REAL OPTIONS

Contents
1.
2.
3.
4.
5.
6.
7.

Basics
What are real options?
Limitations of DCF valuation
Option to delay
Option to expand
Option to abandon
Real options: Caveats
2

1. Basics

What are options?

Types of options
Factors which affect option prices
Models for valuing options: Binomial
& BSM

2. What are Real Options?

It is a decision making framework
Allows decision maker to use updated
information
To expand opportunities for gains OR
To contract investments: to reduce the
possibility of losses
The updated information helps in taking 3
possible decisions related to business
investments
4

2. What are Real Options?

3 possible decisions:
1. Build on good prospects to increase
profits Option to Expand
2. Reduce the amount of investment /
liquidate it if prospects are bad Option
to Abandon
3. Hold on to the current state & not taking
either of the two decisions before
Option to Delay / Wait
5

3. Limitations of DCF
Valuation
DCF analysis blindly believes the expected
cash flows that are likely to occur over the life
time of the asset
So the +ve or ve NPV that is calculated is
not a realistic figure
A +ve NPV project can run into losses due to
bad prospects & wrong decisions after the
investment
A ve NPV project can be made profitable if
prospects are good & by right decisions after
6
the investment

3. Limitations of DCF
Valuation
So DCF analysis does not consider the managers
discretion to influence the cash flows based on
the evolving business prospects
Assuming that managers are rational, they can
take decisions that will increase profits & cash
flows in good times OR decisions that will
minimise losses in bad times
So the DCF value of an investment understates
the value that can be created by good decision
making
Real options enable us to assess the value of
good decision making during the life of an
7
investment

3. Limitations of DCF
Valuation
NPV of an investment is calculated based on the
expected cash flows & discount rates at the time
of analysis
So the NPV computed is a measure of value &
acceptability of the investment at a point of time
But expected cash flows & discount rates
change over time & so does the NPV, due to
changes in business prospects & impact of
managers decisions
Hence NPV is a static measure that overlooks
the changes in business prospects & quality of
managerial decisions
8

3. Limitations of DCF
Valuation
So a ve NPV project now may turn out to be a
+ve NPV project in future & vice versa
This may not happen in a competitive
environment where no firm has any special
advantages over its rivals in implementing
projects
However in a non-competitive environment a
project can be implemented by only a specific firm
This can happen due to barriers to entry in the
form of legal restrictions or high capital
requirements
In such a situation a ve NPV project can become
9
+ve NPV in future

4. Option to Delay
This type of a situation arises in cases of:
(a) Product patents
(b) Natural resource licenses
Product patents provides a firm with the
right to develop & market a product
The firm might have spent an amount of
money in developing it
The firm is allowed to develop & market
the product only during a specified period
of time
10

4. Option to Delay
(b) Natural resource licenses
These provide the firm a right to exploit &
market a natural resource
The firm has to pay fees to acquire license
for this
The firm is allowed to extract the resource
& market it only during a specified period of
time
Both (a) & (b) represent option to delay
Both can be compared with European call
options
11

4A. Option to Delay: Technical Aspects

A project requires an initial outlay of X

The PV(cash inflows) computed now is V
So NPV = V X
The firm considering this project has
exclusive rights for it for next n years
The decision rule:
If V > X : Invest in the project (+ve NPV)
V < X : Do not invest
(-ve NPV)
If it does not invest it will lose the amount it
has spent to acquire the exclusive rights for
12
next n years

4A. Option to Delay: Characteristics

Current Price
of the asset

Call Option
Current Price of
the asset in the
spot market (S0)

Price at which
call can be
exercised

Strike Price of
the call option
(K)

Time to
expiration

Time to
expiration of
the call option
(t)

Option to Delay
Present value
of expected
cash inflows
(V)
Initial
investment
required in the
project (X)
Period for
which firm has
exclusive rights
for the project
(n)

