Investment Research report

Investment Research Report

By: Syed Imran Raza

For: International Research Association

Investment Research report

Introdution Rfrring th rol of Rl Options nlysis (RO) in mking disions on sin nd thnology (S&T) invstmnts. RO is mthod for hlping to mk invstmnt disions whr outoms r unrtin. It sks to quntify numrilly h of th invstmnt options vilbl in prtiulr sitution. It ould hv potntil for pplition to Govrnmnt S&T invstmnt disions in two wys: first s qulittiv mhnism to simplify omplx invstmnt disions by brking thm down into its omponnt individul stgs; nd sond to quntify th outoms t h stg on th bsis of mrkt informtion nd probbility of suss. RO givs th opportunity to rvis futur invstmnt disions t prtiulr strtgi points in rspons to nw informtion or hnging irumstns.

Bkground RO omprd with othr mthods

Investment Research report In prinipl, RO offrs potntil dvntgs ovr trditionl nt prsnt vlu (NPV) nd disountd sh flow (DF) pprohs, both of whih my ld to undr-invstmnt in high-risk rs. It pls positiv vlu on risk by xploiting th opportunity to phs invstmnts nd stg ky disions so s to (i) llow trmintion of initil xplortory R&D projts whih turn out to b unsussful, nd (ii) invst mor in thos showing positiv futur prospts. By ontrst, NPV nd DF viw risk ngtivly nd, by ignoring th option pproh, impos highr disount rts to djust for highr risk, thus rduing th vlu of futur xptd inom strms. Th intuition bhind this potntil outom is s follows. Trditionl invstmnt pprisl thniqus n b onivd s bing onrnd with on-shot vlution of n invstmnt in n sst. Th initil invstmnt is followd by sris of (oftn) unrtin sh flows ovr tim. DF nlysis is th industry stndrd vlution thniqu. It tks ount of th tim-vlu of mony through th us of risk fr intrst rt, nd of riskinss by dding risk prmium to th risk fr rt in disounting futur sk flows. This pproh nglts th insight whih riss from rognising th phsd ntur of mny invstmnt disions, whih my bgin with xplortory phss bfor finl sst invtsmnt disions r md. Mny invstmnt projts hv in

Investment Research report fft n options phs prior to th sst phs. During th options phs, invstmnts r not bing md in n sst to gnrt strm of sh flows but to stblish th opportunity (but not th obligtion) to subsquntly invst in suh n sst. Th invstmnt in R&D is fftivly n options - i n xplortory - phs, whih is th nssry prursor in ordr to llow futur invstmnt in th finl sst phs whih in this s is th futur ommriliztion projt if th R&D is susful. NPV thniqus r inpproprit to vlu projts in options phss, suh s R&D invstmnt, bus first thy do not tk into ount th vlu of th option phs, nd sond thy nglt th ft tht ommitmnts to futur invstmnts r ontingnt on how th futur unfolds. In th s of R&D thy will b ontingnt on thnil suss s wll s mrkt or politil irumstns. Th bility to bndon projt - i not xris th option for furthr invstmnt - mns tht downsid risk n b rdud to th initil invstmnt whn things go wrong. If irumstns r fvourbl, howvr, th full upsid bnfit n b pturd. This ssymmtry gnrts th rl options vlu. Th ttnds r listd t nnx 2.

Illustrtiv xmpl of Rl Options nysis

Investment Research report Suppos n R&D projt rquirs n outly of 3m now to nbl th invsmnt of 80m in nw produt ftr sussful R&D. Suppos furthr tht th rtin vlu of th sh flow from this sst is 100m. If th R&D is blivd to hv 10% hn of suss, stndrd vlution, tking into ount th thnil unrtinty in th R&D ssigns to this projt vlu of

10% x (100m 80m) - 3m =

minus 1m.

On this bsis it dos not sm to b worth doing. Rl options rsoning howvr rogniss tht if th R&D wr sussful, it would giv n option to invst th 80m in nw produt, but rognizs thr is no obligtion to do so.

