SFM | Net Present Value | Discounted Cash Flow

Strategic Financial Management

Chapter V

Real Options
After reading this chapter, you will be conversant with: • • • • • • Financial Options and Real Options Compared Various Types of Real Options The Black-Scholes Model Decision Tree Analysis Application of Real Options Drawbacks of Real Options

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Strategic Financial Management

Let us start with refining the basic concept of real options. In a narrower sense, the real options approach can be viewed to be an extension of the financial option theory. In case of the real options the underlyings are real assets unlike financial assets in the case of financial options. The difference lies in the fact that the financial options are detailed in their contract; the real options that are embedded in strategic investments must be identified and specified. The real option approach provides the managers with opportunities for the way they have to plan and manage strategic investments.

COMPARING FINANCIAL AND REAL OPTIONS
The basic difference that exists between a financial option and a real option lies in its underlying. The underlying that exists in case of the former is a security such as a share of a common stock or a bond, whereas the underlying for the latter is a tangible asset, say for example, a business unit or a project. It is to be noted that both types of options give the right but not the obligation to take an action. Financial options are written on traded securities, whose price is usually observable and one can estimate the variance of its rate of return. In the case of real options, the underlying risky asset is usually not a traded asset, thus one estimates the present value of the underlying without flexibility by using traditional net present value techniques. A further difference exists between the two. Most financial options are not issued by the companies on whose shares they are contingent, but rather by the independent agents who write them and buy those that are not written. As a result of which, the agent that issues a call option has no influence and control of the company and its share price. The real options are different in this aspect because here, the management controls the underlying real assets on which they are written. As an example, a company might have the right to refer a project and it may choose to do so if the present value of the project is low. Now if the company comes up with an innovative idea that has the potential to enhance the NPV of the project, the value of the right to refer may fall and the company may decide not to defer. As a matter of fact, the act of enhancing the underlying real assets value also increases the value of the option. A point of similarity that exists between a financial option and a real option is that in both cases, the uncertainty of the underlying, i.e. the risk is assumed to be exogenous. The uncertainty concerning the rate of return on a share of a stock, is beyond the control and influence of individuals, who are the actual traders of the stock. In case of real options, the actions of the company that own it may influence the action of its competitors, and consequently the nature of uncertainty that the company faces.

TYPES OF REAL OPTIONS
The very first step in valuing a project lies in identifying the options that are embedded within the project. It may happen that though two projects are exactly identical, there may be the presence of several types of real options.

Investment Timing Options
The conventional type of Net Present Value (NPV) analysis is based on the implicit assumption that the project will either be accepted or rejected. This has a simple implication, that a project will be undertaken now or never. Though in practice, companies may even go in for a third choice. They have the option to relay the decisions until at a later point of time when more information is available. Such investment timing options (ITO) result in altering the projects, estimated profitability and risk.

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the Indian financial magazine worked to determine the bottomline impact of the various methods for valuing options. Minimum Value How it works: Calculates Black-Scholes value assuming zero volatility.8 mn (variable). Impact on earnings: If stock increases in value: $66.3 million (variable).5 mn (fixed). Verdict: Thumbs down. this model results in bigger hit to earnings than Black-Scholes. Verdict: Thumbs down.4 mn (fixed).3 mn (fixed). and approximately the number granted by several wellknown companies. and CVS for this purpose. Binomial How it works: Uses Black-Scholes variables. Advantage: Reflects how options really are exercised.7 mn (variable). Impact on earnings: If stock increases in value: $26.230 (variable). Purification. so it overestimates option value.6 mn (variable). $69.3 mn (variable). Advantage: Accounts for most factors affecting future option value. Scientific-Atlanta. which values options on the grant date and expenses them over time regardless of changing stock price and options value. this model requires the smallest earnings charge when companies can escape with no charge by using variable accounting. No improvement over standard Black-Scholes. Verdict: Thumbs down. Disadvantage: No public company stock has zero volatility. and other factors to estimate option value.3 million options which is median number of options granted by S&P 500 companies in 2001. Black-Scholes How it works: Uses formula based on dividend yields. Walgreen. It then came out with five possible ways to value options.3 mn (fixed). $31. If stock decreases in value: $66. Companies would overpay for underwater options. For each scenario. and variable accounting. including Aetna. $97.5 mn (fixed). $31. 56 . If stock decreases in value: $67. $96. It plotted two different performance scenarios: One in which the stock price increased 15% a year over three years and the second in which it decreased 15% a year. it examined the impact on earnings using two types of accounting: Fixed accounting. The five methods are briefly described and evaluated below.Real Options Box 5. but assumes options will be exercised when optimally profitable. Advantage: Of the Black-Scholes variants. formula easily manipulated to boost earnings. Impact on earnings: If stock increases in value: $67. Disadvantage: Doesn’t discount for vesting and other restrictions. volatility.4 mn (fixed). It used a hypothetical grant of 5. which values and expenses options every year. If stock decreases in value: $26.1: Different Methods of Valuing Options BusinessWeek. Disadvantage: If company pays dividends. $472.

2. and 2005. 4. Say for example. Disadvantage: As with any variable accounting treatment. Source: ICFAI Reader. Uses no “assumptions” that can be tweaked to boost earnings. there’s no charge at all. a particular company has plans to introduce an innovative mobile set with a lot of added features. other methods would result in much bigger charges. 2004. Impact on earnings is the cumulative earnings reduction over three years.1 mn (fixed).7 million (variable). licenses or other barriers to entry. impervious to manipulation. If stock decreases in value: $86. If stock decreases in value: $0 (variable). Impact on earnings If stock increases in value: $86. And it’s cheap: With stock gains. and vested in equal installments on the grant date anniversary in 2003. because these factors tend to lessen the threats of competition. Verdict: Thumbs down. Calculations assume 40% volatility. Data: BusinessWeek. It should be borne in mind that the option to delay will only be valuable if it more than compensates any harm that might arise from delaying. Too pricey. minus the exercise price.1 beta. and allows companies that use variable accounting to avoid charge when options plunge underwater.4 (variable). Earnings impact calculated by Towers Perrin Note: For the purposes of this illustration. and with a depreciating stock. Intrinsic Value How it works: The stock price. Well. BusinessWeek assumed the options were granted on June 30. This method accurately tracks true options value over time.5% dividend yield. fixed accounting cannot be used. and 10.9 mn (variable). 1. is the value of the option. March 2003. this method relies on assumptions of future stock gains to determine option value. and underwater options are free. Advantage: Simpler than Black-Scholes. With fixed accounting. Verdict: Thumbs up. Advantage: The simplest method of all.1 mn (fixed). earnings charge could fluctuate wildly with stock price. To delay the investments in the projects until one gets a better idea of the size of the market for the innovative mobile sets. an expensive alternative. Your company may be left with two alternatives.5% market return. $120. 1. Disadvantage: Difficult to determine future stock gains with 100% accuracy. not adjusted for taxes. Further it is also valuable when the market demand is uncertain. with the exercise price set at a current stock price of $30. at 57 . $24.Strategic Financial Management Growth and Discount How it works: Instead of volatility.5% risk-free rate. patents. any other company may take advantage of it and create a strong loyal customer base that in turn might make it difficult for the company to enter the market at a later point of time. 1. The option to delay projects is usually most valuable to the firms with proprietary technology. and too easy to manipulate. Since grant date value is zero. here one should prefer in delaying the investment on the project implementation. Impact on earnings If stock increases in value: $52. To immediately start of with providing the services that are compatible with the mobile sets. It might happen that if one delays.

