Session 04 Real Options Analysis of Capital Investment Proposals

OBJECTIVE
In Reality, the managers has flexibility to revise their investment proposals as new information arrives. How do you handle such managerial options in CIA?

Overview
Managerial options (Real option analysis) Summary

Approaches To Dealing with Uncertainty and Complexity in CIP 1. Traditional Approaches

 Simulation  Cant handle well asymmetries in the distributions introduced by management's flexibility  Decision tree analysis  Number of different paths on the tree increases geometrically.
 Choice of discount rate: Risk of project may change over time.

2. Real Options Approach

 This approach circumvents the discount rate problem by constructing a riskfree hedge.

Difficulties with Simulation

 A. Difficult to interpret a distribution of NPVs. Traditional view of NPV as "increase in shareholder wealth from accepting the project" not applicable.
 Solution: Use simulation to assess the distribution of the net cashflows.

 B. Problems in specifying interdependencies in step 1.  C. Cant handle well asymmetries in the distributions introduced by management's flexibility to revise its prior operating strategy as more information about project cashflows becomes available over time:  Solution: Real Options.

Decision tree analysis

 Helps structure the managerial decision problem by mapping out feasible managerial alternatives in response to future events.  Pro:
Forces management to recognize its implied operating strategy and the interdependencies between the initial and subsequent decisions.

 Cons:
A. Number of different paths on the tree increases geometrically. B. Choice of discount rate: Risk of project may change over time. (Options based approach circumvents the discount rate problem by constructing a riskfree hedge.)

Real Options Approaches To Dealing with Uncertainty and Complexity

 Traditional capital budgeting procedures cannot properly capture managements flexibility to adapt and revise later decisions in response to unexpected regulatory / technological / market developments.  Traditional approaches assume an expected scenario of cashflows and presume managements passive commitment to a certain static operating strategy.

Real Options Approaches To Dealing with Uncertainty and Complexity

 The real world is characterized by change, uncertainty and competitive interactions =>  As new information arrives and uncertainty about market conditions is resolved, management may have valuable flexibility to alter its initial operating strategy in order to capitalize on favorable future opportunities or to react so as to mitigate losses.  This managerial operating flexibility is like financial options, and is known as Strategic Options, or Real Options.

Real Options Approaches To Dealing with Uncertainty and Complexity

 The real option techniques can conceptualize and value managerial flexibility to alter its initial operating strategy in order to capitalize on favorable future opportunities or to react so as to mitigate losses.

Real options
One of the fundamental insights of modern finance theory is that options have value. The phrase We are out of options is surely a sign of trouble. Because corporations make decisions in a dynamic environment, they have options that should be considered in project valuation.

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What is a real option?

 Real options exist when managers can influence the size and risk of a projects cash flows by taking different actions during the projects life in response to changing market conditions.

Alert managers always look for real options in projects. Smarter managers try to create real options.

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NPV Analysis and Real options

Traditional NPV analysis tends to ______________ the true value of a capital budgeting project.

Underestimate

OR

overestimate ?

Why?

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How are real options different from financial options?

 Financial options have an underlying asset that is traded--usually a security like a equity share.  A real option has an underlying asset that is not a security--for example a project or a growth opportunity, and it isnt traded.  The payoffs for financial options are specified in the contract.  Real options are found or created inside of projects. Their payoffs can be varied.

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Corporate Options
4 types of Real Options
 The opportunity to make follow-up investments (Growth) (has

value if demand turns out to be higher than expected)

 Expansion of existing product line  New products  New geographic markets  The opportunity to wait and invest later (timing). It has value if

the underlying variables are changing with a favorable trend.  Abandonment options (Has value if demand turns out to be lower than expected)
 Contraction  Temporary suspension  Opportunity to vary the firms output or production methods. (Flexibility)
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Option

Description
To wait before taking an action until more is known or timing is expected to be more favorable

Examples
When to introduce a new product, or replace an existing piece of equipment

Defer

Expand or contract Abandon

To increase or decrease the scale of an operation in response to demand To discontinue an operation and liquidate the assets

Adding or subtracting to a service offering, or adding memory to a computer Discontinuation of a research project, or product/service line

Stage investment Switch inputs or outputs Grow

Staging of research and To commit investment in stages giving rise to a series of valuations development projects or financial commitments to a new venture and abandonment options To alter the mix of inputs or outputs of a production process in response to market prices To expand the scope of activities to capitalize on new perceived opportunities The output mix of telephony/internet/cellular services

Extension of brand names to new products or marketing through existing distribution channels 15

Discounted CF and Options

We can calculate the market value of a project as the sum of the NPV of the project without options and the value of the managerial options implicit in the project. M = NPV + Opt A good example would be comparing the desirability of a specialized machine versus a more versatile machine. If they both cost about the same and last the same amount of time, the more versatile machine is more valuable because it comes with options.

