Real Options Case Studies

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Real Options Case Studies
Case Studies In Finance (University of Melbourne)
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Real Options
Case Studies in Finance

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Reminder: Financial Options
• A call option is a contract between a holder and writer

which gives its holder the right to buy a particular stock at a
given price, called the exercise price or the strike price,
• A put option gives its holder the right to sell a particular

stock at the exercise price on or before the expiration date.
• Real options are anything that has a similar structure:

– Underlying Asset (S)
– Strike Price (X)
– Volatility (σ)
– Expiration Date (T)
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Call Value at Expiration
• Consider a call with a strike of $30 on MSFT
Stock Value 20 25 30 35 40
Call Value 0 0 0 5 10
© 2008 Patrick J. Kelly Downloaded by karthik sk ([email protected]) 3

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Call Payoff at Expiry: X=30

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Value at Expiry ($)
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Stock Price at Expiry ($)
Calls Call Profit

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Option Value at Expiration
• Calls
– If S > X then payoff = S – X
– If S ≤ X then payoff = 0
• If you write a call the payoffs are flipped:
– If S > X then payoff = –(S – X) (i.e. loss)
– If S ≤ X then payoff = 0
• Puts
– If S ≥ X then payoff = 0
– If S < X then payoff = X - S

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Put Payoff at Expiry: X=30

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Puts Put Profit

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Stock & Bond Payoff at Expiry: X=30
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Value at Expiry ($)
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Stock
Bond
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Real Options
Options are found all over the place in real life.
• Movie studios buy the right to buy a script by some date in the future.
– Type of Option? Call
– Underlying Asset? The script
– Call premium? First payment to writer;
– Strike Price? Fee paid to use the script
• Pre-Paid Dental Plans provide “discounted” service

– Underlying Asset? dental services
– Call premium? cost of the plan;
– Strike Price? the costs for prepaid services dictated by contract

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Real Options
• Australia’s Financial Claims Scheme (FCS) deposit insurance.
– Type of Option? Put
– Underlying Asset? the bank assets guaranteeing their liability to you
– Put premium? the money they pay the FCS
– Strike Price? $250,000
• A limit buy order

– Type of Option? Put
– Underlying Asset? the stock
– Call premium? $0
– Strike Price? the limit price

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Real Options
• A stock in a firm where the value of debt is nearly as high as the value
of the firm.
– Underlying Asset? The firm
– Call premium? The stock price
– Strike Price? The value of the debt

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Real Options
For Real
Using Real Options to Value Projects

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The standard NPV problem
• Is the following project a good investment?
• It costs you $1.50 in discounted tram fare to go out this

Friday.
• There are 4 bars selling $1 beer. Strangely, the quality varies:

– Small Batch Microbrew — worth $4
– Strong Beer Import — worth $3
– Domestic Swill — worth $2
– Brand Weasel— worth $1 and not a penny more
• You do not know which bar is offering which beer for sale
– You are bar monogamous. The first one you go to you stay with.
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Standard NPV: No Bar Hopping

$4-1=3
Assuming you drink
only 1 beer
$3-1=2
Cost = $1.50 $2-1=1 NPV Analysis:
NPV = – 1.50 + .25(3)+.25(2)

+.25(1) +.25(0)
$1-1=0
$0
NPV = 0
Cost = $0
$0
$0
$0
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A real option: Suppose you have the option to switch

Suppose you can switch bars, i.e. delay the
decision to drink. If you don’t like the beer
options, but it costs to $1 to switch. $3
No, everything else worse

$2
Tram
No, the best outcome yields $1 more in benefit, but costs $1
Cost = $1.50

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A real option: Suppose you have the option to switch

Stay (Invest)
options, but it costs to $1 to switch. $3
No, everything else worse

$2
Stay $2
Tram
No, the best outcome yields $1 more in benefit, but costs $1
Cost = $1.50
Some clean up…

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Switching – the real option

options, but it costs to $1 to switch.
Stay (Invest) $3
Stay $2
Tram $1
Cost = $1.50
Stay $3
Impt (p=.33)Stay $2
-$1
$0
Switch again if you land in the bar with the weasel beer!