When one goes for evaluating a potential project. Using a standard model for a financial option. In one type of growth option. The DCF assumes that the assets that are involved in the project will be used over a specified economic life. c. The third type may deal with the opportunity to add new products that even includes the complementary products and successive generations of the original product. Flexibility Options There are many projects that offer flexibility options which allow the firm to alter operations depending on how the conditions change during the life of the project. e.Real Options the same time it is also valuable during periods of volatile interest rates. Thus the inclusion of the option to abandon such a contract might be quite valuable. Though it is correct to say that some projects can be operated over their full economic life. Using the DCF valuation and including a qualitative recognition of any real options value. In contrary. some contracts between the automobile manufacturers and their suppliers mention the quantity and the price of the parts that must be delivered. d. They may be of different types. Valuing Real Options Let us now try to focus on the valuation of real options. This implies that the value of the project using real options will not be as accurate as it had been stated in a simpler DCF model for valuation. Growth Options A growth option lets a company to increase its capacity of operation if the market conditions are better than expected. It may happen that either the inputs or the outputs can be changed. Use of DCF valuation and ignoring any real option. there may be other projects that may be abandoned. The inputs are the cash flow and the risk-free rate that help in accurate estimation of the project’s DCF. They are: a. a company may resort to increase the capacity of an existing product line. b. project specific model with the help of techniques in financial engineering. Abandonment Option There may be many projects that contain abandonment options. The electric power plants provide a good example of the input flexibilities. Another type allows a company to expand into new geographic markets. the standard DCF method is used. Say for example. 58 . Let us first consider a simple project that consists of a single risk-free cash flow that is due one year from today. since the ability to wait aids in allowing the firms to delay the raising of its capital for the projects until the interest rates are lower. There can be five possible procedures that can be used in order to deal with real options. If the labor cost of the supplier increases. DCF value of the project = Cash flow 1+ k RF Where kRF denotes the risk-free rate of return at which the cash flow is discounted. then he might as well lose money on each part he ships. Developing a unique. valuing real options calls for a greater level of judgments in areas of both formulating the model as well as in estimating the values of the inputs. Use of decision tree analysis. with the assumption that their values are zero. The pure DCF value of the project can be calculated as follows. though the market conditions can get adverse and lower the expected cash flows.

25 0.15 crore.80.250 0.200 So. 2.000 So. it will be able to know which of the demand conditions.14) (1+ 0.2 cr. based on the discounted cash flow method. that if the expected cash flow had been slightly lower.50 0. as there lies 25 percent chance that the demand for the devices may be low.2. But each of the expected cash flows will be delayed by one year. but the future cash flows of the project depend on the demand of the conditional access system (CAS) that is to be provided by the government. as calculated above. so instead of implementing the project immediately.3 crore for each of the following three years. 2. in which case the net present value would turn out to be a negative Rs. it can also choose to delay the decision until the coming year.3.5 crore. A basic analysis reveals that the project is somewhat riskier than any other average project. The cost of the project will still amount to Rs. enjoys patent rights on the device’s core modules. say for example Rs.14)3 59 . the NPV would have been negative and this would have resulted in rejection of the project. as a result of which the cost of capital that would be used to discount its cash flow is 14 percent. the expected annual cash flow per year is Rs. It also feels that there lies a 50 percent chance for the demand to be average with subsequent generation of cash flows that will amount to Rs.5 crore + = 10.25 2.5 0. The company feels that there lies a 25 percent chance that the demand for the new set up device is very high. Farther the project is risky.2 cr. in which case the project will be able to generate a cash flow of Rs.3.000 (approx. value) 2 (1+ 0.5 crore per year.3 2.Strategic Financial Management Let us now try to understand each of these with the help of some examples.5 crore if it waits.2.2 cr. Thus on delaying the project it will go in for investments only if the demand is sufficient enough to provide a positive value of net present value. Opportunistics India Ltd.84 crore. the company should go in for the project. Type 1: Using DCF Valuation and not Considering any Real Option by Assuming that their Values are Nil Demand for the device High Average Low Probability (Pi) Annual Cash Flows (cf) (crore) 3. and the project will still generate the expected cash flows that have been stated earlier. It is to be noted here.825 1. then the traditional value of the net present value will be NPV = –Rs. and in return which of the set of cash flows. The total estimated cost of the project is Rs.2.125 0.80. is considering a project for an innovative set up device that will enable cable users to view satellite channels according to their own wish.2 crore. Opportunistic India Ltd. 2. + + +10. If we do not take into account the investment timing option. It should be remembered that if the company waits.14) (1+ 0. along with that the chances that the demand will be low is 25 percent in which case the cash flow generation will be only 50 lakhs.5 Expected Cash Flows (Pi x cf) (crore) 0. which is not very certain. will exist.

25 0.402) + (–0. One being the “scenario analysis”.665 0.402 High –5 Average Low 0.5 3.00 Expected NPV = (0. it is to be said that an option’s value increases with the risk of an underlying asset. If the company goes in for immediate implementation of the project. It is also known that the value of the option increases with the increase in its time to expire. and as 60 0. it is advisable to delay the project. which is fairly a long time for an option. Thus based on this qualitative approach.3 2.20.804 crore.5 0.5 0.25 –0. This too implies that the option is valuable. Finally. and the other being the other “decision tree”.665) + (0. The scenario analysis can be used in the following way.960 . This brings us to another point of discussion: Should the company go ahead with the project now or wait for sometime? While considering this decision.107 In the above diagram.50 1.3 2.108 crore but at the cost of the risk that is involved with the chances of its low demand. in the high demand scenario.5 0. whereas in case of low demand.0. the company will suffer a loss to this extent in case of low demand.50 is definitely worth more if its value were Rs. Type 3: Use of Decision Tree Analysis Let us here take two ways of using the decision tree analysis. Case 1 Scenario analysis – on immediate implementation of the project 2003 2004 2005 2006 NPV of this Scenario 2. as a result the value of the option will be valuable. The DCF valuation is also suggestive of the fact that the underlying value of the asset will be closer to the exercise price.50 on a stock with the current price of Rs.839 crore. Nevertheless. the project should be barely accepted.3 2. which again suggests that the option is valuable.5 0.5 3. other things remaining unchanged.25 0.839 Prob Prob x NPV 0. it is seen that the project is quite risky. In our example.25 3. and it would do just the opposite in case it is worth less than this value.661 0. So.960) = 0. though the NPV would result in earning Rs.5 0. If it is worth more. for example. Here. the NPV of the project is 2.Real Options Type 2: Using the DCF with Qualitative Recognition of the Real Options Value As it is suggested by the discounted cash flow analysis. Say. As is evident from the above example. the option has life of one year. So. and it ignores the existence of a possible value of real option. one should note that the value of an option is higher if the current value of the underlying asset is high relative to its exercise price. accepting the project now implies that it is also foregoing the option of waiting for some more time to gain more market information before it makes any commitments. the decision has to be made on whether the company would be sacrificing worth that is more or less than Rs.108 crore on immediate implementation.661 crore. The branch resembles the cash flows and the probability of the individual scenarios. a call option with an exercise cost of Rs.804 –3. for analysis demand scenario it is 0. it gains the expected cash flow of 0. each possible outcome is shown as a "branch" on the tree. then it should not go in for immediate implementation of the project and defer it for some point of time later.108 crore. the project yields a negative NPV of 3.