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Corporate Options

Value of Real Option = NPV with option - NPV without option

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The Option to Expand (or Contract)

 Mgmt of a company considers entering into a market for a newly developed product. Market size is small in first two years and become very large afterwards.  Lack of economies of scale during first two years lead to negative NPV. Reject?  First mover advantage comes with first-stage investment.  Managements have an option to make a follow-up investment with the current proposal of setting up a small plant.  NPV of this option may offset the NPV of small plant to make overall investment proposal worthwhile.

Project Worth = -3.0 + 5.5 = 2.5

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Option to Abandon
Abandoning a project after it has been undertaken consist of selling the projects assets or employing them in another area. For certain projects, abandonment value is zero. Project should be abandoned when
 its abandonment value exceeds the PV of Future CFs  Divestment

Project worth = NPV w/o AO + Value of AO

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Option to Abandon
Example - Abandon Mrs. Mulla gives you a non-retractable offer to buy your company for $150 mil at anytime within the next year. Given the following decision tree of possible outcomes, what is the value of the offer (i.e. the put option) and what is the most Mrs. Mulla could charge for the option? Use a discount rate of 10%

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Option to Abandon
Example - Abandon
Mrs. Mulla gives you a non-retractable offer to buy your company for $150 mil at anytime within the next year. Given the following decision tree of possible outcomes, what is the value of the offer (i.e. the put option) and what is the most Mrs. Mulla could charge for the option?

Year 0

Year 1

Year 2 120 (.6)

100 (.6) 90 (.4) NPV = 145 70 (.6) 50 (.4) 40 (.4)

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Option to Abandon
Mrs. Mulla gives you a non-retractable offer to buy your company for $150 mil at anytime within the next year. Given the following decision tree of possible outcomes, what is the value of the offer (i.e. the put option) and what is the most Mrs. Mulla could charge for the option?

Year 0

Year 1

Year 2 120 (.6)

100 (.6) 90 (.4) NPV = 162

Option Value = 162 - 145 =

150 (.4)

$17 mil
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Option to Abandon An example

Suppose we are drilling an oil well. The drilling rig costs $300 today, and in one year the well is either a success or a failure. The outcomes are equally likely. The discount rate is 10%. The PV of the successful payoff at time one is $575. The PV of the unsuccessful payoff at time one is $0.

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Option to Abandon An example

Traditional NPV analysis would indicate rejection of the project.

Expected = Prob. Successful + Prob. Failure Payoff Success Payoff Failure Payoff Expected = (0.50$575) + (0.50$0) = $287.50 Payoff NPV = $300 + $287.50 = $38.64 1.10

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The Option to Abandon: Example

Traditional NPV analysis overlooks the option to abandon. Success: PV = $500 Drill
 $500

Sit on rig; stare at empty hole: PV = $0. Failure

Sell the rig; NPV ! salvage value = $250 The firm has two decisions to make: drill or not, abandon or stay. Do not drill
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The Option to Abandon: Example

When we include the value of the option to abandon, the drilling project should proceed:

Expected = Prob. Successful + Prob. Failure Payoff Success Payoff Failure Payoff Expected = (0.50$575) + (0.50$250) = $412.50 Payoff NPV = $300 + $412.50 = $75.00 1.10
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Valuing the Option to Abandon

 Recall that we can calculate the market value of a project as the sum of the NPV of the project without options and the value of the managerial options implicit in the project.