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Stay $3
Stay $2
Tram $1
Cost = $1.50
Stay $3
Impt (p=.33)Stay $2
-$1 $0
Stay $3
-$1
Stay $2
1 1
1.5 1 3 2
2 2
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Stay $3
Stay $2
Tram $1
Cost = $1.50
Stay $3
Impt (p=.33)Stay $2
-$1 $0
Stay $3
-$1
$1.5
Stay $2
1 1
1.5 1 3 2
2 2
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Stay $3
Stay $2
Tram $1
Cost = $1.50
Stay $3
Impt (p=.33)Stay $2
-$1 $0
Go $1.5
$1.5
1 1 1
1.1667 1 3 2 1.5
3 3 3

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Stay $3
Stay $2
Tram $1
Cost = $1.50
Stay $3
Impt (p=.33)Stay $2
-$1
$1.1667
Go $1.5
1 1 1
1.1667 1 3 2 1.5
3 3 3

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Stay $3
1
1.50 3 2 1.1667 1.1667
Stay $2 4
Tram $1 1.50 1.8335
Cost = $1.50
Go $1.1667
0.3335
$1.1667
Go $1.1667

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Example: Robot Machine
• You have the chance today (and today only) to invest in a

machine that costs $2100, which is paid at the end of the
year.
• The machine produces one robot (marketing slogan: "your
plastic pal who’s fun to be with") at the end of each year which,
depending on popularity, you can sell for $300 or $100 with
equal probability.
• Once this value becomes known at t=1 it will stay there

forever. Assume the WACC is 10%.
Unrelated aside:
Anything different
from real life, here?

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Example: Robot Machine

Decision
CF=$0 E[CF]=-$2100 E[CF]=0.5(300) + 0.5(100) E[CF]=0.5(300) + 0.5(100) Etc….
t=0 t=1 t=2 t=3
• The NPV rule sales this is not a great project:
. .
. .
– Okay….

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Deferring the Decision to Invest
• Suppose if you agree to pay $2300 at t=1, you may abandon

the project with no penalty?
Unrelated aside:
• If the price is $300 – brilliant! Notice anything
funny here?
• If the price is $100 abandon the project.
• The real option to defer has a lot of value here!

Numerically, it’s an option worth 454.55 − 90.91 = $363.64.

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Real vs. Financial Options
• A financial option (a call on a stock, for instance) has a

definite no-arbitrage value.
– The value of it derives from the characteristics of the underlying
asset:
• price, volatility, strike price, maturity and interest rates.
• A real option has a similar flavor, but it is fundamentally a

different thing.
– Its value is the value of certain managerial actions that affect
project cash flows of physical assets.

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Real Options vs. NPV
• The traditional NPV analysis assumes there is only one

decision point and that decision is now or never for
accepting the project.
• Real Options and NPV yield the same result IF and ONLY
IF:
– You lay out the projects decisions as incremental values based on
mutually exclusive sub-projects – ONE FOR EACH DECISION
OUTCOME, and adjust discount rates correctly then the NPV
method would equal the real options method.
• This is essentially what we did a few slides back

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Suppose you can switch bars, if you don’t
like the beer options, but it costs to $1 to
switch.
Stay $3
Stay $2
Tram $1
Cost = $1.50
Stay $3
Impt (p=.33)Stay $2
-$1 $0
Stay $3
-$1
$1.5
Stay $2
1 1
1.5 1 3 2
2 2
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switch.
Stay $3
Stay $2
Tram $1
Cost = $1.50
Stay $3
Impt (p=.33)Stay $2
-$1 $0
Go $1.5
$1.5
1 1 1
1.1667 1 3 2 1.5
3 3 3

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switch.
Stay $3
Stay $2
Tram $1
Cost = $1.50
Stay $3
Impt (p=.33)Stay $2
-$1
$1.1667
Go $1.5
1 1 1
1.1667 1 3 2 1.5
3 3 3

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switch.
Stay $3
1
1.50 3 2 1.1667 1.1667
Stay $2 4
Tram $1 1.50 1.8335
Cost = $1.50
Go $1.1667
0.3335
$1.1667
Go $1.1667

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• Financial options:
– Are in zero net supply.
– Have a contractual strike price and underlying asset.
– Do not affect the underlying asset.
– Are “side bets” on the underlying.
• Real options:
– Are company-specific; there is no counterparty.
– Typically view the “underlying asset” as the project itself: the base
case NPV version of the project without recognizing any real
options.
– Typically use the required investment as the “strike price”.