3 crore or 2. then the only action that can be taken is to wait.5 0 3. This clearly shows that the expected value of the project will be much higher if the company delays the project than if it implements the project immediately. 2003 2004 2005 High Wait Average Low 0. Let us now see the decision tree analysis in valuing the project. The expected NPV comes to 0. But this may not be advisable and feasible to do so. same as one estimated using the DCF valuation. so Opportunists India Ltd. and will receive no cash flows in the following years.e. the expected NPV comes to 0.3 2. a.25 1.25 –5 –5 0 3. the company will spend nothing in the year 2004. So.584 0. As there seems to be any possibility of losing money if the company delays the project. we have used the same cost of capital i. a different discount rate is taken. May be then one should discount it at the risk-free rate. the only difference being that the company delays the decision and implements the project only if demand turns out to be high or average. if the company delays the project. other than 14 percent? In both the cases (case 1 and case 2) above.353) + (0) = 0. The NPV of the high demand situation is 2. as there is no possibility of losing money under the option to delay.Strategic Financial Management there is a 25 percent chance of the demand being weak.705 0 Prob Prob x NPV 0.936 crore.108 crore. The expected NPV of the project is the weighted average of the three possible outcomes. yet the investment of the project in the year 2004 in case 2 is known with certainty.335 0.5 0 2006 2007 3.335 crore and that of the average demand situation is 0. Case 2 Decision tree analysis – project implementation in the next year if optimal. 14 percent.5 0 NPV of this Scenario 2. if the demand turns out to be average or high. Say. the project can be considered to be a highly risky one. the resulting NPV will also be zero. if the demand is low. should wait till 2004 before taking any decision to proceed with the investment. this decision also lowers the project’s risk.584) + (0. 61 . The cost of capital of 14 percent may be appropriate for the risky cash flows. Added to this. some lower 0. with the weight for each outcome being its probability.25 0.3 2.5 0.5 crore per year for each of the following three years. c.353 0 b. Case 3 What if.25 0. as all the cash flows under the low demand situation is zero. This clearly indicates that the option to wait is definitely volatile. Now. the investment under the plan is clearly less risky than if it charges ahead today.50 0. Say if the cost is incurred in the year 2003.3 2. mainly because of the following reasons.00 Expected NPV of the Project = (0. This is suggestive of the fact that if 14 percent is the appropriate cost of capital in the first case. Then. the company may spend around 5 crore in 2004 and receive either 3.705 crore. The cash inflows of the project are different in the second case because of the elimination of the low demand cash flows.937 The above diagram can be viewed similar to that of the scenario analysis.

The company’s option to delay the project is comparable to a call option.(5.187) + (0) = 0. which in the Black-Scholes model is the current price of the stock. so the 5 crore value can be used as an exercise price..501) + (0.680 2.5 0 Expected NPV = (0. iv.25 0.255 High Wait Average Low 0. It is to be noted here that a stock’s current price is the present value of its expected future cash flows.480 .018 Prob Prob x NPV 0.3 2. and lower the NPV from 0.5 3.25 1. Valuing the Standard Model of Financial Option – the Black-Scholes Model Till this point of time. v. So. But let us try to value the option using an option pricing model. 2003 2004 2005 2006 2007 NPV of this Scenario 2.00 High Wait Average Low 0.255) = 4.3 2.5 0.00 Expected value of the present values = (1. ii.Real Options rate may be appropriate in the latter one.5 0. coupled with the sensitivity analysis. one can safely say that the decision tree analysis..004 0. Following are the inputs required for the model.25 0.25 0. as a proxy for the stock price.688 crore.50 0.3 2.5 1.501 0.187 0. it will cost Rs.25 0.3 2.721 5. A further assumption is that. iii. hence the Black-Scholes option pricing model can be used. let us take the discount rate to be 6 percent and estimate the expected NPV.5 0 3.3 2.5 crore to implement the project. Let us assume that the rate on a 92-day treasury bill is 6 percent.546 + 0.688 Using 6 percent as the cost of capital.25 - 3..50 0.936 crore to 0.680 + 2.5 0. increase the present value of the cost at 2003.3 2.5 0 3.00 Prob Prob x NPV 0. this rate can be used as the risk-free rate to discount the cash flows.1) 62 . A final assumption in the model is that the variance of the project’s expected return can be used to represent the variance of the stock’s return in the Black-Scholes model. one needs to identify a standard financial option that resembles the project’s real option.50 0.50 0. one can use the present value of the project’s cash flows.091 1.379 0.. It is also to be assumed that there is a need of a proxy for the value of the underlying asset.5 3. i. So.546 0. Risk-free rate Time until the option expires Exercise price of the option Current stock price Variance of the stock’s rate of return. is to be a good provider of information for a good decision. Estimating the inputs for stock price in the option analysis of the investment timing option (Millions of Dollars) Future Cash Flow 2003 2004 2005 2006 2007 NPV of this Scenario 6.25 –5 –5 0 3.25 0. Let us further assume that the company must decide within a year whether or not to implement the project so that there is still a year before the project expires. In order to do this.

