Real Options

FM-II
IIFT
 Introduction
Figure Figure CF
1 CF 2
Goo Inve
d st
Invest
new token Goo
s amount d
Invest CF
new
CF
s CF
CF Bad
Dont new
Invest s
Dont
Bad Invest CF
new CF
s
 Situations
Variant 1
t0 t t
3 5
Decisi Invest Expected
on to $20m inflows
invest $19m

Do not Expected
invest inflows
Variant 2 =0
t0 t t
3 5
Expected
Decisi Invest
More info about inflows
on to $20m
asset $25m
take
option

Why have the expected inflows in variant 2

increased to $25m?
 Decision tree analysis for real
options
Work from right to left, rolling in the tree as you
move
Compute expected payoffs at the right-most
branches
Discount it to the immediate left decision point. Is
it a positive NPV? If yes, include that branch in
rolling back. If not, abandon that branch.
Compute total expected payoffs from the
accepted branches
Discount the expected value to the next left
decision making point and check for NPV
Continue until the entire tree has been rolled
back to the first decision making point.
A primer to financial options
Call option: Option to buy a stock (or any
financial asset the price of which follows a random
walk) at a later date at a predetermined price
Put option: Option to sell a stock (or financial
asset) at a later date at a predetermined price
Options give the right to the holder to exercise or
not; the seller (writer) of the option is obligated
to honour the holders choice

Parallel to real options:

Call option -> right to invest at a future period
-> option to delay a project
Put option -> right to sell at a future period ->
option to abandon a project
 Why does having an option add to the
value of a capital investment project?
30 Profit Holding a call Limited loss if price
option of asset falls and
20 option remains
unexercised;
10 Terminal unlimited gain if
70 80 90 100 stock price price goes up and
0 option is exercised
-5 110 120 130

30 Profit
Limited loss if price
of asset increases Holding a put
and option remains 20
option
unexercised; larger
gain possible if price 10 Terminal
stock price
falls and option is
exercised 0
170 180 190 200 210 220 230
-7
 Value of an option
Value of a call: c max (0, S0-Ke-rt)
Value of a put: p max (0, Ke-rt -S0)
where,
S0 is the value of the asset today
K is the exercise price to be paid (call) at
time t OR received(put) at time t in case
one chooses to exercise the option
The exercise price is discounted to the
present at the risk-free rate r.
Then where does the riskiness of the
asset figure?
 Binomial tree method to value
options
Su = Inputs:
Rs.27 Rf = 5% p.a.
cu = = 30%p.a.
Re.5
Outputs:
S0 = u = (1+) or Exp()
Rs.20 =1.35
K=Rs.22 d = 1/u = 0.74
c=? a = (1+Rf) or Exp(Rf)
Sd =
= 1.05
Rs.15
Hence,
cd = 0
Situation 1: Accept or reject now. Su=S0*u = 27
Investment to be made after 1 year Sd=S0*d= 15
Situation 2: Make decision at t=1 year. p = (a-d)/(u-d) = 0.51
Pay a token to buy the right to wait for 1 and
year. What will this token amount depend 1-p = 0.49
on?
What do the possible outcomes and their
Value of call
probability of occurrence depend on?
= ((p*cu)+(1-p)*cd)/a
So, what variables and relationships
determine the value of the option?
c = S0 * N(d1) Ke-rt * N(d2) and p = Ke-rt*N(d2)
S0*N(-d1)
d1, d2 are functions of S0/PV(K) and t

Relationship between S0 and K: The more in-the-

money the option is, the greater its value
Risk-free rate: Greater is Rf, lower is PV(K)
Variability in asset value (): The greater the
variability, the greater the option value
Time to expiry (t): More the time between valuing
the option and its expiry, greater the option value
In other words option value is an increasing
function of S0/PV(K) and t
 Relating option valuation to DCF
analysis
S0/PV(K) vs. traditional NPV (S0 PV(K))
In DCF, what is the value of t?

OTM in PV NPVq=S0/PV(K ITM in PV terms

terms )
Low

High Highest
value of
option
 Reworking our example using
simplified B-S
NPVq = 20/PV(22) = 20/20.93 = 0.96
t = 30%
Table value = 10.2
Value of option = 20*10.2% = Rs.2.04

Value of a put option

= Call option value (S0 - PV(K))
 Example 1
Disney is thinking of conducting a pilot
project in the Mexico market to set up a
theme park.
Based on the results of this pilot it can
invest $500m for a full-fledged park after 5
years, the present value of whose cash
flows at t=5 work out to $400m.
A Monte Carlo simulation of business from
similar parks yields a standard deviation of
50%p.a. and the risk-free rate is 4%p.a.
Should Disney go for the pilot? What is the
maximum it should invest in this pilot?
 Example 2

Mr. A is planning to buy a house costing

Rs.50 lakhs today. For this, he will make a
down payment of Rs.10 lakhs and take the
rest as a bank loan at interest@6%p.a (Rf).
Assume the loan is on bullet repayment at
the end of 3 years including interest.
House prices show a variance of 6.25%p.a.
Where is a call option embedded in this
deal?
What is the value of this option?
 Concluding

Value of an investment = Value of

assets in place + value of real options
What does it take for a real option to be
valuable?
Is the initial investment a pre-requisite for
a future optional investment?
Volatility in asset returns
Exclusivity/ sustainable competitive
advantage