real options apim

Real Options

Dr. P.K. Gupta

Real Option(RO)

A real option is an option where the underlying asset is a real asset.

Real Option on Projects are the most popular forms of real options.

Real options discussion essentially falls under “Innovative Financing of Projects” because RO offers flexibility, aids in decisions under uncertainty and justifies valuation.

Peculiar Features of RO

The underlying logic of the real options framework is based on the realization that future investment opportunities are contingent on prior investment commitments. Thus, in contrast to net present value analysis, real options analysis accounts for the sequential nature of choice processes.

Peculiar Features of RO

Real options investments are characterized by sequential, irreversible investments made under conditions of uncertainty.

Purchasing a real option on a strategically important opportunity allows firms to postpone commitment until a substantial portion of the uncertainty about the opportunity has been resolved.

Peculiar Features of RO

The value of the option (and the underlying asset) is exogenous to the investor’s activity—the investor cannot take steps to make the intrinsic characteristics of the asset more attractive.

Peculiar Features of RO

The market signal of option value is readily observable and is independent of the investor’s behavior. If these properties carry over to an investment of a non financial sort (such as in plant and equipment, or in technology licenses), then the logic of options can directly carry over.

Peculiar Features of RO

The greater the extent to which

these properties are violated, the

more problematic the application

of an options framework is.

Value of RO

Value “Real Option” = NPV with option

- NPV w/o option

Enhanced NPV (ENPV) = NPV + ROV

Value of RO

Binomial Style- Cash Flows assume two values at every node

Black-Metron- Sholes Style- Cash flows follow a stochastic process

Binomial Model

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Black-Scholes-Merton Model

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Boundaries of RO

Boundaries of RO

Structure of Real Options

Types of Real Options

• Abandon or Terminate• Wait• Intensity or Operating Scale• Expand• Contract• Switching• Growth• Interdependent• Compound

Abandonment or Termination Options

A/T Options

Whereas traditional capital budgeting analysis

assumes that a project will operate in each

year of its lifetime, the firm may have the

option to cease a project during its life. This

option is known as an abandonment or

termination option.

A/T Options

Abandonment options, which are the right to

sell the cash flows over the remainder of the

project's life for some salvage value, are like

American put options. When the present value

of the remaining cash flows falls below the

liquidation value, the asset may be sold.

A/T Options

• Examples

– These options are particularly important for large

capital intensive projects such as nuclear plants,

airlines, and railroads.

– They are also important for projects involving new

products where their acceptance in the market is

uncertain.

A/T Options

A/T Options Illustration

Super Projects Ltd. has undertaken a project a few years ago. The project is still running and has a remaining useful life of 6 years. The company now feels that the project does not fit into its overall strategy and is considering whether it should be abandoned. The following information is available:Year Cash flow (Rs.Crore) Value if sold (Rs.Crore)1 175 5102 200 4753 235 4004 350 3005 400 2006 100 50The cost of capital of the company is 22%. Decide whether the project should be abandoned, and if yes, in which year.

340

Options to Wait

Intrinsic Value

Option to Wait

Option Price

Stock Price

Intrinsic Value + Time Premium = Option Value

Time Premium = Value of being able to wait

Option to Wait

Option Price

Stock Price

More time = More value

Option to Wait

Option Price

Stock Price

Temporary-Stop or Shutdown Options

For projects with production facilities, it may not

be optimal to operate a plant for a given period if

revenues will not cover variable costs.

In a oil extraction plant, if the price of oil falls

below the cost of extraction, it may be optimal to

temporarily shut down the oil well until the oil

price recovers.

Intensity or Operating Scale Options

(Varying output or production)

I/OS Options

Intensity or operating scale options involve the

flexibility to expand or contract the scale of the

project. Management may have the option to

change the output rate per unit of time or to

change the total length of production run time.

I/OS Options

– In order to obtain the option to expand production

if demand increases suddenly, a firm may build

production capacity in excess of the expected

level of output.

– In this case, management has the right, but not the

obligation to expand, and will exercise the option

only if project conditions turn out to be favorable.

I/OS Options

Whereas the excess capacity will have an initial cost, the project with the option to expand is worth more than the project without the possibility of expansion, in which case the extra cost may be justified.

Also, a firm may build a plant whose physical life exceeds the expected duration of use, thereby providing the firm with the option of producing more by extending the life of the project.

Options to Expand

Option to Expand

It is like a American call. Build production capacity or

the infrastructure for the capacity in excess of

expected level of output (so it can produce at higher

rate if needed).

Management has the right (not the obligation to

expand). If project conditions turn out to be favorable,

management will exercise this option.

Option to Expand

Options to Contract

Option to Contract

This is also equivalent to a American put

option. Many projects can be engineered in

such a way that output can be contracted in

future. Forgoing future expenditures is

equivalent to exercising the put option.

