Topic:

Real Options

Agenda:
Why Real Options?
Real options vs Financial options
Real Options and Corporate Finance
Empirical Evidences on Real Options
Methods of Assessing and Valuing Real Options
Conventional Project Valuation vs. Valuations with Real Options
Timing Option, Black and Scholes, Growth Option, Abandonment
Option, and Flexibility Options.
Real Options and the Hurtle Rate

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Why Real Options?

2
 Why Real Options?

Decisions in Conventional NPV analysis:

– Now or never
– Take it or leave it

Managers can influence a project (and value) with respect to

– the size of cash flows (option to expand, option to cut back, option to
suspend),
– timing of cash flows (option to delay or wait, option to extend),
– and risk of cash flows (option to abandon)
by taking actions during the project’s life in response to changing
market conditions.

These actions are options on real assets.

Real Options are very valuable and can significantly increase firm
value.
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Real Options vs. Financial Options

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 Real Options vs. Financial Options
As with financial options, a real option does not obligate the manager to take an
action.

Real options give the right to take actions. Real options and financial options differ
in several ways.

Financial options:
– Both options and underlying assets are usually traded
– Investors can easily take offsetting positions
– Usually issued by an organized exchange or over-the-counter
– There is always a counterparty (seller vs. buyer)
– Specifics are specified in the contract, and hence they are fixed.
Real Options:
– Both the option and underlying assets are not traded
– There is no counterparty
– Are found, created or structured inside projects, not issued by an exchange
– Payoffs can vary (depending on market conditions) and engineered inside
the project by the manager
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Real Options and Corporate Finance

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 Real Options and Corporate Finance
Not a laundry list of real options in corporate finance:

Timing Options: Allow time to wait and learn and make more informed
decisions.

Growth Options: Exposes projects to upside potential, increasing firm

value.

Abandonment Options: Allows the manager to ‘cut losses’, reducing

downside risks and improving firm value.

Flexibility Options: give managers some flexibility to manage better and

create more value and reduce risk. Flexibility Options can combine
timing, growth and abandonment options.

Strategic Default Options: Shareholders can strategically default on

corporate debt. 7
 Real Options and Assets-in-Place

Real options do not produce immediate cash flows. Real options

have the potential to affect the cash flows of a firm in the future.

Assets-in-place, or assets currently producing cash flows, are

separate assets of the firm.

The total value of a firm must incorporate both assets-in-place and

real options. I.e.,

𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 = 𝐴𝑠𝑠𝑒𝑡𝐼𝑛𝑃𝑙𝑎𝑐𝑒 + 𝑅𝑒𝑎𝑙𝑂𝑝𝑡𝑖𝑜𝑛𝑠.

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Empirical Evidences on Real Options

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 Empirical Evidences on Real Options
We know that financial markets value growth options.
– Need only look at the natural resources, high tech, bio tech and other
high growth industries. Firms in these sectors have higher valuations
(high Market-to-Book Ratio, ME/BE, P/E) than other industries.
– Some firms have high valuations even if they are not profitable
(Amazon).
– Growth firms tend to have higher valuations (Market-to-Book Ratio,
ME/BE, P/E ratios) than for slow growth or mature firms.

The risk of firms changes with corporate investments

– Firm betas (and average returns) tend to decrease after Seasoned
Equity Offerings and after large corporate investments.
– Evidence that investments replace real options with assets-in-place
(assets-in-place are safer than options).

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 Empirical Evidences on Real Options
Firm risk varies across firms with varying degree of real option intensities:
– Stock returns and stock return volatility are contemporaneously
correlated.
– This relation is stronger among smaller, younger and growth firms
(growth option intensive firms).
– Hinges on option pricing principles that option values benefit from an
increase in risk.

High distress stocks earn low returns even though they ‘should’ have higher
betas:
– Indication that default option on debt reduces shareholders’ risk .

Conclusion: Real Options are priced by the market and they make up a
significant portion of firm values. This leads to a strong suggestion that
managers should incorporate real options in projects to increase firm value.
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Methods of Assessing and Valuing
Real Options

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 Methods of Valuing and Assessing Real Options

Qualitatively
– Real options are more valuable the greater the operating risks
– Real options are more valuable the greater the life of the option
– Real options are more valuable the greater the firm’s exclusive
market power
– Etc…
Decision Tree analysis and Backward-Recursion
– i) Value the project in each future state, i.e. compute the PV in each
future state
– ii) Choose optimal exercise policies in each state in the future
– iii) Value the project at t=0 by accounting for the optimal policies in
each state in the future
Backward-Recursion values projects under the assumption that optimal
decisions will be made in each of the possible realizations of the state
variable. 13
 Methods of Valuing and Assessing Real Options
Adapting from standard models (such as the Black and Scholes formula)
– Very restrictive. The mapping from financial options to real options
not perfect
– Projects with multiple options rarely equivalent to a portfolio of
financial options
Example: an abandonment option is not very valuable for the shareholders
if they also have a default option on the debt. Adapting from financial
models will overvalue the abandonment option.