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• Real options:
– Are company-specific; there is no counterparty.
– Typically view the “underlying asset” as the project itself: the base
case NPV version of the project without recognizing any real
options.
– Typically use the required investment as the “strike price”.
• What real options offer best, as a framework, is the chance

to implicitly adjust the discount rates in different periods
up or down.
– The base case NPV analysis uses a fixed WACC, and that’s not
always appropriate.

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An example with binomial option pricing
• You are looking at investing in a machine that produces a

new fuel. The fuel produced will be worth either $40 million
or $16 million at t=1, depending on whether alternative fuels
are priced high, or low. The one-period riskless discount rate
• Of rf=5.26% What is this opportunity worth?
• We ain’t got WACC.
• Suppose that the new fuel will have a price perfectly

correlated with oil.
– Oil sells today for $96
– At t=1 it will be worth $160 or $64 with equal probability
• Implies the machine will produce 250,000 barrels
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What is the machine worth?
• It will produce 250,000 barrels of fuel identical to oil. What

must the project be worth?
– $24 million
• If the machine cost $25 million, would we take the project?
• Clearly we would not pay $25 million for this opportunity

today; the NPV would be negative.

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Deferral Payoffs
• Suppose, however, we could take the machine for $25m

today, OR at t=1. How much would be willing to pay to
defer paying $25m for the project for 1 year?
• The net payoffs of the project are:

– NPV will be 40 − 25 → 15 million if oil goes up
– NPV will be 16 − 25 → 0 if oil goes down (reject project)
• What’s the:
– Underlying Asset? Oil (since perfectly correlated)
– Strike Price? $25 million
– Call premium? We’re going to calculate the value of the delay
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A refresher of a bit of binomial option

pricing

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Generalizing Binomial Option Valuation
• Stock returns per period can only take two values:

– u (stock price increases) or d (stock price decreases)
– An up (down) move occurs with probability p (1-p)
p uS or u  S
S
dS or d  S
1-p

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Binomial Option Valuation
• Consider a call option on this share

– The call option values are:
Cu ,0
p
c
Cd ,0
1-p
– The up (down) state takes the value of Cu (Cd)

• Exercise if “up”, expire worthless if “down”
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Binomial Valuation (con’t)
• Consider a portfolio:
Short 1 call, long h shares of stock
• The value of the portfolio after 1 period is:

h × uS - Cu if the stock price went up
h × dS - Cd if the stock price went down
• Is there an h so that the value is the same in both cases?
– Solve for h: h × uS - Cu = h × dS - Cd
Cu  Cd
h
Hedge Ratio
u  d S
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Cu  Cd
• For every 1 call you write, hold h  shares
u  d S
to create a riskless portfolio
• This means that the price of this portfolio must equal

today’s price of a bond with a face value equal to this
certain payoff.
• The certain pay off is:

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I arbitrarily choose the payout in the Up state. I
could have chosen the down state just as well
 huS  C u
Cu  Cd
 uS  C u
u  d S
dC u  uC d

ud
The discounted value of this certain pay off must equal the price of the
portfolio today

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 huS  C u
• This certain pay off is just like a zero-coupon bond.

Call:
– Today’s loan size
– Tomorrow’s face value
– Then:
– Implying:
– And:
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Deferral Payoffs
• The net payoffs of the project are:

– NPV will be 40 − 25 → 15 million if oil goes up
– NPV will be 16 − 25 → 0 if oil goes down (reject project)
• We can assess the value of the ability to delay as the call

premium on an option with similar pay offs.
• We need h and B (note: S=96):
15,000,000 0
156,250
160 64

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Deferral Payoffs
• We need h(=156,250) and B:
156,250 160 15,000,000

9,500,285
1 1.0526
156,250 96 9,500,285 5,499,715
• You could afford to pay up to ~$5.5 million today to be allowed to

wait-and-see about purchasing the machine at a price of$25 million.