Suppos thr is 50% hn of fvourbl rgultion rsulting in n stimtd sh flow from th nw produt of 160m. This is offst by 50% hn of n unfvourbl rgultion, rsulting in vlu of th sh flow of only 40m. Th vrg or xptd vlu of th sh flow is 100m, just

s in th s whr thr ws no unrtinty (Blk, F., Shols, M. 1973 pp.637-640). In th unfvourbl s thr will b no furthr invstmnt - invsting 80m for rturn of 40m mks no sns.

Investment Research report So th projt will b bndond kping th downsid t th sunk ost of 3m. In th fvourbl s, th invstmnt will our nd thn th vlu of th invstmnt will b 160m minus 80m or 80m. Sin thr is 50% hn of fvourbl rgultion, w thrfor xpt vlu of 0.5 x 80m or 40m in th sst phs of th projt. Tking ount of th ft tht thr is only 10% hn of sussful R&D, nd tking ount of th sunk ost of 3m initil invstmnt w rriv t vlu of 0.1 x (40m) 3m = plus 1m. Thus by introduing grtr unrtinty - i mor rlity givn tht thr is usully mor thn on possibl outom - w hv movd from ngtiv projt vlu of minus 1m to positiv vlu of plus 1m.

If th unrtinty in th sst phs is furthr inrsd, for xmpl if in th upsid snrio th produt is worth 200m, but in th downsid it nnot b lunhd t ll nd is worth zro, thn w still hv n vrg vlu of 100m in th invstmnt phs. But now th vlu ftr rl options rsoning is 0.1 x 0.5 x (200m 80m) - 3m = plus 3m. In othr words, th inrsd unrtinty hs givn th projt highr vlu this is quit diffrnt to n NPV nlysis, whr n inrsd unrtinty

Investment Research report would b djustd for by highr disount rt, rsulting in lowr vlu of th projt. RO modlling is wll dvlopd in finnil mrkts whih hv sophistitd nd wll dvlopd mthods of priing risk nd wll dvlopd thory justifying th us of thos pris. Howvr thr r onptul nd mpiril problms to b ovrom in using th thniqu to obtin quntittiv vlutions in rl sst invstmnt dision-tking. Nvrthlss thr r xmpls of th us of RO in mking suh invstmnt disions, prtiulrly in th phrmutils nd tlommunitions industris . RO hs lso bn usd s prt of th Forsight projt on xploiting th ltromgnti sptrum . Th ntrl qustion, whih th Workshop onsidrd, ws whthr RO ould b usd to hlp th DTIs Thnology Strtgy Bord (TSB) in mking finnil llotions btwn diffring thnologis, nd lso btwn diffrnt projts within prtiulr thnologis. Th Workshop lso onsidrd brifly whthr RO ould b pplid to thos invstmnts by Govrnmnt whih ly furthr upstrm, in prtiulr to th grnts md by th Rsrh ounils to univrsitis to support strtgi rsrh. Ths unrtintis dd diffiultis to th vlution pross of th finnil vibility of th projt, spilly givn long onssion priods (Ho nd Liu, 2002). Thy n ply

Investment Research report signifint rol in th totl vlu of th projt; for instn, givn n unrtinty in dmnd, thr is potntil for th projt to hv dditionl vlu if th dmnd inrss. Howvr, thr is lso potntil for rdution in th vlu of th projt if th dmnd drss. Ths unrtintis r onsidrd s dynmi unrtintis. ording to Ford t l. (2002), dynmi rfrs to th volution ovr tim of th unrtin onditions, or th prption of thos onditions, tht dtrmin th optiml strtgy for th prty riving th bnfits nd bsorbing th osts of tht unrtinty. In th s of wtr infrstrutur systms, th dynmi unrtintis r rltd to, mong othr spts, th dtriortion of th infrstrutur omponnts (min pips, vlvs, wtr pumps). If ths omponnts dtriort t highr rt, omprd to th ssumption md t th bidding tim, th privt invstor hs to llot mor rsours to mintin th oprtion of th wtr ntwork. Th rturn on invstmnt my onsquntly drs givn ths pitl invstmnts. (Bitti, ., Rymond, P. 2005, Pp. 56-59) Trditionlly, risk mngmnt strtgis suh s mitigtion, divrsifition, nd limintion hv fousd on th ngtiv impt of th dynmi unrtintis. For instn, in ordr to rdu th risk of dditionl osts for n importnt mintnn tivity, th privt oprtor of th wtr systm