5 crore Prob x NPV 1.290) = 5.402 Co-eff of Variation of PV (2004) = 0. inclusive of those that are not expected even if one does not exercise the call option.5 0.661 5.20 = 20 percent 2005 3.25 = ln(0.3 2.902 + 0.50 0. In case of a stock. one can ignore the project’s exercise price.33 6 percent 1 Rs.112 =–0. CV = Coefficient of Variation T = Time of expiry of the project Variance 2003 High Wait Average Low 0.108 Standard Deviation of PV (2004) = 2.5 2007 3. Similar to that of the stock.48 crore Annualized standard deviation of returns on the underlying asset. The final input for the model is the variance of the project’s return.Strategic Financial Management The above calculations show the estimation of the present value of the project’s cash flows.47 Type 4: Calculation of the Value of the Investment Timing Option using a Standard Financial Option KRF = T X P σ σ2 d1 d2 = = = = = = = Risk-free rate Time (in years) until the option expires Cost of project implementation Current project’s value [as calculated in (i)] Rs. One needs to find the current price of the underlying asset.54 0.37 P [N(d1)] – N(d2) = 0.290 Calculation for Co-efficient of Variation (CV) 2004 - 63 . the underlying asset is the delayed project. and its current price is the present value of all its future expected cash flows.e. The present value of the cash flows as of today (2003) is 4.25 0.915 + 2. which in this condition. the present value of the project also contains all its possible future cash flows.704 20 percent T ) = 0. is the project.25 1.915 2.5 2006 3. i.5 0.902 0.161 Prob 0.3 2. of cost.4. and this is the input one should use for the current price in the Black-Scholes model.480 crore.5 0.50 0. volatility measures Variance of the project’s return {l ∩ (P/X) + [KRF + (σ2/2)] + T}/(– σ d1 – σ N (d1) N (d2) V T = = = 0. the current price is the present value of the expected future cash flows.25 0. In case of the real option.00 Expected Value of PV (2004) = (1.804 1. Variance of the Project’s Return = ln(CV2 + 1) / t Where.3 2. Further. as the price of the stock is not affected by the exercise price of a call option.5 PV in 2004 in this Scenario 7.472 + 1)/t = 0. while estimating its present value.

We could repeat this process many thousands of times and then take the average of all the resulting present values.80). Risk-Neutral Valuation of Real Options: As we discussed in the chapter.08 million. This is significantly higher than 0. As the text shows. In many cases. suppose we simulate a future value at Year 1 for the project and it is $75 million. and a variance of the growth rate (20 percent). For a very clear explanation of how to implement this in an Excel spreadsheet. However. and we could find the present value of the payoff if we knew the appropriate discount rate. We show how to apply this method to the investment timing option that we discussed earlier in the chapter. So it has an expected NPV of $1. 64 . This method is risk-neutral valuation.704 crore.80 million. a growth rate (14 percent). as it becomes difficult to find a standard financial option that corresponds to a real option. Here we use the technique of risk-neutral valuation. Discounting these cash flows at a 14 percent cost of capital gives a present value of $51. decision trees will always give an inaccurate estimate of a real option’s value because it is impossible to estimate the appropriate discount rate. Since this is above the $50 million cost.108 crore under immediate implementation. we would implement the project in this random draw of the simulation. The cost of the project is $50 million. there is an existing model for a financial option that corresponds to the real option in question. 1 This means that the log of the stock price comes from a normal distribution. excluding the $50 million cost of implementing the project. In this draw of the simulation. Given the uncertain market demand for the software. Because we know the distribution of future values. option pricing techniques assume that the resulting value at a future date comes from a lognormal distribution.Real Options As it is seen from the above calculations. it will learn more about the demand for the software and will implement the project only if the value of those future cash flows is greater than the cost of $50 million. Murphy has certain software licenses that allow it to defer the project for a year. Many financial engineering methods are extremely complicated and are best left for an advanced finance course. which in other words. which is our estimate of the value of the option to implement the project in one year. Murphy software is considering a project with uncertain future cash flows. Type 5: Financial Engineering Technique It might sometimes happen that the decision analysis in valuing a real option may not always give satisfactory results. 1998). In such a situation the only other way is to develop a unique model that corresponds to the specific real option being analyzed. The payoff is $25 million. the present value of the project’s future cash flows is $44. however. However. Given a starting value ($44.1 For example. one method is reasonably easy to implement with simulation analysis. Financial Models Using Simulation and Optimization (Newfield. Sometimes. We could then draw a new random variable and simulate a new value at Year 1. the text shows that the variance of the growth rate is 20 percent. It is similar to the certainty equivalent method in that a risky variable is replaced with one that can be discounted at the risk-free rate. If the company implements it immediately. the value of the option to defer investment in the project is 0. If it waits.08 million. one can conclude that the company should defer the final decision until more information is gathered. we know that the rate of growth is very uncertain and could either be much higher or lower than 14 percent. We expect this value to grow at a rate of 14 percent. the resulting NPV could be much higher or much lower. we could use simulation to repeatedly draw a random variable that has this distribution. as the option should be forfeited. we would not implement the project. and financial engineering techniques must be used. NY: Palisade Corporation. which is the cost of capital for this type of project. However. and the payoff is $0. In fact. there is no such model. is called financial engineering. Suppose the new value is $44 million. see Wayne Winston.

Instead of assuming that the project’s value grows at an expected rate of 14 percent. we now discount this at the riskfree rate to find the present value. based on the $44. Let us now try to understand more about the growth option and the abandonment option. Based on its experience with other projects. a 20 percent variance of the growth rate. risk-neutral valuation requires that you know the current value and variance of the growth rate of the underlying asset. Rs.4 crore in each of the next two years. and our first simulation run has a value of $55.000 simulations.2 crore annually for two years. For some real options. Let us here try to understand each of this with the help of an illustrative example. The estimated cost of capital for the project is 14 percent. However. finding the present value of the payoff when discounted at the risk-free rate. As the text shows. Grow well is now considering a project that will cost Rs.19 million. risk-neutral valuation offers many advantages as a tool for finding the value of real options.0 crore.97 million. THE MODEL The growth option for the project resembles a call option on a stock. and so you cannot apply risk-neutral valuation. Suppose we did this. There is a 50 percent chance of average demand. we do not know the appropriate discount rate. We used the risk-neutral approach to simulate the value of the real option. and a 6 percent growth rate instead of the true 14 percent growth rate. given the rapidly changing tastes of the rural population. One disadvantage of the risk-neutral approach is that it may require several hundred thousand simulations to get a result that is close to the true value.3. and simulation can easily incorporate multiple options into the analysis. and the cost will be incurred in 2005. The payoff is only $5 ($55 – $50 = $5). we believe that within ten years. in which case cash flows will be Rs. and it will generate cash flows of only Rs. Similar to the framework of investment timing option. these two can also be categorized under the five different approaches. we would assume that it grows at the risk-free rate of 6 percent. the underlying source of risk is not an asset. the time we must exercise the option. Most of its products have a very short life. there is a 25 percent chance that the rural population will not like the product at all. risk-neutral valuation techniques will be very widely used in business to value real options. The average present value of all the outcomes from the simulation is the estimate of the real option’s value.03 million. the average value was $6. This is where we turn to risk-neutral valuation. However. With 5. it believes the second-generation product will be just as successful as the first-generation product. With 200.Strategic Financial Management Unfortunately. This will reduce the resulting project value at Year 1.000 simulations. The Growth Option: An Illustration Grow well Corporation designs and produces products aimed at the rural market. our average present value was $7. We can repeat the simulation many times. the company believes it will be able to launch a second-generation product if demand for the original product is average or above. The company’s management believes there is a 25 percent chance that the project will “take off” and generate operating cash flows of Rs.3. given the success of the first-generation product. Personal computers are now so powerful and simulation software so readily available.8 starting value.0 crore. Many actual projects have combinations of embedded real options. Note that this is analogous to the certainty equivalent approach in which we reduce the value of the risky future cash flow but then discount at the risk-free rate. Finally. the true value of the real option in this example is $7. However. The example we showed had only one embedded option. since it gives Grow well corporation the opportunity to “purchase” a successful follow-on 65 . This second-generation product will cost the same as the first product.3. after which rural tastes will change and the project will be terminated.2 crore per year. Also.

