Lecture 6 Real Options Basics

REAL OPTION VALUATION
Basics
Taylan Mavruk
Capital Budgeting and Real Options
Part 2: Real Options
2012
Copyright 2007 Pearson Addison-Wesley. All rights reserved. 22-3
A simple example
Assume Megan is financing part of her MBA education by
running a small business. She purchases goods on eBay
and resells them at swap meets.
Swap meets typically charge her $500 in advance to set
up her small booth. Ignoring the cost of the booth, if she
goes to every meet, her average profit on the goods that
she sells is $1100 per meet.
Megans Choices
Effect of the Weather on Megans Options
Megans Decision Tree When She Can Observe the Weather Before
She Makes the Decision to Go to the Meet
Real Options
If Megan commits to go regardless of the
weather, her expected profit is $1100.
0.75 $1500 + 0.25 ($100) = $1100
However, if she goes only when the weather is
good, her expected profit is $1125.
0.75 $1500 + 0.25 $0 = $1125
The value of the real option is the difference, $25.
Real option
The real option approach is the extension of
financial option theory to options on real assets
There is a great value in breaking up large projects
in stages taken in uncertain markets
Uncertainty creates opportunities (NPV >0)
Many strategic investments create subsequent
opportunities that may be taken
The investment opportunity can be viewed as a
stream of cash flow plus a set of options.
RO assumptions
There is uncertainty
Management has flexibility
Flexibility strategies are credible and executable
Management is rational in executing strategies

Important concepts
Market risk; It is correlated with the general movements of the economy and
industry this uncertainty is exogenous to the decision. Incentive to defer
investments.
Private risk; Endogenous to the decision. It can be resolved by making an
investment in exploration a learning option. It gives incentive to divide the
investment stage forward.
9
Four classes of real options
Option to expand

Option to abandon

Option to defer

Option to vary output/input and production methods
Option to Defer
A company holds lease on valuable land or
resources
Wait to see if output prices justify
constructing a building or a plant
Important for resource extraction, real estate
development, farming, forest management
etc.
Option to abandon
If market conditions decline severely,
management can abandon current operation
permanently and realize resale value and other
assets in secondary markets
Important for capital-intensive industries (airlines,
railroads) financial services, and new product
introduction

Option to expand
An early investment (R&D) may be a link (a
prerequisite) in a chain of interrelated projects,
opening up future growth opportunities
Important for infrastructure-based industries
(high-tech), multiple product industries,
multinational operations, FDI.
Option to change input/output and production process
If prices or demand change, management can
change the output mix of facility (product
flexibility)
Alternatively, the same outputs can be
produced using different types of inputs
(process flexibility).
Important for consumer electronics, toys,
machine parts, autos, electric power,
chemicals, crop switching, etc
Common Embedded Real Options
Option to defer
Time-to-build option (Staged investment)
Option to alter operating scale (e.g. to expand; to
contrast; to shut down and restart)
Option to abandon
Option to switch (e.g. outputs or inputs)
Growth options
Multiple interacting options

When to use real options
When there is a contingent investment decision
When uncertainty is large enough to wait for more
information and to make flexibility a consideration
When the value depends highly on future growth
and future prices
When there will be project updates and strategy
corrections

Options
Call Option
Gives the buyer of the option the right to buy the underlying asset
at a fixed price.
Put Option
Gives the buyer of the option the right to sell the underlying asset
at a fixed price

Exercise price (Strike price)
The price the holder of an option has the right to sell/buy a
specified quantity of an underlying asset (share)
Share price
The value of the underlying share
Value of option
The price one pays for the option.
In the money and out of the
money
A call option is in the money if share price is
above exercise price

A call option is out-of-money if the share
price is below the exercise price. The price is
defined by future expectations on changes in
share price.