M = NPV + Opt $75.00 = $38.64 + Opt $75.00 + $38.64 = Opt Opt = $113.64

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TO PROCEED OR ABANDON? We are examining a new project. We expect to sell 7,000 units per year at $60 net cash flow apiece for the next 10 years. (the annual operating cash flow is projected at $60 * 7000 = $42,000. The relevant discount rate is 16% and the initial investment required is $1,750,000.

a) What is the base-case NPV? b) After the first year, the project can be dismantled and sold for $1,500,000. If expected sales are revised based on the first years performance, when would it make sense to abandon the investment? (at what level of expected sales would it make sense to abandon the project?)
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EXPANSION ? Applied Nanotech is considering introduction of a new surface cleaning machine. The marketing department has come up with the estimate that the company can sell 10 units per year at $0.3 million net cash flow per unit for the next 5 years. The engineering department has come up with the estimate that developing the machine will take a $10 million investment. The finance department has estimated that a 25% discount rate should be used. a) What is the base-case NPV? b) If unsuccessful, after the first year the project can be dismantled and will have an after tax salvage value of $5 million. Also, after the first year, expected cash flows will be revised up to 20 units per year or to 0 units, with equal probability. What is the revised NPV?
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The Option to Delay: Example

Year 0 1 2 3 4 Cost $ 20,000 $ 18,000 $ 17,100 $ 16,929 $ 16,760 PV $ 25,000 $ 25,000 $ 25,000 $ 25,000 $ 25,000 NPV t $ 5,000 $ 7,000 $ 7,900 $ 8,071 $ 8,240 NPV 0 $ 5,000 $ 6,364 $ 6,529 $ 6,064 $ 5,628

$7,900 $6,529 ! (1.10 ) 2

 Consider the above project, which can be undertaken in any of the next 4 years. The discount rate is 10 percent. The present value of the benefits at the time the project is launched remains constant at $25,000, but since costs are declining, the NPV at the time of launch steadily rises.  The best time to launch the project is in year 2this schedule yields the highest NPV when judged today.
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WHEN TO PROCURE? Your company is deciding when to invest in a new machine. The new machine will increase cash flow by $280,000 per year. You believe the technology used in the machine has a 10-year life (no matter when you purchase the machine it will be obsolete in 10 years from now). The machine is currently priced at $1,500,000. The cost of the machine will decline by $125,000 per year until it reaches $1,000,000, where it will remain. If your required rate of return is 12 per cent, should you purchase the machine? If so, when should you purchase it?

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Option to Wait

Intrinsic Value
Option Price

Stock Price

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Option to Wait
Intrinsic Value + Time Premium = Option Value Time Premium = Vale of being able to wait
Option Price

Stock Price

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Option to Wait
Intrinsic Value + Time Premium = Option Value Time Premium = Value of being able to wait More time = More value
Option Price

Time premium

Intrinsic value

Stock Price

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The Black-Scholes Model: BlackNotation

 C = price of call  P = price of put  S = price of stock  E = exercise price  T = time to maturity  ln(.) = natural logarithm  e = 2.71828...  N(.) = cum. norm. distn  The following are annual, compounded continuously:  r = domestic risk free rate of interest  d = foreign risk free rate or constant dividend yield  = volatility

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The Black-Scholes Model: BlackEquations

1 2 S ln  r  d  W T 2 E d1 ! W T 1 2 S ln  r  d  W T 2 E d2 ! ! d1  W T W T C ! Se  dT N d1  Ee  rT N d 2 P !  Se  dT N  d1  Ee  rT N  d 2
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The Black-Scholes Model: BlackEquations (Forward Form)

Se r  d T 1 2 ln  W T E 2 d1 ! W T Se r  d T 1 2 ln  W T E 2 d2 ! W T
C ! e  rT N d1 Se r  d T  N d 2 E P ! e  rT N  d1 Se r  d T  N  d 2 E
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The Black-Scholes Model: BlackEquations (Simplified)

If E ! Se r  d T 1 1 d1 ! W T ; d 2 !  W T 2 2 C ! Se  dT N d1  N d 2 ! P If d ! 0 C ! P ! S N d1  N d 2 S C!P} W T } 0.39886 SW T 2T

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Deter i I
t

ti

ri es all
I cr s cr s I cr s i s I cr s cr s

reases i :
ri e, er ise ri e, latilit , si a i et irati , I terest ate, r ash Di i ends, d

t
cr s I cr s I cr s i s cr s I cr s

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What happens to the premium of the option price over the exercise value as the stock price rises?
The premium of the option price over the exercise value declines as the stock price increases. This is due to the declining degree of leverage provided by options as the underlying stock price increases, and the greater loss potential of options at higher option prices.