1 Scenario Analysis and Decision Tree Analysis for the Grow well Project Scenario Analysis of First-Generation Project (Rs. are discounted at the WACC of 14 percent.14)2 = Rs. Table 5. (2) DCF and qualitative assessment. Approach 2 DCF Analysis with a Qualitative Consideration of the Growth Option Although the DCF analysis indicates that the project should be accepted.0) + 0.0. indicating that the growth option is quite valuable.1.4 2. and NPV (calculated on case 2).2.2. Approach 3 Decision Tree Analysis of the Growth Option Table 5.900 crore Ignoring the investment timing option. which do not include the cost of implementing the second-generation project in 2005. the company will incur a cost of Rs.0 crore implementation cost is known. In these scenarios. All operating cash flows.4 crore or Rs.25 –0.4) + 0.1.0.3. If the demand is low.4 3.54. in crore) Future Cash NPV of this Probability Probability x Flows Scenario NPV 2003 2004 2005 3.3.293 0.14) 1 + Rs. 0. which is a relatively long time. it will let the option expire by not implementing the second-generation product. it ignores a potentially valuable real option.50 0.25 –3.875 crore per year: 0.0. depending on the level of demand.970 (1+0. Taken together.25 (Rs. Table 5.1. As shown in Table 5.129 Based upon this DCF analysis.671 0. Approach 1 DCF Analysis Ignoring the Growth Option Based on probabilities for the different levels of demand.0 crore for the next two years. shown on the bottom branch.3.2 shows a decision tree analysis in which Grow well undertakes the secondgeneration product only if demand is average or high. the expected NPV is Rs. The option’s time to maturity and the volatility of the underlying project provide qualitative insights into the option’s value.2) = Rs.25 (Rs.0 Average 0. The cash flows of the project are quite volatile.970 (1+0.0. The following sections apply the first four valuation approaches: (1) DCF.147 Low 0. Because the Rs. it is discounted at the risk-free rate of 6 percent.5 2.1 shows a scenario analysis for Grow well’s project. shown on the top two branches of the decision tree.3. this qualitative assessment indicates that the growth option should be quite valuable.599 0.650 High 0.3 + Rs. indicating that the project is very risky. the traditional NPV is Rs.25 0.2. The coefficient of variation of the project is 14.129 crore: NPV = –Rs. (3) decision-tree analysis.1.50 (Rs. Otherwise.25 0.0 crore in 2005 and receive operating cash flows of either Rs. the company should accept the project. it has no cost in 2005 and receives no additional cash flows in subsequent years.0 0. the expected annual operating cash flows for the project are Rs.668 66 .0 2.2 0.2 –2. Grow well’s growth option has two years until maturity.470 crore. and (4) analysis with a standard financial option.Real Options project at a fixed cost if the value of the project is greater than the cost.

and this provides a good estimate of the risk-free rate.0.25 0.00 Expected value of NPVs = 0. Grow well corporation’s growth option is similar to a call option on a stock.4 shows the estimates for the variance of the project’s rate of return.524 Approach 4 Valuing the Growth Option with Black-Scholes Option Pricing Model The fourth approach is to use a standard model for a corresponding financial option.5.25 1. The calculations in Table 5. and so we will use the Black-Scholes model to find the value of the growth option. The input for stock price in the Black-Scholes model is the current value of the underlying asset. The total NPV is the sum of the first-generation project’s NPV and the value of the growth option: Total NPV = Rs.4 4.3.407 crore.129 1.0 0.25 Average 0.Strategic Financial Management 1. As we noted earlier.3 percent in our initial application of the BlackScholes model.563 crore. Because the exercise cost of Rs.671 = 0.50 1.4 –1. and its current value is the present value of its cash flows.3: Estimating the Input for Stock Price in the Growth Option Analysis of the Investment Timing Option (Rs.2 2005 0. in crore) Probability Probability x NPV 0.4 2.077 High 0.079 –3.129 + Rs.4 3.2 0.668 1. The time until the growth option expires is two years.434 crore value for the growth option.25 –0.2: Decision Tree Analysis of the Growth Option Future Cash Flows 2006 2007 3. the underlying asset is the secondgeneration project.4 High 0.0.059 0.470 Standard deviation = 2. USING THE BLACK-SCHOLES MODEL FOR A CALL OPTION Table 5.308 0.0 crore to implement the project.4 3. Table 5.2.3. We use an initial estimate of 15. As this analysis shows.454 (Rs.0.462 Coefficient of variation = 0. in crore) Future Cash NPV of this Probability Probability x Flows Scenario NPV 2003 2004 2005 2006 2007 3.50 2. The rate on 91-day Treasury bill is 6 percent.0 0 2.25 0. which is much higher than the NPV of only the first-generation project.3 show that this is Rs. the growth option adds considerable value to the original project.00 Expected value of NPVs = Standard deviation Coefficient of variation Table 5.870 = 1. shown in Table 5. the growth option is presently out of the money.0 2003 2004 3.5 shows a Rs.434 = 0.0 0 NPV of this Scenario 4. For the growth option.157 –2.2.25 67 . It will cost Rs.0 Low 0.0 crore is greater than the current “price” of Rs.237 0.407 crore. Table 5. which is the exercise price.

5: Value of a Call Option Using The Black-Scholes Model = = = = = = = Risk-free interest rate Time until the option expires Cost to implement the project Current value of the project Variance of the project’s rate of return {ln(P/X) + [KRF + (σ2/2)]t}/(– σ t ) d1 – σ t = = = = = = = = = = P[N(d1)] – Xe – KRFt[N(d2)] = 6 percent 2 Rs.2.4 5.329 0. The required manufacturing facility will cost Rs.4 3.060 Expected “price” at the time the option expires = Rs.0 2.50 1.267 0.3 percent 0.6 crore. Web World can accurately predict the manufacturing costs.0 0.4: The Value and Risk of Future Cash Flows at the Time the Option Expires Future Cash PV in 2003 for Probability Probability Flows this Scenario PV 2003 2003 2004 2005 2006 2007 3.599 0.407 Standard deviation = 1.2 2. Table 1 shows a detailed projection of operating cash flows over the four-year life of the project.063 1.34 d1 d2 N(d1) N(d2) V Variance of the project’s expected return = ln(CV2 + 1)/t = 15.096 –0.25 Average 0.870 Coefficient of variation PV2005 = 0.54 0.50 Low 0.534 0.60 =2 Table 5.00 Expected value of PV2005 = 3.2 0.060 2.70 Coefficient of variation (CV) Time (in years) until the option expires (t) Real Option KRF t X P σ 2 = 0.647 Low 0.32 Rs.129 Standard deviation PV2005 = 1.25 0.25 2.2 0.3 percent The Abandonment Option: An Illustration Web World Systems produces a variety of switching devices for computer networks at large corporations. There is a 50 percent chance of moderate demand and average 68 .31.29 Standard deviation of expected “price” at the time the option expires = 18.082 1.253 Table 5.439 Coefficient of variation = 0.00 Expected value of NPVs = 2.4.25 1.407 crore 15.0 3.50 1. It is considering a proposal to develop and produce a wireless network targeted at homes and small businesses.50 2.400 High 0.3.46 0.25 0.25 0.000 crore Rs.Real Options Average 0.2 0.0 0. but the sales price is uncertain.293 0.2. There is a 25 percent probability that demand will be strong and the company can charge a high price.

