S < X
• the option is useless • everyone buys on the market
– S > X• the option is valuable• Value of the option: S - X
• Option always has a positive value• Value call option at exercise date = MAX(0,S-X)
S = value share on exercise dateva
lue
call
on e
xerc
ise
date
X
GBOU Ghent University – IMEC – IBBT 12
Value of option before exerciseValue of option before exercise date date
• Value of option = end value + time value• End value
– Value the option would have if today was the exercise date
• Time value– Grows with a growing time to maturity
• Over longer time chance is bigger that good changes will occur
– Grows with volatility of share value• Big volatility, big chance the value will change a lot before exercise
date, bigger option value• Remark: traditional valuation vs. option valuation
– Small when difference between S and X is big• Big |S-X|: value of the option (+ or -) not likely to change, small time
value• Small |S-X|: big chance the option value will change, big time value
GBOU Ghent University – IMEC – IBBT 13
Option valuationOption valuation
• Binomial method– for European call option– assumes 2 possible end values for the stock value
– can be expanded for more time periods: software needed
• Black-Scholes – formula– assumes arbitrage-free pricing, stock prices follow Brownian motion
• Simulations– Monte Carlo simulation– Tools available: e.g. Crystal Ball
SU
D
GBOU Ghent University – IMEC – IBBT 14
Financial versus real optionsFinancial versus real options
Stock option Real option
X exercise price of the option
investments required to carry out the project
S value of the underlying stock
NPV of the cash flows generated by the investment project
volatility of the stock risk grade of the project
r the risk-free interest rate risk-free interest rate
t life time of the option time period where company has the opportunity to invest in the project
GBOU Ghent University – IMEC – IBBT 15
OutlineOutline
• Classical investment decision rules
• Real options valuation
• Network planning problems to be seen as investment decision problems
• Conclusions
GBOU Ghent University – IMEC – IBBT 16
Apply ROV forApply ROV for long-term planning long-term planning
• ROV especially useful for – two-phase investment decisions– with an optional second phase (e.g. only performed if market
situation is favourable)
• OXC introduction in an existing network with growing traffic demand
– can be seen as two-phase decision – phase 1: introduction of the OXC itself (only including
interface cards needed to switch the current traffic)– phase 2: option to expand the OXC with extra interface cards
if needed– Actual decision whether or not to really expand only taken in
phase 1 (uncertainty reduced by then)!!
GBOU Ghent University – IMEC – IBBT 17
Case studyCase study
• European backbone network– 16 nodes and 22 links
– initially WDM point-to-point systems are used on all links
– if an OXC is introduced: transit traffic passes the node optically
– time frame 2002 – 2008
– initial traffic: IP traffic from Lion-Cost266 model
– afterwards: 70% annual growth
– links filled to 60% of there capacity
– network equipment costs: relative to the cost of a WDM mux/demux
– linear price model
– price is changing (in a random way)
• In which nodes is OXC introduction beneficial? When?
GBOU Ghent University – IMEC – IBBT 18
OXC introduction in BrusselsOXC introduction in Brussels
NPVphase 1
NPVphase 2
NPVproject
ROV phase 2
ROV project
2002 -3,17 -94,44 -97,60 7,34 4,18
2003 -3,17 -87,51 -90,67 17,22 14,05
2004 -3,17 -87,08 -90,25 22,18 19,01
2005 -3,17 -95,8 -98,96 20,37 17,21
2006 -3,17 -117,69 -120,86 10,80 7,64
installation OXC + needed interface
cards 2002
installation of extra line cards in considered years optional installation
of extra line cards in considered years
all > 0: OXC introduction should definitely be considered in Brussels
best timing
for upgrade:
2004
GBOU Ghent University – IMEC – IBBT 19
OXC introduction in all nodesOXC introduction in all nodes
• NPV: no OXC introduced in the entire network
• ROV: OXC introduction beneficial in half of the nodes
• Negative ROV project value: OXC not beneficial– Prague, Vienna and Zagreb: overall traffic too low
– Berlin, Munich, London, Lyon and Rome: too little transit traffic
• Positive ROV project value: OXC introduction beneficial – Hamburg, Brussels, Frankfurt, Paris, Strasbourg, Zurich, Milan, Amsterdam
– overall traffic big enough (exceeds router capacity within 2 years), transit traffic fraction > 60%
Value of OXC introduction w ith optional second phase
-200
-150
-100
-50
0
50H
ambu
rg
Ber
lin
Bru
ssel
s
Fra
nkfu
rt
Lond
on
Par
is
Lyon
Str
asbo
urg
Zur
ich
Mila
n
Mun
ich
Pra
gue
Rom
e
Vie
nna
Zag
reb
Am
ster
dam
NPV project value project w ith optional second phase
GBOU Ghent University – IMEC – IBBT 20
Case study resultsCase study results
• Net Present Value – unable to correctly evaluate projects that comprise an
optional follow-up investment– project value for OXC introduction < 0
• Real Options Valuation – aimed to valuate projects where uncertainty is involved– project value for OXC introduction > 0– optional character of second phase leads to bigger project
value (postponing decision reduces uncertainty)– disadvantages:
• often very difficult to detect a real option
• correctly estimating the option value difficult (estimating CF)
• Black and Scholes assumptions should be tested carefully
GBOU Ghent University – IMEC – IBBT 21
OutlineOutline
• Classical investment decision rules
• Real options valuation
• Network planning problems to be seen as investment decision problems
• Conclusions
GBOU Ghent University – IMEC – IBBT 22
ConclusionsConclusions
• Time value of money– Discount future expenses to present values– Always when comparing/ adding CFs for different time points
• Classical investment decision rules– Net Present Value (NPV) best of classical investment rules– Need to estimate CFs– Need to estimate required interested rate (related to risk)
• Real options valuation– Extension of NPV, to include optional future investments– Originates from world of stock options– Need to estimate CFs– Use of risk free discount rate– Several valuation techniques, best-known: Black and Scholes
GBOU Ghent University – IMEC – IBBT 23
ConclusionsConclusions
• Network planning problems seen as investment decision problems
– ROV can be used for two phase investment problems with optional second phase
– disadvantages:• Correct estimation of needed parameters not always easy• Black and Scholes assumptions should be tested carefully
• OXC introduction seen as real option– ROV leads to bigger project value in case of optional follow-up
investment
– According to ROV: OXC introduction beneficial if expected traffic demand exceeds router capacity within next 2 years and the transit traffic fraction surpasses 60%
– Introduction in half of the nodes in considered European backbone
• Future work: use simulations, to avoid B-S constraints
GBOU Ghent University – IMEC – IBBT 24
Thanks for your attention!