Chap 4

Comparing Net Present

Value, Decision Trees, and
Real Options
We reviewed the finer points of net present
value methodology.
It will always be the starting point for real
options analysis ( ROA ) because we need the
present value of a project without flexibility as a
because.
A simple deferral option
Consider a decision that you must make today
either to invest in a $1,600 project right now, or
to defer until the end of a year.
Once made, the investment is irreversible.
600 200 , 2 600 , 1
) 1 . 1 (
200
600 , 1
0
= + = + =

= t
t
NPV
To have perpetual level cash flows, the depreciation of the project
each year is compensated by replacement investment of equal
magnitude.
The price level of output is $200 now, and there is a 50-50 chance
that it will go up to $300 at the end of a year or down to $100.
In either case, the price change is assumed to be permanent.
Therefore the long-term expected price level is also $200.
The first unit is sold at the beginning of the first year of operation.
The cost of capital is 10 percent.
1 1
1, 600 300 1, 600 100
0.5 [ , 0] 0.5 [ , 0]
1.1 (1.1) 1.1 (1.1)
t t
t t
NPV
MAX MAX

= =
=

+ + +

1, 600 3, 300 1, 600 1,100
0.5 [ , 0] 0.5 [ , 0]
1.1 1.1
MAX MAX
+ +
= +
1, 700 850
0.5[ ] 0.5[0] 773
1.1 1.1
= + = =
Thus, we are better off by deciding today to
defer, rather than to invest.
The value of the deferral option is the difference
between the two alternatives, namely $773 -
$600 = $173.
Suppose that the volatility of the price increase
but its expected value stays the same.
For example, there may be a 50-50 chance that it
goes either to $400 or $0.

1 1
1, 600 400 1, 600 0
0.5 [ , 0] 0.5 [ , 0]
1.1 (1.1) 1.1 (1.1)
t t
t t
NPV
MAX MAX

= =
=

+ + +

1, 600 4, 400 1, 600 0
0.5 [ , 0] 0.5 [ , 0]
1.1 1.1
MAX MAX
+ +
= +
0.5 [2, 545.45, 0] 0.5 [ 1, 454.55, 0] MAX MAX = +
= 0.5[2,545.45] = 1,272.73
The value of the deferral option has increased
from $173 to $673.
When uncertainty increases in the economy, due
perhaps to political unrest, then one would
predict that investment would decline in
response because it becomes worth more to
wait to see what happens.
A simplified comparison of net present value, decision
tree analysis, and real options analysis
You have to decide right now whether to
precommit to a project that will cost $115
million next year with absolute certainty, but
will produce uncertain cash flows a 50-50
probability of either $170 million or $65 million.
The alternative to pre-commitment is to wait the
end of the year to decide, and this right costs $C
0
.
Estimating the net present value
Capital Asset Pricing Model, and search for
company-level betas that are presumed to have
the same risk as the project that is being valued.
The payoffs of our project and of the twin
security.
Note that the twin security has cash payoffs that
are exactly one fifth of the payoffs of our project,
% 5 . 17
1
) 13 ($ 5 . 0 ) 34 ($ 5 . 0
20
1
) )( 1 ( ) (
0
=
+
+
=
+
+
=
k
k
k
V q V q
V
d u
100 $
175 . 1
) 65 ($ 5 . 0 ) 170 ($ 5 . 0
=
+
= PV
Its present value is $115/1.1 = $104.55.
The NPV of the project is $100 - $104.55 = - $4.55
Lets use a portfolio of m shares of the twin security
and B bonds to replicate the payouts of our project.
Replicating portfolio payoff in the up state :
m($34) + B( 1 + r
f
) = $170
Replicating portfolio payoff in the down state :
m($13) + B( 1 + r
f
) = $65
Present value of the replicating portfolio :
m($20) + B = 5 ($20) + 0 = $100.
The replicating portfolio approach discounts expected
cash flows at a risk-adjusted rate, while the risk neutral
approach discounts certainty-equivalent cash flows at
the risk-free rate.
Decision tree analysis
This is a long-standing method for attempting to
capture the value of flexibility.


The NPV of the project has increased from
- $4.55 million given the inflexible pre-
commitment alternative to $23.40 million with
the ability to defer.
Consequently, the value of the deferral option,
using the DTA approach is
40 . 23 $
175 . 1
5 . 27 $
175 . 0 1
) 0 ($ 5 . 0 ) 55 ($ 5 . 0
= =
+
+
= NPV
$23.4 ( - $4.55 ) = $27.95 million.
At first glance, this seems to be a good approach,
but on close reflection the DTA method is wrong.
Why? Because the DTA approach violates the
law of one price.
To value the cash flows provided by the deferral
option, we need to use the replicating portfolio
approach.