8 0.2 Based only on this DCF analysis. Approach 2 DCF Analysis with a Qualitative Consideration of the Abandonment Option The DCF analysis ignores the potentially valuable abandonment option. The sum in the last column in Table 5. the company can abandon the project in 2004 and avoid the negative cash flows in subsequent years. 2 (1 + 0.12) (1 + 0. and a 25 percent chance of weak demand and low prices.9 –1. and the cash flows of this scenario are in the middle row.174 crore. It gives Web World the opportunity to sell the project at a fixed price of Rs. one would expect the abandonment option to be valuable because the project is quite risky.1.0. The Model This abandonment option resembles a put option on stock.77 –0. In other words.900 + + = –Rs. this suggests that the option might be valuable. and risk increases the value of an option.750 2005 2006 2. which is relatively long for an option.4 crore in 2004 if the cash flows beyond 2004 are worthless than Rs. Qualitatively. the company will have to cut prices. with the cash flows shown on the top line.0 0.1.4 crore after taxes in 2004 if customer acceptance is low.12) (1 + 0.8 0. in crore) Demand High Average Low Expected operating cash flow = 0.750 0.9 –0.174 crore. The option has one year until it expires.3 2.025 2007 3. There is a 25 percent chance that customers will accept a high price for the product. NPV = –Rs.4 crore.2.3 1.0 –1. Table 5.0. Approach 3 Decision Tree Analysis of the Abandonment Option Table 5.600 0.12)3 Probability 25% 50% 25% 2004 1.0. if customers are reluctant to buy this product. However.600 Approach 1 DCF Analysis Ignoring the Abandonment Option Using the expected cash flows from Table 1 and ignoring the abandonment option.Strategic Financial Management prices. Expected Operating Cash Flows for Project at Web World Table 5.8 0. which is the same as the traditional DCF analysis as calculated in Approach 1 above. the traditional NPV is –Rs. it will let the put option expire and keep the project. resulting in the negative cash flows on the bottom row.2 shows the expected NPV of –Rs.4 crore. The cost of capital for this project is 12 percent. If the cash flows beyond 2004 are worth more than Rs. There is a 50 percent chance that it can charge a moderately high price.1.6: Operating Cash Flow (Rs.1. Again.900 1.8 0.174.6 + 0. Web World can sell the equipment used in the manufacturing process for Rs. In particular. if the company has the –Rs.6 shows a scenario analysis for this project. Web World should reject the project.5 shows a decision tree analysis in which the company undertakes project in the low-price scenario.0.8 crore 69 .

All operating cash flows.3 2006 2007 2. which means that 12 percent may not probably be any longer the appropriate cost of capital.031 0. it will abandon the project and sell the equipment for Rs. in crore) Future Cash Flows 2003 High –Rs. In addition.233 –0.0 –1.8 0.1.0 (Rs.0 0. Note that the company will not abandon the project in the average-demand scenario.1 0.498 1. The salvage value is known with a high degree of certainty. indicating that the abandonment option is quite valuable. the company will abandon the project only in the low-demand scenario.031 2004 1.8 –0. in crore) NPV for this Probability Probability Scenario x NPV 4. the expected NPV is 0.061 –1.25 1.506 0.Real Options operating cash flow in 2004 and the prospect of even bigger losses in subsequent years.7 0.6: Scenario Analysis of the Project (Ignoring the Option to Abandon) (Rs.00 Expected value of NPVs Standard deviation Coefficient of variation Table 5. which do not include the salvage value in the lowdemand scenario of 2004.3 1. and they are positive in the average-demand scenario.00 Expected value of NPVs = 0.3 0.50 1.6 2005 2006 2.061 0.7 0.377 0.25 –0.8 2005 2. even though it has a negative expected NPV as seen above.7: Scenario Analysis of the Project (Ignoring the Option to Abandon) Future Cash Flows 2003 2004 1. This is because the original investment of Rs. As shown in Table 5.031 = = = 0.6 crore is a sunk cost.0 –0.50 0. Therefore.25 –0.50 0.994 0.704 Standard deviation = 2.174 3.50 –0.9 –1. Table 5.25 0. Only the future cash flows are relevant to the abandonment decision.8 0.14 crore salvage value is relatively certain.0 1.3.0 0.6 High Average Low 0. are discounted at the WACC of 12 percent.704 crore. so it is discounted at the risk-free rate of 6 percent.25 0.25 0. but there is a slight chance that it might be either higher or lower.4 crore.9 1. the option to abandon is so valuable that it should accept the project. The option itself alters the risk of the project. the estimated Rs.8 0.26 Average Low 0.8 3.2.25 1.931 –0.8 3.117 –1.565 70 . In fact.692 –2.0 2007 3.2.3 4.233 NPV for Probability Probability this x NPV Scenario –Rs.2 –5.

174 crore.3 2.50 –0.1.481 0.25 1. which begins in 2005.2. Figure H shows Project A. but has the networking project’s operating cash flows in the subsequent years.00 Expected value of PVs = –2. the year after Project A ends.829 1. VCall.064 crore (shown in the last column in Table 5.25 –Rs.25 –0.25 –0.25 0.2.6 crore.890 crore. But in addition to owning Projects A and B.314 0.40) Table 5. Note that combining Projects A and B gives the same cash flows as Web World’s networking project. which is a one-year project that includes the initial cost and firstyear operating cash flows of Web World’s project. But the company also has an option to abandon Project B. the company’s abandonment option is similar to a put option on a stock. it also has the right to “sell” Project B for Rs.8: DCF Analysis of Project “A” that Lasts One Year (Rs. As we have noted earlier.975 0.4 crore.6 Average 0. In other words.890 = –Rs.50 0. Project B has no cash flows in 2003 or 2004. VPut: VPut = VCall – P + Xe-kRFt where the symbols have usual meanings. in Project “A” is already in Place (Rs.9 shows Project B. Project A has an NPV of –Rs.8 3. we must break the original project into two separate projects plus an option to abandon the second project.1.8 –0.7 –1.826 Coefficient of variation = (0. We can use the Black-Scholes model for the value of a call option.25 (5.1.Strategic Financial Management Coefficient of variation Approach 4 Valuing the Abandonment Option with a Financial Option = 0.1. Table 5.248 High 0.2.8) and Project B has an NPV of Rs.1) High 71 .9: DCF Analysis of Project “B” that starts in 2005.8 3.3 5.4 crore.364 The fourth procedure for a real option valuation is to use a standard model for an existing financial option. the same NPV shown for Web World’s networking project. in order to determine the value of a put option. Before we can apply the put formula to determine the value of Web World’s project with an embedded abandonment option. in crore) Future Cash Flows 200 2004 2005 2006 2007 NPV for Probability Probability 3 this x NPV Scenario 2.924 0.0. which gives it the right to sell Project B for Rs.064 + Rs. Table 5.2.993 0. in crore) Future Cash Flow 2003 2004 NPV of this Probability Probability Scenario x NPV 1. The combination of the two projects has an NPV of –Rs. it can invest in Project A by paying the initial cost of Rs.988 Low 0. which also gives it the ownership of Project B.064 Standard Deviation = 0.