For example : Modularization of project.

Option to Contract

Option to Expand or Contract (Switching Option)

It is equivalent to the firm having a portfolio of

call and put options. Restarting operations when

project currently shut down is a call option.

Shutting down is a put option.

SO

A project whose operation can be dynamically

turned on and off (or switched to two distinct

locations) is worth more than the same project

without the flexibility to switch.

SO

Initiation or Deferment Options

Initiation or Deferment Option

The option to choose when to start a project is an

initiation or deferment option.

If the firm is convinced about the technology or

market, but wants to maximize through timing, it

may go for I/D option.

For example - The purchaser of an off-shore lease

can choose when, if at all, to develop property.

Initiation or Deferment Option

• Initiation options are particularly valuable in natural resource exploration where a firm can delay mining a deposit until market conditions are favorable.

• If natural resource companies were committed to producing all resources discovered, they would never explore in areas where the estimated extraction cost exceeded the expected future price at which the resource could be sold.

Initiation or Deferment Options

Intra-project vs. Inter-project Options

Intra-project vs. Inter-project Options

Inter-project options arise when the development of one project creates value that attach to other projects. Sequencing options, for example, are inter-project options because the sequencing of projects creates value for subsequent projects as the direct result of undertaking the initial project.

Intra-project vs. Inter-project Options

Traditional capital budgeting analysis will miss this option because projects evaluated on stand-alone basis.

Growth Options

Growth Options

• The value of the firm can exceed the market value of the projects currently in place because the firm may have the opportunity to undertake positive NPV projects in the future.

• Standard capital budgeting techniques involve establishing the present value of these projects based on anticipated implementation dates.

• However, this implicitly assumes that the firm is committed to go ahead with the projects.

Growth Options

Since management need not make such a commitment, they retain the option to exercise only those projects that appear to be profitable at the time of initiation.

• Example:– High-tech and software industries (where there

are significant first-mover advantages)

Compound Options

Compound Options

R&D projects generally involve multiple phases with or without overlapping. If the investment is made in a phased manner, with the commencement of subsequent phase being dependent on the successful completion of the preceding phase, it is known as sequential investment.

Compound Options

Each stage provides information for the next thus creating an opportunity (option) for subsequent investment in a new technological area. Such projects can be valued using the techniques of ‘Compound Options’, also known as ‘Option on Options’.

Compound Options

By explicitly recognizing the ‘choice to invest’ aspect of earlier stage R&D projects, this mechanism greatly enhances the ability of decision-makers to justify long-term R&D investments made by the public sector. For example, an early R&D investment by the public sector in an emerging technological area may be considered the mechanism for enabling (establishing the option for) the private sector to undertake the follow-up investment required to innovate in that area.

Compound Options

Moreover, by differentiating among the various stages in an R&D program, this mechanism allows the use of more appropriate discount rates that better reflect the differential risks of technologies in various stages of development.

Compound Options

Models have tended to treat R&D investment as a sequential compound option, where investments take place in a phased manner. It is widely known in the innovation systems literature, however, that this assumed ‘linearity’ is false for two reasons:- R&D phases very often take place in parallel or, at least, overlap significantly;- Binomial method can be applied but continuous time real options are difficult to value.

Comparison of RO with traditional approaches

Criteria NPV/DCF DTA RO

Valuation Expected Cash Flows discounted at WACC

Expected Cash Flows discounted at arbitrary rate(WACC/risk free rate)

Synthetically recreate cash flows with a portfolio of traded assets with change in cost of capital at every node.

Decision Year 0 Deferred until time period t

Deferred until time period t

Flexibility Not Valued Valued with error Valued correctly

Comparison of the approaches

Problems with DCF

Applies a single time and risk-adjusted discount rate to derive and compare the NPVs of:

• Different projects with different risk characteristics

• Projects under different development design

scenarios, e.g. different capital-intensity, operating

leverage

• Both the riskier revenue and less risky cost functions

of their financial models biasing decisions against

incurring expenditure now to save costs later

Other Bias in DCF

• Revenues run price risk and are more risky

than costs

• Capital and operating costs which are known

with greater certainty, can be controlled and

are not subject to price risk

• If costs are less risky than revenue then using

a single, high, risk-adjusted discount rate

biases DCF/NPV against incurring appropriate

levels of expenditure now to save costs later.

Illustration

A project is costing 2000 million with a with a life of 25 years and its present value is 1850 million. The company has an option to sell the plant after the end of 10 years at 1800 million. Volatility of cash flows is 30% and risk free rate is 8% Value the abandon option.(? – Type, Method)

Illustration

Super Products Ltd. Plans proposes to come out with a new product with the help of R&D activities. The marketing cost of the product would be Rs. 15 crores equally divided over the next two years. Expected cash inflows for the year 3 to 8 are: -Year 3 4 5 6 7 8 Cash Flow 1 2 4 4 3 1 (Rs. Cr)

Illustration contd..