Advanced mathematical modelling

– Most advanced. Entails complex mathematical modelling.
– Entails solving Partial Differential Equations, modelling with
Stochastic Calculus, and solving models by employing
computational/numerical methods
– Most flexible and customizable for the application in hand.
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Conventional Project Valuation vs.
Valuations with Real Options

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 Conventional NPV Example: Nutty Chocolates

Nutty Chocolates can invest $5 million in a new production plant.

After construction of the plant, the price and the incremental

increase in quantity sold will be either $2.5 and 6 Million in case of
a boom, or $1.5 and 3 Million in case of a bust. There is a 60%
probability of boom and 40% probability of bust.

The plant has an expected life of 5 years. Incremental fixed costs

are $2 million a year, and variable costs are $1 per bar. The plant
will be depreciated on a declining balance over 5 years to a
salvage value of $1 million with a depreciation rate of 40%. The
opportunity cost of capital is 12% and T is 40%.

What is the project’s NPV and CV under the baseline assumptions?

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 Conventional NPV Example: Nutty Chocolates

The NPV as a function of price and quantity is:

𝑁𝑃𝑉(𝑃, 𝑄)
$1𝑀 1 − 1 + .12 GD
= −$5𝑀 + D
+ 𝑂𝐶𝐹(𝑃, 𝑄)×
1.12 .12
$5𝑀×.4×.4 1 $1𝑀×.4×.4
+ − D
×
.12 + .4 1.12 .12 + .4
.4 5𝑀 1 − .4 D − 1𝑀
+
1.12D

Where 𝑂𝐶𝐹(𝑃, 𝑄) = (𝑃 − $1 ×𝑄 − $2𝑀](1 − .4)

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 Conventional NPV Example: Nutty Chocolates

NPV for each state:

𝑁𝑃𝑉($2.5,6𝑀) = $11.9326𝑀
𝑁𝑃𝑉($1.5,3𝑀) = −$4.2889M

Expected value:
𝑁𝑃𝑉OPQR = 0.6×$11.9326𝑀 + 0.4× −$4.2889𝑀 = $5.444𝑀

Variance is:
Variance of NPVOPQR = 0.6×($11.9326𝑀 − $5.444𝑀)T
+0.4×(−$4.2889𝑀 − $5.444𝑀)T = 63.15284𝑀T

Coefficient of variation is:

UPVWPXYR Z[ \]U^_`a cd.eDTfgh
𝐶𝑉 = = = 1.4597
\]U^_`a D.iiijg
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Timing Options

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 Timing Options
Timing Option:
• Delay investment in project
• Delaying helps learn more about market conditions (the passage of
time resolves uncertainty).
• Akin to having a long position in a call option
• Beneficial if the firm has proprietary technology, patents, licenses,
or other forms of barriers of entry because these factors lessen the
threat of competition.
• Otherwise, competitors can pre-empt the market and the option
may not be valuable
• Therefore, the downside of delaying is opportunities costs in the
form of lost profits or even losses.
• Option may never be exercised, but may be valuable in face of
market uncertainty.
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 Timing Option Example: Nutty Chocolates
Instead of investing now, Nutty Chocolates can wait one year, learn about
the realization of the state of the economy and make a decision then.
What is the value of the project and the CV if the investment decision can
be delayed?

.6×𝑀𝑎𝑥 0, 𝑁𝑃𝑉($2.5,6𝑀) + .4×𝑀𝑎𝑥(0, 𝑁𝑃𝑉($1.5,3𝑀))

𝑁𝑃𝑉lRmPn =
1 + .12
.c×gPp(j,$ee.qdTcr) w.i×gPp(j,G$i.Tffqr)
stua`v xytz v stua`v
= = $6.3925𝑀
ew.eT
$ee.qdTcg
Variance of 𝑁𝑃𝑉lRmPn = 0.6×( − $6.3925𝑀)T
e.eT
$0
+0.4×( − $6.3925𝑀)T = 27.2425𝑀T
1.12
UPVWPXYR Z[ \]Uxa{_| T}.TiTDgh
𝐶𝑉 = = = 0.8165
\]Uxa{_| c.dqTDg

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 Timing Option Example: Nutty Chocolates

Q) What is the value of the option to delay investment?