Investment Research report my fix th vlu of th mintnn srvi with subontrtor, whih mns tht ny futur hng in th pris of mtrils, lbor, nd quipmnt will b ssumd by th subontrtor. Obviously, this strtgy prvnts dditionl osts to th gnrl ontrtor, but it lso limits th opportunitis for ost rdution if th mrkt pris of mtrils drs t th ommnmnt of th mintnn tivitis. Givn th dynmi bhvior of th unrtintis, (ost rdution ovr tim, nw thnologis, omptition btwn subontrtors, nw mtrils) thr is positiv point of viw tht should b tkn into ount during th vlution of th projt. For xmpl, nw thnologis nd mtrils my hlp to mintin th infrstrutur for longr priod of tim t th sm ost. In ordr to ssss th dynmis of th unrtinty nd its impt on th vlu of th projt, it is nssry to pproh th pitl invstmnt problm with nw mthodologis tht hv bn pplid sussfully in othr domins, suh s th finnil mrkts, sin trditionl mthodologis suh s disountd sh flow do not ount for flxibl mngril strtgis by th privt invstor. On of ths novl mthodologis is rl options nlysis (RO). ording to D Nufvill (2004), th dvlopmnt of RO holds th promis of nbling th nginring profssion to lult th vlu of flxibility. Hr, th onpt of

Investment Research report flxibility rfrs to th bility of th projt mngrs to mk hngs in th oprtionl strtgis of th filitis bsd on th urrnt onditions of th infrstrutur systms. Ths onditions my b diffrnt whn omprd to th onditions ssumd during th bidding pross.

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Utilizing PPP for wtr nd wstwtr systms rquirs dtild vlution of th projt sh flow. s prt of this vlution pross, it is nssry to onsidr th xptd rvnus nd osts. n importnt lmnt of th ost stimtion is ssssmnt of th dtriortion pross of th diffrnt infrstrutur omponnts. Bsd on this ssssmnt, th privt prtnr n stimt th rsours (pitl invstmnts) rquird to oprt nd mintin th infrstrutur systm throughout th onssion priod without ompromising th qulity of srvi. Dtriortion modls r nssry to dtrmin th projt's pitl invstmnts bus th dtrmintion of ost-fftiv mintnn tions rquirs informtion bout its urrnt ondition, s wll s th ntiiptd futur onditions of th infrstrutur's omponnts (Wirhdikusumh, 1999). Stohsti prosss hv bn usd to modl th dtriortion pross of infrstrutur systms (Rmswmy nd Bn-kiv, 1990; Morous t l., 2002). ommon stohsti pross usd is th Mrkov hins mthodology, whih ssums

Investment Research report tht th ondition of th infrstrutur t tim t+1 dpnds on th ondition t tim t nd dos not dpnd on th stts th hin pssd through until tim t (Winston, 2004). Givn tht th futur ondition of n infrstrutur systm is unrtin, it is possibl to onsidr tht this unrtinty my provid flxibl mintnn strtgis to th oprtor of th infrstrutur (privt prtnr), givn tht th rl ondition t tim t is urrntly unknown but will b known in th futur (i.. t t+1). Thrfor, thr is vlu in witing until th ondition of th infrstrutur omponnt is known to dtrmin th mount of th pitl invstmnt rquird to mintin th oprtion of th infrstrutur. If th ownr of th infrstrutur (publi prtnr) is bl to stimt th vlu of unrtinty (flxibility), it is possibl to xpt highr bidding pris from th privt invstors intrstd in th oprtion nd mintnn of n xisting infrstrutur systm. This hppns bus th totl mrkt vlu of th projt is th sum of two omponnts: 1. Vlu without flxibl ltrntivs (fixd mintnn