13

4B. Valuing Option to Delay

(a)Inputs required
(b)Practical considerations

14

4B(a): Inputs Required

(i) Value of the underlying asset
(ii)Volatility in the value of the asset
(iii)Exercise price of the option
(iv)Expiration of the option & risk-free
rate
(v)Cost of delay

15

4B(a)(i): Value of Underlying

Asset
The underlying asset is the project itself
Current value of the underlying asset is
PV(Cash Flows expected from initiating
the project now)
Do not deduct the amount of investment
outlay from the PV calculated above you
are not calculating the NPV

16

4B(a)(ii): Volatility in the Value of

Asset
Volatility is measured as variance in value
PV (Expected Cash Flows) will change
over time because:
a) Demand might change over time
b) Technological changes will change the
cost structure & profitability of the
product
So volatility means variance in the
PV(Cash inflows from the project)
17

4B(a)(ii): Volatility in the Value of

Asset
3 Ways of Estimating Volatility:
Variance in cash flows of similar projects
executed in the past
Probabilities assigned to various market
scenarios & variance in PVs estimated
Variance in the market value of listed cos.
in the same industry can be calculated;
average of the variance in the value of
firms in the same industry can be used
18

4B(a)(iii): Exercise Price of

Option
The cost of making the investment
(outlay)
Assumption: This cost remains
constant in terms of present value
Any uncertainty in the demand for
the product & cash flows does not
affect this amount it is reflected in
the PV(Cash Flows)
19

4B(a)(iv): Expiration of Option &

Risk-Free Rate
The option to delay expires when the exclusive
rights to the firm for making the investment
lapse
It is assumed that investment made after the
exclusive rights expire will have zero NPV
because entry of competitors will eliminate the
excess returns
The risk-free rate should be the rate that
corresponds with the time to expiration of the
option
20

4B(a)(v): Cost of Delay

The firm might wait for the expected NPV to
turn +ve; however after it turns +ve it should
not wait for long in making the investment
Each year of delay implies 1 year less value
creating cash flows
If the cash flows are uniformly distributed
over time & exclusive rights last n years
then:
Annual cost of delay = 1/n
This increases as each year elapses
21

4B(b): Practical
Considerations
The limitations of using option pricing models to
value real options are:
1. The underlying asset is not traded in a market.
So it is difficult to estimate its value / price &
volatility (variance) of price
The approach of estimating the price / value on
the basis of cash flows and a discount rate can
be highly erroneous due to wrong estimation of
cash flows & wrong discount rate used
Estimation of volatility depends on the
distribution of prices which is not known for
projects
22

4B(b): Practical
Considerations
2. The period for which firm may have
exclusive rights may not be clear
Competitive advantages of a firm over its
rivals are like exclusive rights to the
project as long as the rivals are not able
to emulate them
The time for which firm will be able to
maintain its competitive advantages
cannot be clearly stated
23

4B(b): Practical
Considerations
3. The behaviour of prices of the asset may
not fit with the price behaviour assumed by
option pricing models.
As BSM assumes, the prices change by
small amounts continuously & the variance
in value remains constant over time, may
not apply to real investments (projects)
A sudden technological change /
emergence of a substitute will significantly
increase / decrease the value of project
24

4C: Option to Delay: Valuing Patents: Eg. 1

A drug for treating a serious ailment has just
received FDA approval
(Expected Cash Inflows) from drugs if
introduced now, = $3.422 bn, computed now.
The initial cost of developing the drug for
commercial production = $2.875 bn.
The patent has a life of 17 years
17-year risk-free rate = 6.7%
Average variance in market value for publicly
traded cos. in that industry based on historical
data = 0.224
25
Calculate the value of the patent

Eg. 1: Sol.

