REAL OPTIONS

WHAT IS A REAL OPTION?• A situation in which an investor is able to choose

between two different investments where both choices involve tangible assets. The investor may choose between assets; like land or inventory; financial instruments like stocks and bonds are not involved in a real option.

• Real options, as a discipline, extends from its application in corporate finance, to decision making under uncertainity in general, adapting the techniques developed for financial options to "real-life" decisions.

• It should be noted that a real option has nothing to do with an option contract.

• Real option applies option valuation techniques to capital budgeting decisions.

• Real options represent a company’s rights to make chronological decisions in a capital project.

• Real options increase the NPV of a project because a firm would not rationally exercise an option which lowers value.

• They are referred to as "real" because they usually pertain to tangible assets such as capital equipment, rather than financial instruments. Taking into account real options can greatly affect the valuation of potential investments.

TYPES OF REAL OPTIONS

TYPES OF REAL OPTIONS• Options relating to project size; where the project’s scope is

uncertain, flexibility as to the size of the relevant facilities is valuable, and constitutes optionality.

1. Option to expand2. Option to contract 3. Option to expand or contract (Switching option)

• Options relating to project life and timing; they refer to the option to exercise only those projects that appear to be profitable at the time of initiation.

1. Initiation or deferment options2. Option to abandon (Termination option)3. Sequencing options

• Options relating to project operation; management may have flexibility relating to the product produced and /or the process used in manufacture.This flexibility constitutes optionality.

1. Output mix options (product flexibility)2. Input mix options (process flexibility)3. Operating scale options (Intensity options)

Five Procedures for ValuingReal Options

1. Discounted cash flows analysis of expected cash flows, ignoring the option.

2. Qualitative assessment of the real option’s value.

3. Decision tree analysis.4. Standard model for a

corresponding financial option.

5. Financial engineering techniques.

Analysis of a Real Option: A Numerical Example

• Initial cost = $70 million, Cost of Capital = 10%, risk-free rate = 6%, cash flows occur for 3 years. Annual

Demand Probability Cash FlowHigh 30% $45Average 40% $30Low 30% $15

Procedure 1: DCF Analysis

• Expected(CF)=Probability1 xcash flows1+ Probability2 xcash flows2 +Probability3 xcash flows3

=0.3($45)+0.4($30)+0.3($15) = $30• PV of expected CFs = ($30/1.1) + ($30/1.12) +

($30/1/13) = $74.61 million.• Expected NPV = PV of expected CFs- Initial cost = $74.61 - $70

= $4.61 million.

Investment Timing Option

• Project’s expected NPV is $4.61 million.• However, the project is very risky.Now,we

should find Present Value of expected CFs in the high and low demand.

Investment Timing Option– High Demand

PV of CFs = ($45/1.1) + ($45/1.12) + ($45/1.13) = $111.91

NPV = $111.91 - $70 = $41.91

– Low Demand PV of CFs=($15/1.1) + ($15/1.12) +

($15/1.13) = $37.30 NPV = $37.30 - $70 = -

$32.70

Investment Timing Option

• If we wait one year, we will gain additional information regarding demand.

• If demand is low, we won’t implement project. • If we wait, the up-front cost and cash flows

will stay the same, except they will be shifted ahead by a year.

Procedure 2: Qualitative Assessment

• The value of any real option increases if:– the underlying project is very risky– there is a long time before you must exercise the

option• This project is risky and has one year before

we must decide, so the option to wait is probably valuable.

Procedure 3: Decision Tree Analysis (Implement only if demand is not low.)

Discount the cost of the project at the risk-free rate, since the cost is known. Discount the operating cash flows at the cost of capital. Example: $35.70 = -$70/1.06 + $45/1.12 + $45/1.13 + $45/1.14.

Cost NPV this

2001 Prob. 2002 2003 2004 2005 Scenarioa

-$70 $45 $45 $45 $35.7030%

$0 40% -$70 $30 $30 $30 $1.7930%

$0 $0 $0 $0 $0.00

Future Cash Flows

• Use these scenarios, with their given probabilities, to find the project’s expected NPV if we wait.

• E(NPV) = 0.3($35.70)+0.4($1.79) + 0.3 ($0)

= $11.42.