For the owner of a put the opposite holds

19
B-S Valuation of a European Call
The Value of a European Call Option on a Stock:

2
)) ( / ln(
1
T
T
X PV S
d
o
o
+ =
T d d o =
1 2
Where
and
X = Exercise Price,
T = Years to expiration,
= Annualized Standard Deviation of the Natural Logarithm of the Stock Return,
ln() = represents the natural logarithm
N(z) = the probability that a normally distributed variable with a mean of zero and variance of 1 is less than z
X = Exercise Price,
T = Years to expiration,
= Annualized Standard Deviation of the Natural Logarithm of the Stock Return,
ln() = represents the natural logarithm
N(z) = the probability that a normally distributed variable with a mean of zero and variance of 1 is less than z

) ( ) (
2 1
d N Xe d SN c
T rf
=
How changes in option variables influence the
value of the option
Variable Change
in
variable
Change in
value for a
call option
Change in value
for a put option
Share Price (S)
+ + -
Strike price (exercise
price) (k)
+ - +
Years to maturity (t)
+ + +
Risk in underlying
asset (o)
+ + +
Risk free interest rate
(r
rf
)
+ + -
Dividends
+ - +
A common option

A real option to
defer

A real option to
expand

The share price
S

the present value of
expected cashflow
from initiating the
project

The net present value
of the cash flow from
the original project

Strike price
k

The initial
investment

The initial
investment of the
expanding project

Years to maturity
t

The option expires
when the right to the
project lapse

The option expires
when the right to the
expanding project
lapse

Risk in underlying
asset
o

the variance (risk) in
the expected cash
flow

The variance in the
expected cash flow
from the expanding
project

The risk free
interest rate
r
rf
the risk free interest
rate corresponding to
the length of the
option

the risk free interest
rate corresponding to
the length of the
option

Dividends

Cost of delay = the
cash flow that will be
lost because delaying
the project

Most often not
concidered

Comments on different variables
The higher the variance the higher the value of the option
The value of an option in a stable business will be less than the value
of one in an environment where technology, competition and
markets are changing rapidly
When you give up your option to wait, you can no longer take
advantage of the volatility of the projects future value
The arguments against NPV is that it is always a now or never
decision.
Investment made after the right to expire are assumed to deliver a
NPV of zero value, mainly because increased competition.

Strategy and real option
Finance theory and traditional approaches to strategic planning may
be kept apart by differences in language and culture
Discounted cash flow analysis may have been misused, and
consequently not accepted, in strategic applications
Discounted cash flow analysis may fail in strategic applications even if
it is properly applied. Myers, Interfaces 14 Jan-Feb. 1984
smart managers

CAN REAL OPTION VALUATION BRIDGE THE CAP BETWEEN FINANCE
AND STRATEGY

Options as a strategic tool
Waiting
Does the opportunity materialize?
Given uncertainty managers are likely to make
small investments rather then a large, risky,
investment.

Striking
To wait for the correct moment
The arrival of the opportunity (the option is unfolded)
The expiration signal
Downside risk and inertia
Options reduce downside risk
Sunk costs produces a pressure to hold on to old
investment
There is an optimal inertia
Conclusion:
Firms with bundles of options will grow
aggressively in upcoming markets and persist
longer in difficult markets
Perceived environment uncertainty
The higher the environmental risk the higher
the value of an option
In high risk environment options are hold open
for a longer period
Conclusion:
Organization that hold options during instable
period and strike option in stable periods will
show superior long-term growth
The size and timing of organisational
investments
Experience and learning
Small steps followed by a large strike
Conclusion:
Organizations that enter new business and
markets by linking investments, so that small
options are followed by a large strike will
perform better than those entering in discrete
small or large investments

The size and timing of organisational
investments
Two signals (see earlier slide)
The end of wait and see period
The imminent closure of the option
Conclusion:
The optimal strike is to wait for both signals:
that is when the opportunity has clearly arrived and the value
of waiting is at lowest

A final conclusion, linking options and strategy:
Organizations entering new areas will achieve superior
growth and performance by striking small investments and to
hold options open and follow with a large strike investment
upon both signals.

Irreversible costs (sunk cost)

An investments economic life span is dependent
on the amount of irreversible costs included.
The abandon, and defer option will therefore be
of high importance.
Example

Investment as a Call Option
Assume you have negotiated a deal with a
major restaurant chain to open one of its
restaurants in your hometown.
The terms of the contract specify that you must
open the restaurant either immediately or in exactly
one year.
If you do neither, you lose the right to open the restaurant
at all.
Restaurant Investment Opportunity
How much you should pay for this opportunity?
It will cost $5 million to open the restaurant, whether you
open it now or in one year.
If you open the restaurant immediately, you expect it to
generate $600,000 in free cash flow the first year.
Future cash flows are expected to grow at a rate of
2% per year.
The cost of capital for this investment is 12%.
If the restaurant were to open today, its value would be:
This would give an NPV of $1 million.
$6 million $5 million = $1 million
Given the flexibility you have to delay opening for one year, what
should you be willing to pay?
When should you open the restaurant?
$600,000
$6 million
12% 2%
V = =