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What are the assumptions of the Black-Scholes Option Pricing Model?

The stock underlying the call option provides no dividends during the call options life. There are no transactions costs for the sale/purchase of either the stock or the option. kRF is known and constant during the options life.
(More...)
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Security buyers may borrow any fraction of the purchase price at the short-term riskfree rate. No penalty for short selling and sellers receive immediately full cash proceeds at todays price. Call option can be exercised only on its expiration date.  Security trading takes place in continuous time, and stock prices move randomly in continuous time.
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What are the three equations that make up the OPM?

V = P[N(d1)] - Xe -k t[N(d2)].
RF

W t [k + ln(P/X) + RF d2 = d1 - W t. (W2/2)]t

d1 =

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What is the value of the following call option according to the OPM? Assume: P = $27; X = $25; kRF = 6%; t = 0.5 years: W2 = 0.11

V = $27[N(d1)] - $25e-(0.06)(0.5)[N(d2)].

d1 =

ln($27/$25) + [(0.06 + 0.11/2)](0.5) (0.3317)(0.7071)

= 0.5736. d2 = d1 - (0.3317)(0.7071) = d1 - 0.2345 = 0.5736 - 0.2345 = 0.3391.

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N(d1) = N(0.5736) = 0.5000 + 0.2168 = 0.7168. N(d2) = N(0.3391) = 0.5000 + 0.1327 = 0.6327.
Note: Values obtained from Excel using NORMSDIST function.

V = $27(0.7168) - $25e-0.03(0.6327) = $19.3536 - $25(0.97045)(0.6327) = $4.0036.

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What impact do the following parameters have on a call options value?

Current stock price: Call option value increases as the current stock price increases. Exercise price: As the exercise price increases, a call options value decreases.

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Option period: As the expiration date is lengthened, a call options value increases (more chance of becoming in the money.) Risk-free rate: Call options value tends to increase as kRF increases (reduces the PV of the exercise price). Stock return variance: Option value increases with variance of the underlying stock (more chance of becoming in the money).

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Val e f a all and t rrent t

ti ns ith tri e ri e
11 10 9 7 6 5 4 3 2 1 0

1.0

0.9

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0.0

Ti e-t -Mat rit

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all and

t ri e

c ll

Call and Put Prices as a Function of Volatility

6 5 call put

Call and Put Prices

4 3 2 1 0 0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

0.16

0.18

0.20

Volatility

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Computing Implied Volatility volatility call strike share rate_dom rate_for maturity factor d_1 d_2 n_d_1 n_d_2 call_part_1 call_part_2 error 0.3154 10.0000 100.0000 105.0000 0.0500 0.0000 0.2500 0.0249 0.4675 0.3098 0.6799 0.6217 71.3934 -61.3934 0.0000

Insert any number to start

Formula for option value minus the actual call value

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Computi vol tility call stri share rate_dom rate_for maturity factor d_1 d_2 n_d_1 n_d_2 call_part_1 call_part_2 error

mpli

ol tility 0.315378127101852 10 100 105 0.05 0 0.25 =(rate_dom - rate_for + (volatility^2)/2)*maturity =(LN(share/stri e)+factor)/(volatility* Q T(maturity)) =d_1-volatility* Q T(maturity) =NORMSDIST(d_1) =NORMSDIST(d_2) =n_d_1*share*EXP(-rate_for*maturity) =- n_d_2*stri e*EXP(-rate_dom*maturity) =call_part_1+call_part_2-call
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Construction of Pat's Get Rich Portfolio

80 60 40

Portfolio Values

20 0 -20 -40 -60 -80 -100 -120 call P_Share P_bond Portfolio Tangent 50 60 70 80 90 100 110 120 130 140 150

Share Price

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Summary
 Managerial options are important considerations in capital budgeting viz. Flexibility that mgmt has to alter a previously made decision.  Greater the uncertainty surrounding the use of an option, the greater its value.  A projects worth can be viewed as its traditional NPV together with the value of managerial option.  Consideration of these corporate options can sometimes turn a reject decision into an accept decision and an accept decision into a decision to postpone.

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