11: Find the Value and Risk of Future Cash Flows at the Time the Option Expires (Rs.50 Low 0.195 = 119.152 We can use the standard Black-Scholes equation to determine the value of Web World’s abandonment option.528 crore.354 crore.Real Options Average 0.174 = 0.890 crore.10 shows an extremely high coefficient of variation. As in the previous examples.0.914 0. Table 5. Table 5.14 option expires Coefficient of variation (CV) = 1. Table 5. As the last column in Table 5. Using the BlackScholes model for a put option.548 1.1.4 crore. since we have the option to abandon it.144 0. Project B’s “current price” is the present value of its future cash flows.00 Expected value of PVs = 1.0 1. Web World can sell the equipment for Rs. time until the option expires.2 Average 0. The rate on a 91-day Treasury bill is 6 percent. Web World decided to undertake the project. one can use the indirect method (refer to table 2) to convert the coefficient of variation at the time the option expires into an estimate of the variance of the project’s rate of return: Table 5.21.890 Standard deviation = 2.957 –2.25 1. The time until the growth option expires is one year. 0.3 2.t = 119.518 Time (in years) until the option expires (t) = 1 Variance of the project’s expected return = ln (CV2 + 1)/.50 0.9 0.10: Indirect Method: Use the Scenarios to Indirectly Estimate the Variance of the Project’s Return Expected “price” at the time the option expires = Rs.869 Coefficient of variation = 0.9 1.5 % 1 Figure K shows the calculation of the abandonment option’s value. The underlying asset in this application of the option-pricing model is Project B.8 0.32.9 –1. which is the exercise price.072 72 .8 0. Note that we need the same five factors to price a put option using the Black-Scholes model as we do to price a call option: risk-free rate.0 –1.5 % ln (1. reflecting the enormous range of potential outcomes. Given the improvement in NPV caused by the abandonment option.50 1.528 – 0.518. exercise price.1. The total NPV of the project is the sum of the original project’s NPV (which is also equal to the sum of NPVs of Projects A and B) and the value of the option to abandon: Total NPV –0.8 3. and variance of the underlying asset’s rate of return.2 1.25 –0. this is Rs. in crore) Future Cash Flow 2004 200 200 2007 PV in Probability Probability 5 6 2004 for x PV2004 this Scenario 2. current price of the underlying asset.50 0.17 Standard deviation of expected “price” at the time the = Rs.9 shows.3 6.0 2.659 High 0.635 0.10 shows the estimates for the variance of Project B’s rate of return using the method previously described in the analysis of the option to delay.25 0.192 0. and this provides a good estimate of the risk-free rate.5182 + 1) = 1. the resulting value is Rs.

The decision regarding the exploration of oil is made by valuing the tract under each initial exploration strategy.890 + 1. for the project to successfully lead to oil production.890 175 0.0 –1.518 Table 5.318 0. Several earlier attempts to carry out similar projects were futile because the estimated development costs were supposed to exceed the production profit or because the oil price fell too low so as to justify more expenditures.614 1.25 0.117 Standard deviation of PV2002 = 3.9 –1.527 = = = = = = = 6 percent 1 1.Strategic Financial Management Low 0.934 –0.099 – 1. There is huge involvement of money in the project.455 kRFt t X P σ2 d1 d2 N(d1) N(d2) V of Call V of Put V of Put V of Put = = = = = = = = = = = = = Risk-free interest rate Time until the option expires Salvage value if abandoned Current value of the Project B Variance of Project B’s rate of return {ln(P/X) – [kRF + ( σ 2 /2)]t}/( σ t ) d1 – σ t 0. that will amount to crores. – – – 73 Oil Prices Reserve Size Chance Of Success (COS) . and the drilling would add information about the amount of oil reserves and could resolve whether the oil could be produced. The strategy that is able to deliver the highest valued tract is chosen. as well as the other contingent follow on strategies. Should Reliance begin the exploration? Which exploration investment strategy should they use? Following are the risk elements that Reliance was aware of – – – Six to fifteen years time is required to get an unexplored tract into production. There lies a very small chance.82 0. in crore) –0.00 Expected value of PV2002 = –2.214 Coefficient of variation of PV2002 = 0. The tract value is dependent on three sources of uncertainty.25 –0.39 = 1.12: Value of a Put Option Using the Black-Scholes Model Real Option (Rs. The Government of India were to provide additional information about the amount of oil in the ground.099 Applications of Real Options Exploring for Oil Reliance Petrochemicals has leased a large tract of land somewhere in the Southern India and was evaluating alternate exploration strategies.400 1.2 –2. say about 10 percent.35 P[N(d1)] – Xe – kRFt[N(d2)] Cal – P + Xe (–kRFt) 1.

when the development costs are high. thereby reducing the value of the exploration option. The upper right of the grid suggests an optimal strategy to wait to develop as the estimated reserve size is high but the price of oil is a bit too low to justify the development. At the end of the lease. – – – Future decision involving exploration Current value of oil prices Uncertainty type. keeping the other inputs constant. The real option approach of valuing the project shows that the value of resolving uncertainty depends on the following factors. differs by the type of investments.1 actually reflects a very interesting feature of the oil industry. The optimal strategy will be immediate implementation in case the payoff resulting from producing oil is so high that the managers are willing to risk abandoning the tract after a sizeable development expenditure. an increase in the oil price brings tracts out of delay mode and into exploration. This ratio is always less than one. This is because the oil prices and the estimate of reserve size is low. The following figure shows the optimal first stage exploration investment strategy as a function of the current estimate of reserve size and of current oil prices. the value of resolving the company’s uncertainty is high and the seismic investments are not very valuable as they are unable to supply the important piece of information. Figure 5. The market priced risk is easily tracked and the private risks are uncorrelated with any traded asset. and its value decreases with the stage of investment. thus creating demand for oil services.Real Options The current spot price of the oil is observed daily and the volatility of the oil prices is estimated as the volatility that is implied by the option contract on the oil. The use of the real option aligns the value of the information with financial market valuation. Say for example. The figure 5. The Findings The first finding of the problem is the value of the tract that is under each first stage strategy. This in turn enhances the cost of further exploration development. When the optional strategy is to delay the project. the tract is either developed or abandoned. The featuring ratios for the companies with drilling equals zero. This ratio can be defined as the (Standard deviation after the exploration)/(Standard deviation before the exploration investment). The final deals with the value of the information that is proportionate to the extent of how much the oil company would be willing to pay to further resolve reserve size or company’s uncertainty. The initial level and the standard deviation of the companies are based on historical experiences in the region and also the experience with specific geological features.1: Strategy Space for Oil Exploration Investment High Seismic Drill Seismic Drill W ait to explore W ait to develop Strategy space for oil exploration i nvestment Current oil price Low High Estimate Reserve Low Size 74 . the same analysis is repeated after one year’s time with the changed oil prices and a shorter time to the expiration of the lease. The figure reveals two types of waiting – the lower left of the grid power of the optimal strategy calls for the condition of wait to explore. because drilling fully resolves the companies uncertainty.

