© 2003 The McGraw-Hill Companies, Inc. All rights reserved.

Basics of Real Options

14.2 What is a Real Option?

• The ability to alter a project midcourse as a result of some investment.

• Also known as strategic options and managerial options.

• Provide managers the opportunity to respond to changing circumstances in an effort to maximize shareholder wealth.

• In theory, real options must have a cost in order to be valuable.

14.3 Real Options and You

• You may have already invested in real options in your life:

Real Option Cost

Get an MBA

Go to a concert

Go scuba diving

Use a credit card

14.4 Real Options: Five Flavors

• Expansion – invest more in the future if results are strong (i.e.; add another factory)

• Extension – lengthen the timeline on the project if it lasts longer than expected

• Deferral – wait before making a decision (i.e.; metal price uncertainty with mines)

• Contraction options – invest less in the future if results are weak (i.e.; factory sublease)

• Abandonment – divest sooner than expected if results are weak (i.e.; R&D)

14.5 Base Case NPV Example

Ompi Fan Works Inc. has developed a revolutionary fan that magically increases shareholder wealth when financial markets collapse. If the company decides to manufacture the fan today, they will have to invest $100 million in start-up costs. The expected total cash flows will be $13 million this year, $47 million next year, and $73 million the following year. They expect Microsoft to come out with a better fan in three years that will put Ompi Fan Works out of business. Assume a discount rate of 10%. What is the NPV?

14.6 Real Option - Defer

• OFW will have a much clearer picture of the health of financial markets in a year from now. Exercising the option to wait one year to invest will also defer cash flows one year. The cash flows for a healthy and unhealthy markets scenario are shown below. What is this option to defer worth?

Year Healthy Unhealthy1 ($100) ($100)2 $23 $763 $48 $132

Pr(x) 0.6 0.4

14.7 Real Option - Extension

• If Microsoft is unable to bring its fan to market after the first three years, OFW has the option to remain in business one more year, which will result in cash flows in the fourth year of $155 million. The probability of this happening is estimated to be 20%. What is this option to extend worth?

14.8 Real Option - Expansion

• If sales are strong after the first two years, OFW has the option to invest another $50 million in two years, which will result in cash flows of $173 million rather than $73 million in the last year. The probability of this happening is estimated to be 50%. What is this option to expand worth?

14.9 Deferral Revisited

• Note that, when valuing real options with B-S, you must consider all possible outcomes, not just the non-negative outcomes

• The option to defer production can be valued using Black-Scholes, assuming:• rf= 6%

• σ2 = 0.287

14.10 Black-Scholes Formula

tdd

t

trXPln

d

dNXedNPCall

f

tr f

12

20

1

210

2