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poliy); nd 2. Th vlu of th mngril options. Th mthodology proposd in this ppr uss Mrkov hins trnsition probbilitis s msur of th systm's unrtinty nd is rprsntd by th dtriortion urvs of

Investment Research report

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th infrstrutur omponnts. This unrtinty is onsidrd in th RO in ordr to stimt n urt vlu of th projt. In this ppr, th nlysis nd vlution of th flxibility of th pitl invstmnts rquird to mintin th oprtion of th infrstrutur systm will b ssssd from th ownr's prsptiv. Howvr, similr produrs n b pplid by th projt's potntil invstor. In ordr to obtin n urt projt vlu, it is nssry to xpnd th onpt of disount sh flows nd to ount for th vlu of th flxibility (unrtinty) in th xisting infrstrutur systms. mthodology tht hs bn usd to vlu flxibility in pitl invstmnts is rl options nlysis (RO). vn though th onpt is not nw (Lunbrgr, 1998), its pplition in th vlution of pitl invstmnts is rnt (Ho nd Liu, 2002; Ford t l., 2002; Yo nd Jfri, 2003; Grvin nd hh, 2004; oplnd nd Tufno, 2004; Vn Puttn nd MMilln, 2004). ording to Ross t l. (2002), n option is ontrt giving its ownr th right to buy or sll n sst t fixd pri on or bfor givn dt, whih mns tht it is possibl t tim t+1, givn nw informtion olltd in th tim priod btwn t nd t+1, to mk bttr dision bsd on th urrnt vlu of th sst t tim t+1. For instn, if th futur pri of n importnt onstrution mtril in projt is unrtin, ontrtor my py prmium to supplir in ordr to hv th

Investment Research report option of buying givn mount of mtrils t pri (xris pri) dtrmind tody (tim t). Dpnding on th mrkt ondition t tim t+1, th ontrtor will hv th flxibility of diding whih pri is th most onvnint. If th mrkt pri is highr thn th xris pri, th ontrtor will buy th mtrils t th xris pri, sving mony omprd to th urrnt mrkt pri. If th mrkt pri is lowr thn th xris pri, th ontrtor will not us his option nd h will buy th mtrils t th mrkt pri. Th originl prmium is not rovrd in ny s. This simpl

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xmpl illustrts tht th onpt of rl options n ptur th flxibility of mngmnt disions undr unrtinty. Th privt oprtor of th infrstrutur systms mks pitl invstmnt disions (rstortion, mintnn, nd oprtion) bsd on th sttus of th infrstrutur throughout th projt's lif. This dt is olltd from th thnil vlution (on-sit insption) of th urrnt onditions of th diffrnt omponnts. So, th privt invstor is mking disions bsd on xisting dt (no unrtinty) during th oprtion of th infrstrutur. Howvr, th originl bid ws prprd bsd on ssumptions (forsting) of th sttus of th infrstrutur x yrs from th dt of th bid submission. t th tim of th bid submission, thr ws unrtinty, but whn th pitl invstmnt disions r md, this unrtinty no

Investment Research report longr xists bus urrnt ondition dt of th infrstrutur omponnts boms vilbl. Trditionl DF mthodologis r unbl to ptur th unrtinty in th

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ondition of th infrstrutur systms, nd th nlyst t most my rt snrios to rprsnt diffrnt infrstrutur onditions. Ths snrios sk to rprsnt th rng of possibl outoms in simpl, trtbl mnnr. In gnrl, thr r thr snrios: 1. 2. 3. Bst s; Bs s; nd Worst s.

nothr mthodology tht n b usd to stimt th vlu of th option is pplying ontinuous-tim modl (Lunbrgr, 1998; Grvin nd hh, 2004). This mthodology rquirs thorough undrstnding of diffrntil lulus to solv th diffrntil qution (gomtri Brownin motion) tht dsribs th bhvior of th undrlying sst. numril produr tht is lso usd to vlu options is th binomil mthod, nd this mthod is sir to dpt to th vlution of rl options omprd to th Blk-Shols modl or th ontinuous tim modl. Th binomil mthod uss binomil trs to pproximt th bhvior of th undrlying sst, ssuming tht th invstors r risk-nutrl. In this s, it is ssumd tht th invstors dmnd no dditionl ompnstion byond th risk-fr