2 ( a ) ( b ) R e a l o p t i o n v a l u e p e r d r u g ( c ) N u m b e r L u n o e c f v e l i n i t y e r t a V m o l a t i l i t y o f a r k e t p r i c e r i s k E N a r l y u m in L a t e E a b e r o f s u r v i v in N g d e v e lo p m e n t E u d mr u b g e s r o f s u r v i v i n g U i n d e v e l o p m e n t r l y L a t e a n d r l y c e r u g r t a s L i n i t y a t e a b o u t d r u g v a l u e 75 . The real option based approach to drug development relies more on the evaluation of the consequences of private risk. While valuing a drug development project with the help of real options. and the initial marketing efforts resolve the uncertainties about the size of the drugs market. Market priced risk is relatively more important in case of oil exploration strategies and transacted values of reserves. These characteristics make it a very good case for the real option approach in investment decision making. Each of the options contain the opportunity to make a similar decision in future periods and later garner possible profits in the life cycle of the project. The application of the real option associates the following sources of uncertainties.2 (a) shows that as the managers opt for using the option to abandon the project. the reward that the firm gets by continuing the next option. the number of drugs that are in the development stage falls by phase of investments. how the level of uncertainty about surviving drug projects decreases by phases until a time comes when all the private risk is eliminated and the uncertainty of the project is equal to the volatility of the market priced risk.2 (c) shows. Figure 5. In case of drug development the private risk is relatively important. The level of uncertainty is relatively small as compared to the private risk uncertainty. – – What are the roles that private and market priced risks play in the development of decisions and valuations? What are the possible implications of the large amount of the private risk? The drug development process and the marketing process can be modeled as a sequence of fearing investment and abandonment options. The development of a drug can be viewed as a learning investment in which the R&D investment reduces the uncertainty regarding the remaining costs to complete the development of the drug.Strategic Financial Management APPLICATIONS OF THE REAL OPTIONS IN THE DRUG INDUSTRY The process of developing and marketing a drug is a very costly as well as a lengthy process. the firm divides on whether to make expenditures at a predetermined amount for further development and marketing or to abandon the development process. During the first year of drug development there is the birth of the market priced risk. Figure (b) reveals that the value of a surviving drug increases as it paves the regulatory hurdles along with uncertainty about the remaining costs and size of the market is resolved. The Findings The following figure 5. In each of the periods. Figure 5. – – – – Remaining life cycle costs of drug The size of the market for the drug that completes development Industry wide evidence of value Probability of passing regulatory tests. certain questions need to be answered.

if one considers all the options during the drug’s life cycle it reveals that the correct valuation might be much higher. 76 .Real Options Though the use of a discounted cash flow analysis might show that developing a drug is a zero NPCE investment. Using the real option approach. to manage a portfolio of drugs results in more drugs in the development process to more drugs to be abandoned.

one may notice that the calculated option values are exploding towards plus or minus infinity. or what could be the smallest possible estimate one could use for volatility? d. 77 . a. influence the decision if they were linked by some economic mechanism. The other assumption the option theory makes is that the risks of an option can be hedged away. The results of option valuation are sometimes in conflict with common sense approach. If hedging is feasible the option will be priced as if it had been hedged. Using the wrong real option model It is easy to wrongly assume that the actual decisions pertaining to the project is “Like” a given real option model while in reality it is “Unlike” so. should it change the decisions to a large extent if the interest rates were truly variable. Let us now try to discuss each of the drawbacks in brief. it is important to make as many logical checks as possible to ensure that these results are commensurate with the economic rationality. c. These pitfalls can broadly be categorized under the following: – Using the real option analysis when one should not use them – Framing a wrong model for the purpose of valuation – Using incorrect data and biased judgments in the model – Miscalculation in the process of valuation. Coupled with this. Such assumptions are in fact violated if there exists a small number of leading competitors. Getting both the models of the data right. Nevertheless. the value of the call option is increased in the time to expiry and the volatility of the underlying asset is increased. b. in which case the risk is risk-free. but making mistakes in the solution It may sometimes happen. While calculating the option value. or are oscillating between the two. If one bases his assumption that the prices of oil and gas are independent of each other. if one has assumed that the interest rates are fixed. One basic assumption of real option is that the relevant uncertainities are random walks and as a result are unforeseeable. try to understand how the errors in the variables could result in based results. Thus picking up a wrong model can be disastrous. one can easily miss an important variable. Using real option analysis when one should not Real option analysis takes into account a number of assumptions.Strategic Financial Management Drawbacks of using Real Option Analysis Though the use of real options had brought in considerable advantages in creating a project. that while using the complete mathematical algorithm. in any way. how can it. Miscalculation in the data inputs It is important to understand the drivers of the option value in any specific real option model. If it is given that hedging is indeed possible it does not matter whether any one option is actually hedged or not. Say for example. still there exists some pitfalls in their usage. it also states that the consumer is the price taker. Each player’s action can influence the price of all the players who will take decisions with full knowledge of what the possible counter moves will be for every other player. Say for example. and decision taken by the consumer can change the future course of the random walk. As far as this is concerned it is important to note that one has overestimated the length of the available time. In this case the decisions may not be random. One needs to check the model for sensitivity to the associated variables.

• – – – – Investment timing option – that allows the firm to delay the project. Growth option – that enable a firm to manage its capacity in response to changing market conditions. ignoring the real option. • a. • There are five possible procedures for valuing real options. DCF analysis and qualitative assessment of the real option value Decision tree analysis Analysis with a standard model for an existing financial option. d. Abandonment option. Many projects include a variety of ‘embedded options’ that can dramatically influence its NPV. Such projects are also called as real options as they deal with real rather than financial assets. Financial engineering technique. and Flexibility options – which give flexibility to a firm over its operations. Using it where it is not applicable Framing a wrong model for valuation Using incorrect data and biased judgment. b. DCF only. b. These can be – a. The various drawbacks of real option analysis includes 78 . c. e. c.Real Options SUMMARY • Opportunities to respond to changing circumstances are called managerial option as they give managers a chance to influence the outcome of the project. and Miscalculation. d.

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