Prof.

Dr. Stefan Spinler

Director, Khne Institute for Logistics Management
Group speaker, Supply Chain Management Group
WHU Otto Beisheim School of Management
Burgplatz 2
56179 Vallendar
Phone: +49 261 6509 430
email: sspinler@whu.edu

Real Options Analysis

1. Content

This course will present the methodology to value Real Options and illustrate applications in in
vestment decision making in a variety of business contexts: exploitation of natural resources, in
ternational production networks, flexibility in equipment and capacity, software upgrades etc. Tra
ditional valuation methods, such as Net Present Value, are not suited to account for managerial
action in the presence of unfolding contingencies or the staged nature of an investment project. An
alternative for the decision maker that finds increasingly widespread use is Real Options Analysis,
which will be introduced as an analogy to valuation of financial options. Diverse types of real op
tions will be discussed, for instance the option to defer, to switch, to abandon as well as compound
options, related to investment decisions.

The analysis builds mostly on lattice tree models, Monte Carlo simulation will allow the student to
do numerical analysis. The student is expected to be somewhat familiar with the mathematical tools
necessary to value financial options. Each session will consist of a theoretical part focused on one
particular aspect of real options valuation and a corresponding business case, which makes explicit
some of the issues when applying the valuation models in practical circumstances. An important
aspect of this course is the use of Excel spreadsheets to carry out the valuation of real options re
quired in the case assignments.

2. Grading

The course grade will be based on one set of exercises (see session 02) (25%) and three case as
signments (75%). The case assignments are to be done in teams of three to five students, make sure
that visiting students are integrated into the case teams. The submission (electronic format only!)
will typically consist of a spreadsheet that contains the valuation model with appropriate com
ments. Use the following file format: case # <last names of group participants>.xls. Be prepared to
discuss your groups results in class.

3. Literature

Relevant literature for each session indicated below is on moodle.



... when evaluating investments, optionality is ubiquitous and unavoidable. If modern fi
nance is to have a practical and salutary impact on investment decision making, it is now
obliged to treat all major investment decisions as option pricing problems.

S. Ross: Uses, Abuses and Alternatives to the NetPresentValue Rule, 1995

Real Options Analysis 2016 1 S. Spinler

Schedule

Lecture 1, October 31

The Net Present Value approach to valuation, basic Real Options valuation
Presents key advantages as well as shortcomings of traditional valuation methods and introduces real op
tions as an alternative decision making tool.

Topics: DCF, WACC, IRR, NPV, mapping of financial options into real options, examples for real options.

Reading:

T. Copeland, P. Tufano: A realworld way to manage real options. Harvard Business Review, March 2004.


Lecture 2, November 02

Real Options: Binomial Lattices
The binomial lattice method pioneered by Cox, Ross and Rubinstein as a tool for valuation of real options
is introduced. We discuss how dividends and timevarying interest rates can be incorporated into the valu
ation.

Topics: Riskneutral probabilities, replicating portfolio; European and American Call and Put

Individual assignment (due: November 08)

Valuation of various puts and calls using binomial lattices, will be distributed in class.

Reading:

Mun (2006), ROA, Chapter 6, pp. 123 162.
Bailey et al. (2003), Unlocking the value of Real Options, 2003, pp. 4 19.


Lecture 3, November 08

Real Options: The option to switch and interaction of multiple options
The option to switch is prevalent in, for instance, international production networks: based on the evolution
of exchange rates, production capacity may be shifted to the less expensive country. The value of being able
to switch will be determined.

Topics: Switching options: costless and costly switching; interaction of multiple options

Case: Merck and Co. (A), Cornell
In the context of preparing to launch a new pharmaceutical product, the MK640, the Merck Manufacturing
Division has to decide on the scale and type of production capacity. Real options analysis will be utilized to
quantify the different scenarios.

Assignment: (due November 16)

Advise the management of Merck by providing an analysis on the following issues:

How much capacity should be built?
Should the production facility (PF) be easily expandable?
Should it be designed with additional flexibility features?

Reading:

Mun (2006), ROA, Chapter 7, pp. 163 189.

Real Options Analysis 2016 2 S. Spinler


Lecture 4, November 16

Investments into renewable energy and flexible generation assets
The risk of climate change makes it mandatory to introduce greater shares of renewable energy into gener
ation portfolios. Two issues will be studied in this session: How can Feedin Tariffs foster investment into
renewable energy and at what cost? Given the intermittency of most renewable energy sources (wind, solar
power), conventional flexible generation assets such as gas power stations are needed to smoothen supply.
How can investments into such flexible power generation assets be incentivized?