The payoff if you delay is equivalent to the payoff of a one-year European call
option on the restaurant with a strike price of $5 million.
Assume
The risk-free interest rate is 5%.
The volatility is 40%.
If you wait to open the restaurant you have an opportunity cost of
$600,000 (the free cash flow in the first year).
In terms of a financial option, the free cash flow is equivalent to a
dividend paid by a stock. The holder of a call option does not
receive the dividend until the option is exercised.
Table

The current value of the asset without the dividends
that will be missed is:
The present value of the cost to open the restaurant in
one year is:
$0.6 million
( ) $6 million $5.46 million
1.12
x
S S PV Div = = =
$5 million
( ) $4.76 million
1.05
PV K = =
The current value of the call option to open the
restaurant is:
1
2 1
ln[ / ( )] ln(5.46 / 4.76)
0.20 0.543
2 0.40
0.543 0.40 0.143
x
S PV K T
d
T
d d T
o
o
o
= + = + =
= = =
1 2
( ) ( ) ( )
($5.46 million) (0.706) ($4.76 million) (0.557)
$1.20 million
x
C S N d PV K N d =
=
=
The value today from waiting to invest in the restaurant
next year (and only opening it if it is profitable to do so)
is $1.20 million.
This exceeds the NPV of $1 million from opening the
restaurant today. Thus, you are better off waiting to
invest, and the value of the contract is $1.20 million.
What is the advantage of waiting in this case?
If you wait, you will learn more about the likely
success of the business.
Because the investment in the restaurant is not
yet committed, you can cancel your plans if the
popularity of the restaurant should decline. By
opening the restaurant today, you give up this
option to walk away.
Whether it is optimal to invest today or in one
year will depend on the magnitude of any lost
profits from the first year, compared to the
benefit of preserving your right to change your
decision.
Option to expand, a software example
Investment in a project called Blue Eye 1, a software application.

1982 1983 1984 1985 1986 1987
FCF -200 +60 +59 +195 +310 +125
(after tax)

Initial -250
investment

CF -450 60 59 195 310 125

K = 20%

NPV = -46.45 ~ -$46

Investing in Blue Eye 1 includes a call option to expand. It gives the opportunity to
make follow-on investment which could be extremely profitable. The option on the
second project Blue Eye 2 is therefore worth a lot.
Assume for Blue Eye 2:
1. It must be made after 3 years (1985)
2. It is double the scale of Blue Eye 1 and requires an initial investment of
$900 (exercise price)
3. Forecasted cash flow from Blue Eye 2 has a PV of $800 in 1985:
(800/1.2
3
= $463 in 1985)
4. The future value of Blue Eye 2 is highly uncertain. The value evolves like
the companys stock price with a standard deviation of 35%.
5. The annual interest rate is 10% (risk free)

The option value for Blue Eye 1 (the value of Blue Eye 2)
The opportunity to invest in Blue Eye 2 is a three year call
option on an asset worth $463 million with a $900 million
exercise price

( ) | | ( ) ( ) | |
( ) | |
| |
( ) ( )
| | | | 59 . 53 $ 676 1767 . 0 463 3739 . 0 value Call
1767 . 0 , 3739 . 0
9279 . 0 606 . 0 3216 . 0
3216 . 0 2 / 606 . 0 606 . 0 / 685 . 0 log
2 / / / log
value Call
676
1 . 1
900
) price exercise (
2 1
1 2
1
2 1
3
= =
= =
= = =
= + =
+ =
=
= =
d N d N
t d d
t t EX PV P d
EX PV d N P d N
PV
o
o o
The option value for Blue Eye 1 (the value of Blue Eye 2)
The value for Blue Eye 1 with option to abandon equals
-$46.45 + $53.59 = $7.14

Invest in Blue Eye 1

Investing in Blue Eye 2 gives new options in Blue Eye 3 and
so on.

Lecture 6 Real Options Basics

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