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The Same Answer with Pseudo Probabilities
• Recall from your derivatives class:

(1  r )  d u  (1  r )
 , 1  
ud ud
1.0526 0.66667
0.38593
1.66667 0.66667
C u  (1   )C d
c
(1  r )
.38593 15,000,000 0.61407 0

5,499,667 A little too much
1.0526 rounding in the
risk-free rate

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What if the future isn’t discrete?
• What if we thought that oil prices are random and could

have many outcomes?
• Then the Black-Scholes model can be used instead.

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Full BS Option Pricing Model
• This formula is for a European call option

with no dividends:
Inverse of rf T
c  SN (d1 )  Xe
Probability
Hedge N (d 2 ) the option will
Ratio (h) finish in the
money
where
d1 

ln(S 0 / X )  r   2 / 2 T 
 T
d 2  d1   T
• Note: you would need to scale up the Black-Scholes inputs

250,000 barrels to make the results comparable.
– Already have everything but volatility of oil prices.
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Assumptions of Black-Scholes (BS)
• No dividends are paid before the expiration date
• The risk-free interest rate is constant
• The stock price variance is constant
• Stock prices move continuously

– No big jumps in prices
• These assumptions may seem pretty heroic but Black-

Scholes and variations of the model are used to price options
on the floor of the CBOE

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Beyond Deferral: Other Types of Real Options
• Expansion Options — these recognize the value in only

expanding when the outcome state is good (a high demand
for a product, or a good economy)
– American call
X = cost of further investment
S = value of the project
C = cost of testing (to see what demand is)

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• Contraction Options — these recognize the value in only

contracting when the outcome state is bad (a low demand
for a product, or a bad economy).
– For example, the ability to give us part of space or equipment you
use, for example to lease it out when you don’t need it.
– American put
X = present value of lease payments
S = value of space or equipment to be leased

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• Abandonment Options — these recognize the value in

ditching a project that just isn’t working out
– American put:
– Say you invest in a car (with resale value) to deliver pizza
S = the value of delivering pizza
X = the resale value of your Hyundai
p = $0
• Abandonment options (2)

– Prenuptial agreement
S = the value of marriage/love of your spouse
X = value of assets not subject to communal property laws
p = the pain of convincing your fiancée to sign the prenup
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• Abandonment Options — these recognize the value in

ditching a project that just isn’t working out
– American put:
– Say you invest in a car (with resale value) to deliver pizza
S = the value of delivering pizza
X = the resale value of your Hyundai
p = $0
• Abandonment options (2)

– Prenuptial agreement
S = the value of marriage/love of your spouse
X = value of assets not subject to communal property laws
p = the pain of convincing your fiancée to sign the prenup
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• Extension Options — these recognize the value in extending

the life of a good project or in extending a brand into a new
product line
– American call:
S = the good project or brand
X = cost/investment needed to extend life or develop new line
• Compound Options — these recognize the value in multiple
decision points. for instance, expansion is a call option. two
successive expansion points mean the first is like having a
call on a call (a compound call).
• Rainbow Options — these are for situations where there are
two (or more) sources of uncertainty, such as oil prices
AND interest rates.
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Application: Bankruptcy and Real Options
• Consider a firm filing Chapter 11 bankruptcy.
• Some or all creditors will ask the court to order a liquidation.

The management will argue that would destroy a viable (if
cash-strapped) business.
• The court must decide: continue, or liquidate? When would

it be best to say "No more!"?
• As long as continuation does not impair the liquidation

value, a short continuation will almost always make sense.
• Can we be any more specific?

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Continuation
• Creditors say the firm should be liquidated today since that

would bring in $100,000.
• Management presents its plans to the court. These plans are

highly risky, of course, and will pay off at t=1 as follows:
– 15% chance of success, payoff $200,000
– 85% chance of failure, payoff $80,000
• The expected payoff of management’s plan (before

discounting):

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Continuation
• The expected payoff of management’s plan
• However, this is NOT the value the court should use. If

continuation does not ruin the liquidation value, then the
“bad” outcome of continuing is better (there is a real option
value):
• The court should allow a continuation in this case.