If the project is successful the company has option to expand at the end of year 5 and invest additional 10 Crores. The probability of success is 0.60 and if successful, the company would be earning 6 crores every year from year 6 to 10 with probability of 0.50 or Rs. 4 crores with probability of 0.50. The opportunity cost is 14%. Decide the option to expand.(?- NPV with option to expand = NPV of the project + Value of the option to expand)

Some Research Studies

Use of Real Options

Trade-offs between capital and operating costs and by constructing models that separate and discount more realistically the inherently higher-risk revenue function of projects as compared to discounting their cost function using a risk-free rate{Salahor (1998) and Samis (2002)}

Ander & Daniel A. Levinthal(2004)

Greater the extent to which choice sets evolve as a consequence of firms’ exploration activities, the less structured the firms’ abandonment decisions become and, in turn, the less distinguishable a real option is from more generic notions of path dependence—a sequential stream of investment in and of itself does not constitute a real option. While organizational adaptations can extend the applicability of real options, they impose tradeoffs that may lead to the under utilization of discoveries made in the course of exploration.

Option Creation

The stock market supports “option creation” by valuing some non-dividend-paying companies holding sub-economic mineral deposits of commodities with volatile prices. It does so on the basis of their growth potential even though the NPVs of their projects may be negative at current prices This result in a “market premium” between a company capitalisations and the the sum of the “fundamental valuations” (NPVs) of all its projects.

Option Creation

Exploration, R & D and pilot studies have the characteristics of real options, in that they create opportunities but not obligations Yet many of them continue to be penalised by DCF analysis and are often unwisely rejected This is due to investors not recognising and valuing management flexibility to keep their future options open to progressively adjust their actions as a project unfolds, depending on emerging circumstances and information.

Giuseppe Alesii(2003)

• Real options reduce the variability of expanded NPV in projects.

• VaR on NPV decreases dramatically with the exercise of real options.

• Real options are effective not only in enhancing value but also in taming operational risk. (Also to Cash Flow at Risk (CFaR).

Andrew Wong Lip Soon et. Al.

• Investment practitioners are more willing to change their investment decision making with or without the presence of real options framework in 3 main areas. They are:* investment strategy* valuation * investment structure

• Investment practitioners are more concern about their investment health

Andrew Wong Lip Soon et. Al. contd..

• Second, multiple interacting option, time-to-build options and options to switch have the highest weight age in the venture capital processes.

• Investment practitioners are learner and adaptor in which they will place a small investment to have an options for the future to either switch, perform a stage investment or using multiple interacting options.

Helen Weeds

• Managers tend to influence rivals’ behavior to operate in their own favor to avoid harmful reactions by rival firms, or to lessen their effects, and to stimulate investment by other firms when this confers some benefit.

• Real options may provide an additional motivation for mergers or joint ventures: when options interact joint management is desirable.

Helen Weeds contd..

• When options interact, their combined value is not additive: there is an additional gain due to the enhanced ability to hold the option and choose its exercise date optimally.

• This principle may be extended to diversification into sectors that are currently unrelated but are likely to converge in the future: diversification gives firms options over future synergies between these areas, including the ability to exercise these options optimally.

Han Smit and Pim van Vliet

Impact of growth options on the performance of stocks.

Large asset firms show a more symmetrical return distribution, small growth firms show a typical asymmetrical risk return distribution. While many growth options expire worthless, a few firms will be able to successfully exercise their sequential options, and enter a period of extreme growth.

Han Smit and Pim van Vliet contd..

In addition to mean variance trade off, investors seem to prefer firms with upward potential and willing to accept a growth discount on average return. Real options theory can explain why the betas of growth firms are too-high or average returns too low.

Tom Arnold & R. L. Shockley, Jr.

If a manager is willing to make the assumptions necessary to apply the NPV rule to a potential investment, then the manager has already made all of the assumptions necessary to also price options on that project. In other words, real options analysis is perfectly valid in any situations where DCF/NPV is applied without further assumptions.

Rochman(2002)

While theory of constraints shows how to maximize the throughput of the system and at the same time the return on investment, real options shows how to value companies with flexibilities, which is something inherent and necessary to the use of the theory of constraints.

Rochman(2002) contd..

Both theories requires that management must be proactive and know how and when make use of the flexibility existent in the system. The correct use of both theories together result in optimization of decision making in the short and long run..

Marcus Dimpfel(2002)

For investments that can be characterized by a high operating risk and low reselling possibilities as well as high parameter values of the different forms of uncertainty (e.g. market demand, competitor’s actions and technological developments), especially learn and growth options are of importance.

Thank You