Investment Research report rt, rgrdlss of th risk of th sst in qustion (Ross t

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l., 2002). Th binomil trs ssum tht ovr singl priod, th undrlying sst pri n mov from its urrnt pri to on of two possibl lvls: up or down. This movmnt is rltd to th voltility of th undrlying sst. On of th bnfits of RO in PPPs is th pprition of th diffrnt ltrntivs ssoitd with th projt. For instn, th publi ntity my did to postpon th ommnmnt of th projt in ordr to gthr bttr informtion rgrding th dtriortion pross of th infrstrutur systms or to dtrmin th vribility of th projt's dmnd. It is nssry to ontmplt wht typs of options xist (dfr, bndon, swith) in th projt, how ths options n b rtd, how thy dd vlu to th projt, nd how th mngmnt tm n tk dvntg of th unrtinty involvd in th projt. This dos not mn tht trditionl mthods should b ignord, rthr tht RO provids dditionl tools to do bttr ssssmnt of th onomi bnfits of th projt.

onlusions t prsnt, th prinipl vlu of RO s n id to Govrnmnt invstmnt disions ws likly to b in dtrmining th qulittiv pross to nbl nlysts to look t

Investment Research report prtiulr invstmnt opportunity nd brk it down into its omponnt stgs. Using RO s qulittiv disiplin nd dopting n xpliitly phsd pproh ws vry vlubl in stimulting thinking bout th rng of invstmnt options vilbl, how ths might hng with tim, whr th invstmnt ut-off points wr, wht th probbility of suss of h option t h stg in th pross might b, nd s

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lrning mhnism for futur disions. RO ws t rltivly rly stg of dvlopmnt s quntittiv nlytil tool for publi stor dision-mking, omprd with othr thniqus suh s NPV nd DF. Morovr thr ws som unrtinty s to th xtnt to whih it ws usd in th privt stor nd th rsons for its pprntly pthy doption. Thr ws, howvr, n tiv intrntionl dmi nd prtitionr rsrh intrst in its dvlopmnt nd pplition nd som mjor ompnis wr vluting its potntil. Mor dvlopmnt work on RO would b ndd bfor it ould b pplid quntittivly in publi stor ontxt to th sort of disions tht th TSB wr mking bout th lvl of invstmnt in prtiulr ky thnologis. In prtiulr, it ws urrntly not wll suitd t prsnt to dtrmining invstmnt lvls t high lvl of gnrlity, for xmpl invstmnt in imging thnologis vs nrgy thnologis, or mission to Mrs vs stm ll rsrh. It ws lso snsitiv to th ft tht th diffrnt stgs in

Investment Research report projt invstmnt oftn rrid diffrnt lvls of risk, nd th ovrll RO lultions rfltd th prntg hn of

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suss t h of th stgs. Thr wr prllls btwn wht Govrnmnt ws sking to do through its support for sin nd thnology, nd th outoms tht quntittiv RO thniqus might offr for th dision-mking prosss. In diding whih S&T projts to support, Govrnmnt ould b sn in prt s buying options for th UK onomy, in trms of kping opn portfolio of thnologis hving diffrnt lvls of risk nd rturn. RO ould ssist in hlping to nsur th TSB nd possibly th Rsrh ounils (lthough this spt ws not onsidrd in dpth t th Workshop) supportd fullr rng of risk/rwrd outoms for xmpl idntifying low probbility/high vlu outoms whr th upsid rturns wr potntilly vry high, ithr in trms of ground brking or disruptiv thnologis, or ompltly novl nd xiting sintifi rsrh. Th diffiulty right now in using RO to hlp dision-mking on th lvl of invstmnt in diffrnt thnologis or rs of sin ws th bsn of onsistnt st of mtris to input into th RO pross nd to msur outputs. Driving proxis for mrkt vlu s n output msur ws prtiulrly diffiult. Th ft tht input dt ws oftn highly unrtin riskd invlidting th RO pproh. This bsn of onsistnt mtris nd high qulity input dt lso

Investment Research report limitd th pplition of RO to invstmnt disions in

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diffrnt projts within prtiulr thnology r, lthough hr ths ffts wr likly to b lss signifint.