Spot price of asset (S) = 3.422 bn

Strike price of call option = 2.875 bn
Time to expiration (t) = 17 yrs
Risk-free rate (r) = 6.7%
Variance in value (2) = 0.224
Dividend yield = Expected cost of delay =
1/17
= 0.0588 = 5.89%
Model: BSM with adjustment for dividend
yield

26

BSM: Modified for Known Dividend Yield

c S0e

yT

pKe

N (d1 ) K e

rT

rT

N (d 2 ) S 0 e

N (d 2 )
yT

N (d1 )

2
ln(S 0 / K ) (r y / 2)T
where d1
T
2
ln(S 0 / K ) (r y / 2)T
d2
d1 T
T
27

Eg. 1: Sol.
BSM value of option to delay = 906.86 m
This is the value of waiting up to the time
just before the patent expires &
implementing the project
NPV = 3422 m 2875 m = 547 m
Hence the co. likely to gain substantially
by delaying the investment in the
expansion project
The difference = 906.86 547 = 359.86 m
is called time value of the option
28

4C: Implications of Valuing

Patents & Real Options
Even those patents / technologies which are not
viable, will tend to have some value (because
options have time value), especially in those
industries where there is substantial volatility
Cos. may deliberately withhold developing &
commercialising viable patents if they feel they
will gain more from waiting than they will lose in
cash flows
Since option value increases with volatility,
value of patents will be more in risky businesses
so more R&D expense might flow into the
29
lesser known areas of research

5. Option to Expand
Sometimes firms may have to make an
investment although it might lose money on that
This would be the situation when such an
investment would allow the firm to expand
business starting from that point or to enter into
new markets
In such conditions the firm may be willing to lose
funds on the initial investment in order to exploit
the option to expand in future
The option to expand is expected to have
sufficient value to cover the loss on initial
30
investment

5. Option to Expand
PV(Cash Flows from expansion / new market)
=V
Total investment required to expand / enter
new market = X
Firm has a fixed time horizon (t) at the end of
which it has to decide on whether to
expand / not
The firm cannot make the investment related
with expansion / entry into new market if
does not make the initial investment
31

5. Option to Expand
This situation is like a call option with:
Spot price of asset (S) = PV(Expected Cash
Flows)
Strike price (K) = Cost of expansion
Volatility () = SD in value of the
expansion
Time to expiration (t) = Time horizon for
decision
Risk-free rate of interest (r) = As
applicable
32

5. Option to Expand: Eg. 2

Disney is planning to make an investment in
Mexico for starting a new Disney Channel
The NPV of this investment is $ -150 m
If the venture does better than expected
then Disney will expand the network to the
entire South America at a cost of $ 500 m
PV(Expected Cash Flows) on this investment
$ 400m
S.D. of the value of the investment = 50%
The expansion has to be done within 5 years
33

5. Option to Expand: Eg. 2

Spot price of asset (S) = $ 400 m

Strike price (K) = $ 500 m
Volatility () = 50%
Time to expiration (t) = 5 years
Risk-free rate of interest (r) for 5 years =
4%
Calculate the value of the real option
based on BS model
34

5. Option to Expand: Example 2 Sol.

a. Value of option to expand = $ 167 m (BS Model)
The value of option to expand is the value to be
realised from exercise of the option
b. Add: Existing NPV
= $ - 150 m
This ve NPV is like the option premium
c. Resulting value (net of a & b) = $ 17 m
d. Since the value (a) is greater than the value in
(b) & the value in (c) is +ve it should invest in
the project
e. Practical considerations associated with option
to expand are similar to those for option to delay
35

5A: Option to Expand: Practical

Considerations
Firms with options to expand have no clear
time horizon by which they have to make the
decision to expand open-ended options
Even if the life of the option can be
estimated neither the size of investment nor
the potential size of the market may be
known with certainty
Firm may not have good estimates of either
of the cost of investment or PV(Cash Flows)
because it may not have information about
36
the market