𝑉lRmPn = 𝑁𝑃𝑉lRmPn − 𝑁𝑃𝑉OPQR = 6.3925𝑀 − 5.4440𝑀 = $0.9484𝑀

Q) What is the total cost of investing now?

Investing now extinguishes the timing option. Investing now gives rise to
an opportunity cost.
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 = 𝐼 + 𝑉lRmPn = 5𝑀 + 0.9484𝑀 = $5.9484𝑀

Q) Is it better to delay or invest immediately?

𝑁𝑃𝑉XZ• = −𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 + 𝑃𝑉OPQR = −5.9484𝑀 + $5.444𝑀 + 5𝑀
= $4.4956𝑀
vs.
𝑁𝑃𝑉lRmPn = $6.3925𝑀

It’s better to keep the option alive.

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 Timing Option Remarks
Investing now kills the option;

Akin to having mutually exclusive projects. Now or Later. Can’t have

both now and later;

𝑁𝑃𝑉€RmPnGXZ• = 𝑁𝑃𝑉€RmPn − 𝑁𝑃𝑉XZ• = 6.3925𝑀− 4.4956𝑀 > 0.

Delay!;

The higher the option value, the greater the incentive to delay
(opportunity costs is higher);

Similarly, the greater the factors that lead to a greater option value, the
greater the incentive to delay investment;

The exercise decision is a trade-off between total exercise cost (inclusive

of the opportunity cost) and the project value.
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Real Options and Black and Scholes
Model

24
 Timing Option and Black and Scholes Model
A timing option on a project is like a call option. Black and Scholes
Formula:

𝐶𝑎𝑙𝑙 𝑉, 𝐼, 𝑟, 𝜎U , 𝑇 = 𝑉×𝑁 𝑑1 − 𝐼×𝑒 GVׄ ×𝑁 𝑑2

where
𝑉 𝜎U T
ln + 𝑟+ 𝑇
𝐼 2
𝑑1 = , 𝑑2 = 𝑑1 − 𝜎U 𝑇,
𝜎U 𝑇
1 p G‰ ∗
𝑁 𝑥 = ˆ 𝑒 T 𝑑𝑧
2𝜋 GŠ
𝑉 : PV of the underlying project;
𝐼 : strike price or the cost of the project;
𝜎U : return volatility of the project;
𝑇 : time to investment decision;
𝑟 : risk free rate
* In Excel, NORMDIST(x) will give you the standard normal cumulative distribution to the left of x.
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 Timing Option with BS Formula: Nutty Chocolates

The value of the underlying project is :

𝑃𝑉 = 0.6×($11.9326𝑀 + 5𝑀) + 0.4× −$4.2889𝑀 + 5𝑀

= $10.444𝑀
The return (not value) volatility of project is:
T
$11.9326𝑀 − $5.444𝑀
0.6×
$5.444𝑀 + 5𝑀
𝜎U = T = 0.7609
−$4.2889𝑀 − $5.444𝑀
+0.4×
$5.444𝑀 + 5𝑀

The value of the timing option on the project according to BS Formula:

𝐶𝑎𝑙𝑙 $10.444𝑀, $5𝑀, . 05,0.7609,1 = $6.0877𝑀

Value of Project with Timing Option using decision trees = $6.3925𝑀

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Growth Options

27
 Growth Options

Growth Options can increase capacity if market conditions turn out

better than expected;
– I) by expanding existing projects,
– II) by breaking into new product or service markets
– III) by breaking into new geographical markets.

Akin to having a combined position in the underlying project and call

options to incrementally increase scale.

Example: investment in technology that allows for future incremental

increases in production if market conditions gradually improve from
current conditions.

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 Growth Option Example: Nutty Chocolates
Q) Nutty Chocolates can invest now and wait one year, learn about the
realization of the state of the economy and make a decision to double capacity
with an additional investment of $3M which will result in salvage value of $0.8M
at project completion. What is the value of the growth option?

