Investment Timing

Strategy as per Real

Option Valuation
Strategy
GROUP # 9

Niranjan Bhalya – 204 Vivek Parab – 248

Sangeeta Chauhan – 209 Tejas Parte – 251

Surbhi Jain – 219 Abhay Tiwari – 276

Yasif Lakhani – 226 Sachin Shinde – 284

Lalit Mishra – 238 Vasim Shaikh – 285

 THE VALUE OF INTANGIBLE ASSETS

INTANGIBLES THAT GENERATE CASHFLOWS INTANGIBLES WITH POTENTIAL FUTURE

CASHFLOWS
1) Trademarks, Copyrights
2) Brand Value 1) Undeveloped Patents
3) Human Resources 2) Natural Resources Options
4) Others
3) Option to expand in new Market

4) Others

These are difficult to value on DCF basis and

often impossible to value on relative basis.

These assets are best valued using option

pricing models.
WHAT IS REAL OPTION VALUATION

• Real option is a contingent claim or option on an asset that pays

off only under certain contingencies
• The option pays off if the value of the underlying asset exceeds
a pre-specified value for a call option, or is less than a pre-
specified value for a put option.
• It is the premium on value that makes real options so alluring
and so potentially dangerous.
• It is also used as a valuation technique in capital budgeting
decisions.
Payoffs on Options as a function of the underlying
asset’s value

Strike Price
Value of Asset

Put Option
Call Option
EXAMPLE

• Cisco has been successful at buying firms with nascent and

promising technologies (options) and converting them into
commercial success (exercising these options).

• An oil company can observe what the oil price is each year
and adjust its development of new reserves and
production in existing reserves accordingly rather than be
locked into a fixed production schedule.
DIFFERENT FROM DCF

• DCF model values assets based on expected cash flows and

do not consider the possibility that firms can learn from
real-time developments and respond to that learning.
• The essence of real options argument is that DCF models
understate the value of assets with option characteristics.
• Under DCF, high risk results to lower valuation but in
option valuation this does not hold true
 ADVANTAGES
1) Few assets cannot be valued
with conventional methods
2) Yields realistic estimates
obtained from learning and
flexibility
3) Highlight aspect of risk
DISADVANTAGES
1) Can result in overpayment
2) Competitors can adapt
behavior thus reducing pay
off
3) Limitations to value long
term options on non traded
assets
 INVESTMENT TIMING STRATEGY

• Present value of cash flow from drug introducing now = S = $3.422 billion
• Initial cost of developing drug for commercial use (today) = K = $2.875 billion
• Patent life = t = 17 years
• Riskless rate = r = 6/7% (17 year treasury bond rate)
• Variance in expected present value = σ² = 0.224
• Expected cost of delay = y = 1/17 = 5.89%

• A Call option strategy

 INVESTMENT TIMING STRATEGY Contd…

• Value of patent = $907 million*

• NPV = $547 million
If company invest today it will need to pay a premium of $360 million.
It is suggested that the firm should wait rather than producing the drug today.

*Value of patent based on Dividend adjusted Black-Scholes options pricing model

INVESTMENT TIMING STRATEGY Contd…

• So when should the drug company exercise their option?

OPTION TO EXPAND INVESTMENT

• Firms sometimes invest in projects because the

investments allow them either to make further
investments or to enter other markets in the future.

• A firm may accept a negative net present value on the

initial project because of the possibility of high positive net
present values on future projects.
OPTION TO EXPAND EXAMPLE

• A is a popular soft drink company in Brazil

• B, a US company looking to acquire A

• B’s Investment strategy

• First introduce the product in metropolitan area to gauge
potential demand
• If the above turns out to be success introduce the product
across US.
OPTION TO EXPAND EXAMPLE (Contd…)

• Based on certain assumptions and estimation company B reaches the

following information.

• NPV of limited introduction = -500 + 400 = -100 million

• Value of option to expand = $203 million
• NPV with option to expand = -$100 + $203 = $103 million

• Even though net NPV is negative, company B should invest in limited

introduction because it acquires an option of much greater value.
TEST FOR EXPANSION OPTION

• Is the first investment a prerequisite for the later

Investment/expansion?
• Does the firm have an exclusive right to the later
investment/expansion?
• How sustainable are the competitive advantages?

• If the answer in all three cases is affirmative, then the option to

expand can be valuable.
OPTION TO ABANDON INVESTMENT

• When investing in new projects, firms worry about the risk that the
investment will not pay off and that actual cash flows will not measure
up to expectations.
• Having the option to abandon a project that does not pay off can be
valuable, especially on projects with a significant potential for losses.
• The option pricing approach provides a general way of estimating and
building in the value of abandonment.
OPTION TO ABANDON EXAMPLE

• Lear Aircraft wants to build a small passenger plane.

• It approaches Airbus with a Joint Venture proposal.
• Each firm will invest $500 million in the joint venture and
produce the planes.
• Airbus estimates that the NPV on project is $480.
• As the net NPV is negative Airbus rejects the offer.
OPTION TO ABANDON EXAMPLE (Contd…)

• Lear Aircart approaches Airbus with new proposal.

• To buy out Airbus’s 50% share of the joint venture at any
time over the next five years for $400 million.
• This is less than what Airbus will invest initially but it puts a
floor on its possible losses and thus gives Airbus an
abandonment option.
OPTION TO ABANDON EXAMPLE (Contd…)

• Airbus does there simulation, estimation and black-scholes

pricing model.
Value of abandonment option =
• 400e(-0.05)(1-0.5776) – 480e(-0.0033)(1-0.7748) = $40.09 m

• Since this is greater than the negative NPV of the

investment, Airbus should enter into this joint venture.
DETERMINANTS OF OPTION VALUE

1. Current value of underlying asset

2. Variance in value of underlying asset
3. Dividends paid on underlying asset
4. Strike price of option
5. Time to expiration on option
6. Riskless interest rate corresponding to life of option
Thank you