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Shutdown
• In reality, each continuation decision costs something. There

is also the possibility that over time the liquidation values
will become impaired.
– At some point, unless improvements are evident the plug gets
pulled.
– The longer in court, the more cumulative likelihood of being
liquidated

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Shutdown
• The longer in court, the more cumulative likelihood of being

liquidated

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Challenges Using Real Options
• If using Black-Sholes one of the big challenges is estimating volatility

(σ). Here are 3 approaches:
– Gather data: Are there comparable firms? But be aware that most
firms are levered and that it is necessary to unlever the equity
returns to get asset betas. Perhaps the firms deals in a commodity
with a long history of data?
– Simulate σ: If you know (have a good guess about) the return
distributions of inputs underlying the firm’s assets, Monte Carlo
simulations can be used to simulate asset value paths and, in turn to
calculate volatility. If you are willing to make assumptions about
the distribution of the asset values, you can simulate those directly.
– Make an Educated Guess: And then use sensitivity analysis to
see how important it is that you are right. Note that β and σ are
generally positively correlated. Single projects more vol. than
diversified.
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Challenges Using Real Options continued
• Simplifying complex projects:

– try to break up the project or project into a series of more simple
options.
– Try to find a simplified version of the project that is either clearly
better or clearly worse than the project. This can be used as an
upper or lower bound for value.
• Check models and distributions: Black-Scholes assumes
continuous trading and log-normal distributions. If your
underlying data are not close to normal or log normal, there
are variations of Black-Scholes that may be better to use.
– If that doesn’t work, then go back to decision trees and crunch
numbers in a monte carlo simulation.
• Sensitivity Analysis: can’t be emphasized too often
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Challenges Using Real Options continued
• The problem is people: for real options to work managers

MUST make decisions at the right time. This is the biggest
failing in the implementation of the real-options
methodology.
– Falling asleep at the wheel.
• Moel and Tufano (????) find that less profitable firms shut down under
performing mines faster than profitable firms.
– Example: Split protection and dividends on options.

• Opposite problem, Poteshman and Serbin (????) find that 2 to 3% of options
are exercised to early.

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Summary
• Decision “trees” impart a structure to cash flows that looks

like the tree structure common in option pricing theory.
• Real options are a clear way of organizing one’s thinking

about the decision processes where value is most affected.

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Summary
• Real options are not a way of saying the NPV rule is wrong.
They are a clever way of illustrating mutually exclusive
branches of a decision process, and they easily handle
different opportunity costs (discount rates) at different
points in time.
• Real options show up in many places, not just firm

investments.
– Bankruptcy courts apply a real options methodology, for instance.
– Another favorite example is the pharmaceutical industry’s process
for new drug approval: there are multiple stages, or varying risk,
between discovery and final approval.

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Remember how to value combinations of

options
This is simple, but might provide useful hints for
working on the MW Petroleum (B) case.
64

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Combinations of Puts, Calls, Stocks and Bonds
• Consider the payoffs if you buy a MSFT (same example) and

a put. (Consider an option with a strike of $30 on MSFT )
Payoff
Stock Value 20 25 30 35 40
Put Value 10 5 0 0 0
Portfolio Value 30 30 30 35 40

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More generally
• Buy a MSFT (same example) and a put.
Payoff
ST ≤ X ST > X
Stock Value ST ST
Put Value X- ST 0
Portfolio Value X ST

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Protective Put Payoffs (in orange)

70
60
50
Value at Expiry ($)
40
30
20
10
0
0
8
10
12
14
16
18
20
22
24
26
28
30
32
34
36
38
40
42
44
46
48
50
52
54
56
58
60
Puts Stock Protective Put

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Covered Call
• Write a call, and to protect you in case the stock price

rises, you buy the underlying stock.
Payoff
ST ≤ X ST > X
Stock ST ST
Written Call 0 -(ST – X)
Portfolio Value ST X

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Covered Call Payoffs (in pink)
70
60
50
40
30
Value at Expiry ($)
20
10
0
10
12
14
16
18
20
22
24
26
28
30
32
34
36
38
40
42
44
46
48
50
52
54
56
58
60
0
-10
-20
-30
-40
Written call Stock Covered Call

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Other Option Strategies
• Straddles
– Buy a call and a put with the same strike price and
expiration date.
• Spread
– 2 or more calls OR 2 or more puts with the same or
different strike prices (money spread) and the same or
different exercise date (time spread)
• Collars
– Combinations of the stock and puts and (written) calls, to
create cheaply a portfolio whose losses are capped (in
exchange for capped gains.