Real options analysis
To confirm with the law of one price when we evaluate
the deferral option, we can form a complicating
portfolio that is composed of m shares of the twin
security,
Replicating portfolio in the up state :
m($34) + B( 1 + r
f
) = $55
Replicating portfolio in the down state :
m($13) + B( 1 + r
f
) = $0
Default-free bonds pay 8 percent interest.
Replicating portfolio in the up state :
2.62($34) - $31.53( 1.08 ) = $89.08 - $34.05 =$55.00
Replicating portfolio in the down state :
2.62($13) - $31.53( 1.08 ) = $34.06 - $34.05 =$0
Present value of the replicating portfolio :
m($20/share) + B($1.00) = 2.62($20) - $31.53 = $20.87
The value of deferral is therefore $25.42 million.

The DTA approach



The DTA approach will give the wrong answer because it
assumes a constant discount rate throughout a decision tree,
when the risk-less of the cash flow outcomes changes based on
where we actually are located in the tree.
Replicating portfolio in the up state :
m($34) + ( 1 + r
f
) B = $0
Replicating portfolio in the down state :
m($13) + ( 1 + r
f
) B = $50
Present value of the replicating portfolio :
m($20) + B = - 2.38 ($20) + $74.93 = $27.34
% 9 . 31
1
) 0 ($ 5 . 0 ) 55 ($ 5 . 0
87 . 20 $
=
+
+
= =
k
k
PV
Intuition of the replicating portfolio
approach
m V
u
+ B (1 + r
f
) = C
u

-[ m V
d
+ B (1 + r
f
) = C
d
]


m V
0
+ B
0
= C
0


security
u d
u d
C C Incremental option payoff
m
V V Change in the value of the twin

= =

The marketed asset disclaimer

The frustrating part of the twin security approach
is that it is practically impossible to find a priced
security whose cash payouts in every state of
nature over the life of the project are perfectly
correlated with those of the project.
Therefore, it is nearly impossible to find market-
priced underlying risky assets.

Early applications of real options analysis used the
prices of world commodities as the underlying risky
asset, but made the somewhat arbitrary assumption that
the volatility of the underlying project without
flexibility was the same as the observed volatility of the
world commodity.
We are willing to make the assumption that the present
value of the cash flows of the project without flexibility
is the best unbiased estimate of the market value of the
project were it a traded asset.
We call this assumption the Market Asset Disclaimer
( MAD ).
If we use the MAD assumption, the payouts of
the twin security are the same as those of the
project itself, $170 in the up state and $65 in the
down state, and the present value of the project
is $100.
Replicating portfolio in the up state :
m($170) + B( 1 + r
f
) = $55
Replicating portfolio in the down state :
m($65) + B( 1 + r
f
) = $0
m = 0.524 and B = - $31.54
Present value of the project with flexibility :
m($100) +B = 0.524($100) - $31.54 = $52.40 -
$31.54 = $20.86
MAD assumption as the basis for valuing real
options on any real asset where we are able to
estimate the traditional net present value without
flexibility.
And if its okay for NPV analysis, then we can
reasonably assume that the PV of a project
without flexibility is the value it would fetch
were it a marketed asset.
The risk-neutral probability
approach
It starts out with a hedge portfolio that is
composed of one share of the underlying risky
asset and a short position in m shares of the
option that is being priced; in our example this is
a call position, the right to defer.
uV
0
mC
u
= dV
0
mC
d

170 m(55) = 65 0
909091 . 1
0 55
100 ) 65 . 0 7 . 1 ( ) (
0
=

=
d u
C C
V d u
m
Where :u = Up movement = 1.7
d = Down movement = 0.65
V
0
= Starting value = 100
C
u
= call value in up state = 55
C
d
= call value in down state = 0
Given that we are long one unit of the
underlying and short 1.909091 units of the call
option :
0 0 0
0 0 0
: 170 - 1.909091(55) 65.00
: 65- 1.91(0) 65.00
V - 100 - 1.909091
(V - ) (1 ) V -
(100
u
Hedge portfolio payoff in the up state
Hedge portfolio payoff in the down state
mC C
mC rf u m C
=
=
=
+ =
0
- 1.909091 ) (1.08) 1.7(100) - 1.909091(55) C =
86 . 20
) 909091 . 1 (
]
100 08 . 1
) 100 170 (
[
0
=

= C
) 1 ( )]
) 1 (
( )
) 1 (
( [
0 f
f
d
f
u
r
d u
r u
C
d u
d r
C C +

+
+

+
=
) 1 (
) 1 (
0
f
d u
r
C p pC
C
+
+
=
1 ) ( ]
) 1 (
[ ]
) 1 (
[ =

+
+

+
d u
d u
d u
r u
d u
d r
f f
More on the risk-adjusted and risk-
neutral approaches
Exhibit 4.6 shows a two-period example of a project
that has a current value of $100 with objective
probabilities, q = 0.6, and ( 1 q ) = 0.4, of moving up
by 20 percent or down by 16.67 percent each time
period.
Given a weighted average cost of capital of 5.33 percent,
we have a mutually consistent set of assumption.
The present value, the objective probabilities multiplied
by the payoffs, and the risk-adjusted discount rate are a
triad of assumptions that must be mutually consistent
with each other.
$100
1095 . 1
95 . 110 $
1095 . 1
11 . 11 48 84 . 51
0533 . 1
) 44 . 69 ( ) 4 . 0 ( 100 ) 4 . 0 )( 6 . 0 ( 2 ) 144 ( ) 6 . 0 (
2
2 2
= =
+ +
=
+ +
=
PV
PV
V0 = $100, V1 = 0.6 (120) + 0.4 (83.33) =
$105.33,
and V2 = 0.36 (144) + 2 (0.6)(0.4)(100) + 0.16
(69.44) = $110.95
(1 )
(1.03) 0.833
0.53722
1.2 0.833
f
r d
p
u d
+