5B: Option to Expand: Implications

Option to expand can be used to rationalise
accepting ve NPV investments; the option
value makes the decision process more
objective
Option to expand is more valuable in more
volatile businesses with higher returns (eg. IT,
Biotechnology) than in stable ones with lower
returns (housing, utilities, automobiles)
Option to expand may justify making large
investments by breaking them down into
smaller phases or investments for strategic
37
reasons

6. Option to Abandon
Often it is important in capital budgeting
decisions to maximise the value created either
by continuing with a project or exiting it
The option to abandon refers to the value that
can be unlocked by exiting or abandoning a
project when the cash flows are below
expectations
Option pricing approach provides a
methodology for estimating and incorporating
this value in capital budgeting decisions
38

6. Option to Abandon
Let V be the PV of cash flows during the
remaining life of a project
L the liquidation or abandonment value of
the project at the same point of time
The project has remaining life of n years
Payoff from the abandonment option:
= 0 if V > L
= L V if V < or = L
This is equivalent to that of a Put option
39

6: Eg. 3
ABC Ltd. Is considering partnership in a
real estate project with a life of 25 years
Initial outlay required: $ 100 m
PV(Expected Cash Flows) = $ 110 m
The co. has the option to abandon the
project at any time during the next 10
years by selling its share of ownership to
the other partners for $ 50 m
Variance in the PV (Cash Flows) = 0.09
40

6: Eg. 3
Spot price of the asset (S): PV(Cash
Flows) = 110 m
Strike price (K): Liquidation value = 50 m
Variance in value of underlying asset =
0.09
Time to expiration = 10 yrs
10-year risk-free rate = 6%
This is equivalent to a put option
Estimate the value of the real option
41

6: Eg. 3: Sol.

Initial outlay: 100 m

PV(Cash flows): 110 m
NPV = 110 100 m = 10 m
BSM value: put option (option to
abandon)= 1.53 m
NPV with abandonment option: 10 + 1.53
= 11.53 m
The presence of abandonment option
increases the NPV
42

6A: Implications
Option to abandon provides firms with
operating flexibility to scale down /
terminate projects when they fall short of
expectations
Value of this real option provides an
objective measure for assessment /
comparison
The option to abandon represents the ability
of the firm to get out of long term
investments that turn out to be bad in future
43

6A: Implications
The flexibility to abandon depends on
the nature of business
Service businesses are easier to
abandon than manufacturing
businesses
Capital intensive businesses
(infrastructure sector) are less easy
to abandon
44

6B: Abandonment Option:

Issues
In reality the firm may have an option to
abandon & the salvage value of the
abandonment can only be estimated with
error in advance
Moreover the value of abandonment can
change during the life of the project
Abandonment of project may entail costs
which may exceed the liquidation value of
assets severance pay to be paid to
workers for laying off
45

7. Real Options: Caveats

Real options approach should not be used
to justify poor / risky investments
Not all investments have embedded
options
Not all embedded options have value
So there two aspects in the real options
analysis of a capital expenditure
proposal:
1. Identifying the presence of an embedded
option
46

7. Real Options: Caveats

In order to apply the real options
approach the following Key questions to
be answered affirmatively:
A. Is the initial investment a prerequisite/
necessary for the later investment?
B. Does the firm have an exclusive right to
the later investment?
C. Are the excess returns sustainable?

47

7A: Initial Investment

Patents: A firm cannot create patents without
investing in research or buying it from another
firm
Natural resources: A firm cannot get rights to
exploit a natural resource without bidding for the
same in a govt. auction
The initial investment is required above: outlay
for R&D, license fee for the natural resource
But if a firm wants to invest in a new market just
to get information then it is not a prerequisite
If a firm wants to acquire firm in a new market to
enter there then that is not a prerequisite
48

7B: Exclusive Right

What matters is whether the firm gets
significant competitive advantages by
making the initial investment
Getting an exclusive right to the later
investment is a type of competitive
advantage
The value of the option derives from the
excess returns generated by the cash
flows from the later investment the
higher the potential for excess returns the
higher the value of the option
49