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Straddle
35
30
25
Value at Expiry ($)
20
Calls
Puts
Straddle
15
10
0
0
2
4
6
8
10
12
14
16
18
20
22
24
26
28
30
32
34
36
38
40
42
44
46
48
50
52
54
56
58
60

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Collar
140
120
100
Stock
80
60 Payoff of all 3
Payoff
40
20
Put, X=$60
0
0
12
16
20
24
28
32
36
40
44
48
52
56
60
64
68
72
76
80
84
88
92
96
0
10
10
10
11
11
12
-20
-40
Written Call,
X=$80
-60
Price

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Vertical Spread - Example
Bullish Spread
100
80
Long Call X=30
60
Portfolio Payoff
40
Vertical Spread Payoff
20
0
0 10 20 30 40 50 60 70 80 90 100 110 120
-20
-40
Short Call X=70
-60
Stock Price (S)

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What if…
• You bought
– A Stock
– A put
• And wrote
– A call

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Stock + Put - Call

70
60
50
40
30
Value at Expiry ($)
20
10
0
0
8
10
12
14
16
18
20
22
24
26
28
30
32
34
36
38
40
42
44
46
48
50
52
54
56
58
60
-10
-20
-30
-40
Puts Stock Written call Stock, Put, and Written Call

lOMoARcPSD|2535112
Stock + Put - Call

70
60
50
40
30
Value at Expiry ($)
20
10
0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 61
-10
-20
-30
-40
Stock, Put, and Written Call

lOMoARcPSD|2535112
Stock + Put - Call
• Buy a stock, a put and write a call.
Payoff
ST ≤ X ST > X
Stock ST ST
Put X – ST 0
Written Call 0 -(ST – X)
Portfolio Value X X

lOMoARcPSD|2535112
Stock + Put - Call
• That is the payoffs from a stock, a put and a written call

are
– identical to the payoffs from a bond with the face value of
the strike price
• That means:
X
S  pc 
1  rf T

lOMoARcPSD|2535112
Put-Call Parity for European Calls and Puts
X
c p  S 
1  rf T

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What is the European Call Price?
• Suppose you have European put with a strike price of

$20 that expires in 3 months and costs $1. The
underlying stock is currently trading for $19.50. The
annual risk-free rate is 4.06%
X
c p  S 
1  rf T
20
c  1  19.50  c = $0.698
1  .0406.25

Real Options Case Studies

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Real Options Case Studies

Case Studies In Finance (University of Melbourne)

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Case Studies in Finance

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Reminder: Financial Options

• A call option is a contract between a holder and writer

• A put option gives its holder the right to sell a particular

• Real options are anything that has a similar structure:

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Call Value at Expiration

• Consider a call with a strike of $30 on MSFT

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Call Payoff at Expiry: X=30

Calls Call Profit

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Option Value at Expiration

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Put Payoff at Expiry: X=30

Puts Put Profit

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Stock & Bond Payoff at Expiry: X=30

© 2008 Patrick J. Kelly Downloaded by karthik sk ([email protected]) 7

• Pre-Paid Dental Plans provide “discounted” service

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• A limit buy order

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© 2008 Patrick J. Kelly Downloaded by karthik sk ([email protected]) 10

Using Real Options to Value Projects

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The standard NPV problem

• Is the following project a good investment?

• It costs you $1.50 in discounted tram fare to go out this

• There are 4 bars selling $1 beer. Strangely, the quality varies:

Standard NPV: No Bar Hopping

Cost = $1.50 $2-1=1 NPV Analysis:

NPV = – 1.50 + .25(3)+.25(2)

A real option: Suppose you have the option to switch

No, everything else worse

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A real option: Suppose you have the option to switch

No, everything else worse

Some clean up…

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Switching – the real option

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Switching – the real option

Switching – the real option

Switching – the real option

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Switching – the real option

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Switching – the real option

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Example: Robot Machine

• You have the chance today (and today only) to invest in a

• Once this value becomes known at t=1 it will stay there

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Example: Robot Machine

t=0 t=1 t=2 t=3

• The NPV rule sales this is not a great project:

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