= = =

1 (1 0.53722) 0.46278 p = =
$100
0609 . 1
106.16 $
1.0609
14.87 49.73 41.56
3 0 . 1
) 44 . 69 ( ) 63 4 . 0 ( ) 100 ( ) 63 4 . 0 )( 537 . 0 ( 2 ) 144 ( ) 537 . 0 (
2
2 2
= =
+ +
=
+ +
=
PV
PV
2
0
0
0
(1 ) 49, 95
(1 ) 5
1 92.23
120 92.23 27.77
f
f
mu V r B K
mudV r B
m and B
Cu muV B
+ + = =
+ + =
= =
= + = =
This is greater than the $25 payoff if we exercise
the option at node D.
Therefore, we hold (i.e., we keep our option
alive to exercise later).
At node E : m = 0.1636,B=-10.88,C
d
= 2.75
At node F : m = 0.6823,B=-52.53,C
0
= 15.70
(1 )
1
uu ud
u
qC q C
C
RAR
+
=
+
RAR +
+
=
1
) 5 ( 4 . 0 ) 49 ( 6 . 0
77 . 27
13.07% RAR =
The risk-adjusted return changes from node to
node reflecting the changing risk of the payoffs.
53722 . 0
833 . 0 2 . 1
833 . 0 03 . 1
1
,
1
) 1 (
=

+
=
+
+
=
d u
d r
p
r
C p pC
C
f
f
ud uu
u
80 . 27
03 . 1
) 5 ( 46278 . 0 ) 49 ( 53722 . 0
=
+
=
u
C
The advantage of the risk-neutral probability
approach is that the risk-neutral probabilities
remain constant from node to node.
100 $
168 . 1
) 67 ($ 4 . 0 ) 150 ($ 6 . 0
0
=
+
= V
) 1 (
) 1 (
0 0
0
f
r
dV p puV
V
+
+
=
0 0 0 0
(1 )
f
V r puV dV pdV + = +
d u
d r
p
f

+
=
) 1 (
2
0
0
(1 ) 75
[ (1 ) 0 ]
f uu
f ud
mu V B r C at node A
mudV B r C at node B
+ + = =
+ + = =
0
( )
uu ud
muV u d C C =
) (
0
d u uV
C C
m
ud uu

=
0
(1 )
f ud
mudV B r C + + =
) 1 (
0
f
ud
r
mudV C
B
+

=
0
0 0
0
=
( ) (1 )
uu ud ud
D
f
C C C mudV
C muV B uV
uV u d r

= + +
+
0
0
0 0
( ) 1 ( ) 1
uu ud ud uu ud
f f
C C C C C udV
uV
uV u d r uV u d r

= +
+ +
[1 ]
1 1
uu ud ud
f f
C C C d
u d r r

= +
+ +
1
1 1
f
uu ud ud
f f
r d
C C C
u d r r
(
+

= +
(
+ +
(

1 1
1 1 1
f f
uu ud ud
f f f
r d r d
C C C
u d r u d r r
(
+ +
| |
= +
(
|
+ + +
( \ .

1 1
(1 )
f f
uu ud f
r d u r
C C r
u d u d
+ (
| | | |
= + +
( | |

\ . \ .

[ (1 ) ]
(1 )
uu ud
f
pC p C
r
+
=
+
Comparison of financial and real
options
The underlying for a financial option is a security such
as a share of common stock or a bond (or interest rates),
while the underlying for a real option is a tangible asset,
for example, a business unit or a project.
Both types of option are the right, but not the obligation,
to take an action.
The fact that financial options are written on traded
securities makes it much easier to estimate their
parameters.
With real options, the underlying risky asset is usually
not a traded security; therefore, we make the Marketed
Asset Disclaimer assumption that we can estimate the
present value of the underlying without flexibilities by
using traditional net present value techniques.
Another important difference between financial and real
options is that most financial options are side bets.
They are not issued by the company on whose shares
they are contingent, but rather by independent agents
who write them and buy those that are written.
Consequently, the agent that issues a call option has no
influence over the actions of the company and no
control over the companys share price.
Real options are different because management controls
the underlying real assets on which they are written.
The act of enhancing the value of the underlying real
asset also enhances the value of the option.
Finally, with both financial and real options, risk the
uncertainty of the underlying is assumed to be
exogenous.
The actions of a company that owns a real option may
affect the actions of competitors, and consequently the
nature of uncertainty that the company faces.