Topics: Real options in the electric power sector

Case: Bidding for Antamina HBS (9297524)

In June 1996, executives of the multinational mining company RTZCRA contemplate bidding to acquire the
Antamina copper and zinc mine in Peru. The Antamina project is being offered for sale by auction as part of
the privatization of Peru's state mining company. RTZCRA has to determine what the mine is worth and
decide whether and how it should bid in the upcoming auction. The bidding rules put in place by the Peru
vian government dictate that each company's bid contain two components: an upfront cash amount and an
amount the bidder will invest to develop the property if development is warranted after further exploration
is completed.

Assignment: (December 01)

In what way is the development of a copper mine such as Antamina a real option? In what way is
the bidding structure put in place by the Peruvian government a real option?
Build a spreadsheet to value the Antamina project. What are key assumptions and limitations of
your model?
Based on your model, prepare a bid under the following scenarios:
If the winning bidder was legally forced to develop Antamina after completing the explora
tion phase, and was required to pay the Peruvian government upfront for this project,
what is the most they would be willing to pay?
If the winning bidder could choose to whether or not to develop Antamina at the end of
two years, but was required to pay the Peruvian government a single upfront fee for the
right to develop the project, what is the most they would be willing to pay?
Under the current bidding rules, the winning bidder states both an initial cash payment as
well as an investment commitment that is paid only if they choose to develop the field. Bids
are evaluated by summing upfront amount and 30% of the investment commitment. If you
proceed with development but fail to spend the full investment commitment, the govern
ment will fine you 30% of the difference. What is the most you would be willing to bid un
der these rules? How would you trade off these two components of the bid?

Reading:

T. Couture, Y. Gagnon (2010): An analysis of feedin tariff remuneration models: Implications for renewable
energy investment. Energy Policy 38, 955 965.



Lecture 5, December 01

Real Options: Monte Carlo simulation, rainbow options

Rainbow options are options that are valued on multiple underlyings, e.g., the sales of a new product may
depend on price and quantity. The binomial approach will be enhanced to the quadranomial approach to
value this kind of options. Monte Carlo simulation and the tools that come with it are shown to be a useful
component of a real options analysis.

Topics: Rainbow options with uncorrelated and correlated underlyings; foreign exchange rate risk.

Real Options Analysis 2016 3 S. Spinler

Case: Lufthansa Cargo AG: Capacity Reservation and Dynamic Pricing, WHU
Presents a discussion of how to optimally structure flexibility contracts between the freight forwarder and
the airline. Introduces options on capacity as a way to properly price the flexibility.

Assignment: (due December 06)

How does Air Cargo differ from passenger business in terms of Revenue Management?
What are the purposes of selling longterm contracts? Does Lufthansa Cargo achieve its goals?
Interpret the capacity reservation contracts in terms of real options.
Provide a Monte Carlo simulation to answer the following questions:
o The forwarding company TransAsia Inc. has regular customers that ship stuff from Ger
many to Thailand. Total weekly demand averages 50 tons (normally distributed with
standard deviation of 30 tons). Implement a newsboy model in Excel with @risk that sim
ulates a CPA between TransAsia and LCAG. Make the following assumptions:
TransAsia is paid $205/ton by its customers
LCAG charges $160/ton under the CPA
TransAsia can find additional capacity at $180/ton (spot market)
LCAGs variable cost is $100/ton.
How much capacity should TransAsia optimally reserve? What are the expected profits of
LCAG and TransAsia, respectively?
o Do the same for an option contract with a reservation fee of $60/ton and an execution fee
of $100/ton.
o Suppose that spot price is longer deterministic but rather normally distributed with a
mean of $180/ton and a standard deviation of $100/ton (make sure that negative values
are truncated). Evaluate both types of contracts with this new data.

Reading:
R. Hellermann, A. Huchzermeier, S. Spinler (2013): Options Contracts with Overbooking in the Air Cargo
Industry. Decision Sciences 44 (2), 297 327.


Lecture 6, December 06

Further applications of real options: migration to electric vehicles, risk management via capacity
options.
In this session, we discuss applications of real options to decisions on software upgrades. Moreover, a val
uation methodology for options on capacity is provided and properties of contingency contracts in the con
text of risk management are discussed.

Topics: Software investment decisions, capacity option, flexibility contracts

Reading:

P. Kleindorfer, A. Neboian, A. Roset, S. Spinler (2012): Fleet renewal with electric vehicles at La Poste. Inter
faces, 42 (5), 465 477.

Real Options Analysis 2016 4 S. Spinler