References Baietti, A., Raymond, P. (2005), Financing Water Supply and Sanitation Investments: Utilizing Risk Mitigation Instruments to Bridge the Financing Gap, The World Bank, Washington, DC, . Pp. 56-59 Baik, H. (2003), "Development of an asset valuation model for wastewater infrastructure assets", PhD thesis, Purdue University, West Lafayette, IN.

Investment Research report Barlow, M., Ehrhardt, S. (2004), "A debate on water privatization", Grist Magazine, Pp. 34-36. Black, F., Scholes, M. (1973), "The pricing of options and corporate liabilities", Journal of Political Economy, Vol. 81 No.May/June, pp.637-640. Copeland, T., Tufano, P. (2004), "A real-world way to manage

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real options", Harvard Business Review, Vol. March pp.90-92 De Neufville, R. (2004), "Uncertainty management for engineering systems planning and design", Engineering Systems Monograph, MIT Engineering Systems Division, Cambridge, MA, . Ford, D., Lander, D., Voyer, J. (2002), "A real option approach to valuing strategic flexibility in uncertain construction projects", Construction Management and Economics, Vol. 20 No.4, pp.343-344 Garvin, M.J., Cheah, C.J. (2004), "Valuation techniques for infrastructure investment decisions", Construction Management and Economics, Vol. 22 pp.373-79. Ho, S., Liu, L. (2002), "An option pricing-based model for evaluating the financial viability of privatized infrastructure projects", Construction Management and Economics, Vol. 20 No.2, pp.143-144

Investment Research report Luehrman, T.A. (1998), "Investment opportunities as real options: getting started on the numbers", Harvard Business Review, Vol. July/August pp.51-67. Luenberger, D. (1998), Investment Science, Oxford University Press, New York, NY. PP. 13-16 Merton, R.C. (1973), "Theory of rational option pricing", Bell Journal of Economics and Management Science, Vol. 4 No.Spring, pp.141-83. Morcous, G., Rivard, H., Hann, A.M. (2002), "Modeling bridge deterioration using case-based reasoning", Journal of Infrastructure Systems, Vol. 8 No.3, pp.86-95. Ramaswamy, R., Ben-Akiva, M. (1990), "Estimation of highway pavement deterioration from in-service pavement data", Transportation Research Record, No. 1272, Transportation

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Research Bureau, National Research Council, Washington, DC, pp. 96-106, . Ramirez, N. (2002), "Valuing flexibility in infrastructure developments: the Bogota water supply expansion plan", MSc thesis, Engineering Systems Division, Massachusetts Institute of Technology, Cambridge, MA, . Rode, D.C., Lewis, P.R. (2003), "Probabilistic risk analysis and project capital structures", Journal of Structured and Project Finance, Vol. 9 No.2, pp.65-80.

Investment Research report Ross, S.A., Westerfield, R.W., Jaffe, J.F. (2002), Corporate Finance, 6th ed., McGraw-Hill, New York, NY, .

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Trigeorgis, L. (1996), Real Options Managerial Flexibility and Strategy in Resource Allocation, MIT Press, Cambridge, MA, . Van Putten, A.B., MacMillan, I.C. (2004), "Making real options really work", Harvard Business Review, Vol. December pp.134-41. Water Partnership Council (2005), Establishing Public-Private Partnerships for Water and Wastewater Systems: A Blueprint for Success, Water Partnership Council, Washington, DC, . Winston, W. (2004), Operations Research. Applications and Algorithms, 4th ed., Brooks Cole, Belmont, CA, . Wirahadikusumah, R. (1999), "Optimization modeling for management of large combined sewer networks", PhD thesis, Purdue University, West Lafayette, IN, . Yao, J., Jaafari, A. (2003), "Combining real options and decision tree: an integrate approach for project investment and risk management", The Journal of Structured and Project Finance, Vol. Fall pp.53-55.