7C: Sustainability
Excess returns attract competitors & competition
eliminates excess returns
The more sustainable the competitive advantages
are the more sustainable will be the excess
returns & the greater the value of the embedded
options in the initial investment
Competitive advantages will not be sustainable if:
a) entry into the business is easy
b) competitors are aggressive
c) if the resource controlled by the firm is abundant
d) if it results from being the 1st mover / technology
50

7. Caveats..
While assessing the value of the real option the
life of the option (time to expiration) should be
set equal to the period of competitive
advantage
Option valuation approach rests on two basic
assumptions:
a. The underlying asset is tradable in a market
b. The option is tradable
Both these are not fulfilled in real options
So although the value of the real option might
be estimated it should be monetised with
51
caution

Black-Scholes Model: Basic

c S 0 N (d1 ) K e
pKe

rT

rT

N (d 2 )

N (d 2 ) S 0 N (d1 )

2
ln(S 0 / K ) (r / 2)T
where d1
T
2
ln(S 0 / K ) (r / 2)T
d2
d1 T
T
52

BSM: Modified for Known Dividend Yield

c S0e

yT

pKe

N (d1 ) K e

rT

rT

N (d 2 ) S 0 e

N (d 2 )
yT

N (d1 )

2
ln(S 0 / K ) (r y / 2)T
where d1
T
2
ln(S 0 / K ) (r y / 2)T
d2
d1 T
T
53

Additional Examples: Eg. 4

A co. is planning to invest in a project for
producing electronic educational support
systems
Investment outlay required now = 150 m
The PV(Cash inflows) now = 132.5 m
This investment will give the option to
expand & make further investment after
4 years
54

Additional Examples: Eg. 4

The expansion will require an investment
of 300 m
The PV(cash inflows) at the end of 4 years
= 265 m
The SD of value of the co. = 40%
Cost of capital of co = 18%
Risk free interest rate = 12%.
Calculate the value of the option to
expand & the revised NPV
55

Additional Examples: Eg. 5

An oil co. is assessing the value of the
option to extract oil from an oil basin
Estimated oil reserve in basin: 50 m bbl
(constant)
Cost of developing the basin: $ 600 m
Period of validity of right to exploit the
basin: 20 yrs
Marginal value per barrel of oil (marginal
price marginal cost) now: $ 12
Variance of ln(oil price): 0.03
56

Additional Examples: Eg. 5

Once developed the net production
revenue each year = 5% of the value of
reserve
Risk-free rate: 8%
Development lag: 2 yrs
Calculate the value of the option to
develop the reserve using an appropriate
approach
57

Additional Examples: Eg. 5

NOTE: Calculating the value of the option to
develop natural reserves requires two
adjustments:
1. Adjustment for the loss of value during the
development lag time taken develop the
reserves
2. Adjustment for the loss of value that will
take place for each year of delay in
developing the reserve
Both require adjustment with: dividend yield
58
(rate of loss of value pa.)

Additional Examples: Eg. 6

A builder owns a plot of land that can be used to
build either 8 or 12 apartment units
An 8 unit building costs Rs. 3.6 m, 12 unit
building costs Rs. 6.2 m
Current price per unit: Rs. 0.6 m
If the conditions are good next year then each
unit would have a value of Rs. 0.80 m; if
conditions are average each unit would have a
value of Rs. 0.59 m
Risk-free rate = 12%
Assuming that the construction cost will remain
constant next year, estimate the value of the plot.
59

Additional Examples: Eg. 6:

Sol.
Appropriate approach: 1 Step Binomial
Model
Steps:
Step 1: Identify which type (12-unit or 8unit) of apartment will be more profitable
in good & average conditions next year
Step 2: Calculate risk-neutral probabilities
Step 3: Calculate the expected cash flow
next year
Step 4: Compute the current value
60