𝑁𝑃𝑉($2.5,6𝑀, 𝐼 = $3𝑀, 𝑆 = $0.8𝑀, 𝑛 = 4)

𝑁𝑃𝑉ŽVZ••• = 𝑁𝑃𝑉OPQR + .6×
1.12
= .6×𝑁𝑃𝑉($2.5,6𝑀) + .4×𝑁𝑃𝑉($1.5,3𝑀) + .6×9.7566𝑀 = $11.2980𝑀

Variance of 𝑁𝑃𝑉ŽVZ••• = 0.6×($11.9326𝑀 + 9.7566𝑀 − 11.2980𝑀)T

+0.4×(−$4.2889𝑀 − 11.2980𝑀)T = 161.9667𝑀T

UPVWPXYR Z[ \]U’“y”v• ece.qcc}gh

𝐶𝑉 = = = 1.1264
\]U’“y”v• ee.Tqfjg

𝑉ŽVZ••• = 𝑁𝑃𝑉ŽVZ••• − 𝑁𝑃𝑉OPQR = 11.2980𝑀 − 5.444𝑀 = $5.8540𝑀

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Abandonment Options

30
 Abandonment Options

Abandonment Options:

Options to abandon a previously adopted project

Exercised if market conditions deteriorate badly enough

Akin to having a combined position in the underlying project and

put options

Abandonment Options are similar to insurance policies.

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 Abandonment Option Example: Nutty Chocolates
Q) Nutty Chocolates can invest ¼ of the investment cost immediately and ¾
of investment can be made one year later after the management learns
about price and quantity demanded. All other cash flows will be deferred by
one year and the management can decide to abandon the project if
unfavorable.

d
𝑁𝑃𝑉 $2.5,6𝑀, 𝐼 = $ 5𝑀, 𝑆 = $1𝑀, 𝑛 = 5 = $13.1826𝑀
i
𝑎𝑛𝑑
3
𝑁𝑃𝑉 $1.5,3𝑀, 𝐼 = $ 5𝑀, 𝑆 = $1𝑀, 𝑛 = 5 = −$3.0389𝑀
4

$5𝑀 1
𝑁𝑃𝑉POPX€ZX = − + ×
4 1.12
0.6× 𝑀𝑎𝑥 0, $13.1826𝑀 + 0.4× 𝑀𝑎𝑥(0, −$3.0389𝑀) = $5.8121𝑀
–ZX•WX—R •W•• TX€ ›OPX€ZX ••R
Q•P˜R Z[ ]VZ™RY•, ]VZ™RY•,]Uš$j
]Uš$ed.efTcg 32
 Abandonment Option Example: Nutty Chocolates

𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑁𝑃𝑉POPX€ZX
T
$5𝑀 1
= 0.6× − + ×$13.1826𝑀 − $5.8121𝑀
4 1.12
T
$5𝑀 1
+0.4× − + ×0 − $5.8121𝑀
4 1.12

$h dd.Tiqegh
𝐶𝑉 = = 0.9921
$D.feTeg

Option Value:
𝑉POPX€ZX = 𝑁𝑃𝑉POPX€ZX − 𝑁𝑃𝑉OPQR = $5.8121𝑀 − $5.444M
=$0.3681M
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Flexibility Options

34
 Flexibility Options
Flexibility options:
Allow the firm to alter operations if conditions change;

May require additional investments to structure the option into the

project at the outset;

Example: option to suspend and restart production according to

market conditions;

Example 2: Option to scale down (mothball) and scale up production

according to market conditions ;

Similar to having combined long positions in a project, and many put

options, and many call options, or compound options.

Common in mining and natural resources sector where cash flows are
35
sensitive to fluctuations in commodity and metal prices.
Real Options and the Hurdle Rate

36
 Real Options and the Hurdle Rate

Financial markets price risk by demanding a higher return for a

greater exposure to systematic risk.

The previous examples showed that real options can significantly

reduce the risk of projects.

Conclusion: The real options were likely undervalued. Those

values should serve as lower bounds.

37
 Real Options and the Hurdle Rate

Alternatives and guidelines:

Leave as is and acknowledge that the project is likely undervalued;

Discount certain future cash flows (such as tax savings from

depreciation) at the risk-free rate;

Adjust down the hurtle rate by an appropriate amount. This approach

is ad hoc and subjective.

Resort to sensitivity analysis to scrutinize the relationship between

project value and hurtle rate.

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 Conclusion
Conventional NPV analyses do not explicitly account for real
options;

Empirical evidence support the view that investors value real

options in firms.

Projects can be structured to incorporate real options;

The increase in value may justify the cost of acquiring options.

The lecture covered some basics. An entire course could be

devoted to real options alone.

Questions: 14.1, 14.2, 14.3, 14.4

Problems: 14.1, 14.2, 14.5, 14.6, 14.7, 14.8 39