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Topic: - What are the four main types of real options? Explain the
implications of real options in case of analyzing the project.
Submitted to: - Prof. Paresh Shah
Prepared By: - Siddharth Kothari PGP/SS/08-10/B
IIPM, Ahmedabad Page 1
What are Real Options? Real options are methods which quantify the value of management flexibility in the uncertainty prevailing world. These options are said to be the strategic options. They adapt to the decisions wherein they have to response to uncertainty or unexpected market developments. Conceptually saying, Real Options allows the management to determine and communicate the strategic value of the project wherein investments have been made. Traditional Methods like NPV etc. sometimes fails to determine the economic value on investments in such an environment where there is huge uncertainty and rapid change, and that is where Real Options are useful. Identifying, managing and exercising Real Options can also be used for creating the shareholders value which is compounded by their investment portfolio. The real options method represents the new state-of-the-art technique for the valuation and management of strategic investments. The real option method enables corporate decision-makers to leverage uncertainty and limit downside risk. A firm has always one or more options to take strategic decisions during lifespan of a project. For example, a natural resource firm can take decision to not extract the gold from the mine if the price of the gold falls below the cost of extraction and vice versa. These strategic options, which are known as real options, are typically ignored in standard discounted cash flow (DCF) analysis where a single expected present value is computed. These real options, however, can significantly increase the value of a project by eliminating unfavorable outcomes
Types of Real Options There are basically four types of Real Options:1) Abandonment or Shutdown Options
2) Investment Timing Options 3) Growth Options 4) Flexibility Options
1) Abandonment or Shutdown Options In traditional business format, a project is said to run throughout its lifetime but a firm may have option of ceasing the project anytime during its life. This is called abandonment or shutdown options. This option means the right to sell the cash flows over the remainder of the projects life for some value. When the present value of the remaining cash flows falls below the liquidation value, the asset may be sold. Abandonment is effectively the exercising of a put option. These options are particularly important for large capital intensive projects such as nuclear plants, airlines, and railroads. They are also important for projects involving new products where their acceptance in the market is uncertain. Example: Suppose your resource management company has a two-year lease over a small copper deposit and is deciding whether or not to mine the deposit. At the end of the lease, all rights to the property revert to the government. It is known that the deposit contains eight million pounds of copper. Mining would involve a one-year development phase that would cost $1.25 million immediately. The company would then pay all extraction costs to a subcontractor, in advance, at a rate of 85 cents per pound. This amounts to a cash payment of $6.8 million one year from now. Your company would then sell the rights to the copper recovered (8 million pounds) to a third party at the spot price of copper
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one year from now. Copper prices follow a process such that percentage price changes are normally distributed with mean 7% and standard deviation 20%, and the current price is 95 cents per pound. What is the expected NPV of mining if the required return for copper mining projects is 10% and the riskless rate of interest is 5%? Answering the above question may tell whether we have an option to abandoned or shut down the project 2) Investment Timing Options When there is more uncertainty about the future cash flows and this increased uncertainty makes the firm more or less willing to invest in the project today, this is investment timing options. This option talks about the time of the investment of the project whether it right time to invest or not. These are the following questions which one may ask in the option What is the NPV of doing Project X today?
What is the NPV of Project X in 5 year if the market is strong? What is the NPV of Project X in 3 year if the market is weak? What is the expected NPV of Project X if any firm waits 6 and half
months to decide whether to undertake the project? What is the value of this investment timing option? 3) Growth Options The value of the firm can exceed the market value of the projects currently in place because the firm may have the opportunity to undertake positive NPV projects in the future. Standard capital budgeting techniques involve establishing the present value of these
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projects based on anticipated implementation dates. However, this implicitly assumes that the firm is committed to go ahead with the projects. Since management need not make such a commitment, they retain the option to exercise only those projects that appear to be profitable at the time of initiation. The value of these options should be considered in valuing the firm. Growth options are particularly valuable in infrastructure-based or strategic industries. For example, in the hightech and software industries (where there are significant first-mover advantages) valuable growth options can be obtained through R&D expenditure and by creating strategic links with other industry players -- even though these activities may appear to be negative NPV investments when viewed in isolation.
4) Flexibility Options Choice of capital structure can affect value of project. Like operating flexibility, financial flexibility can be measured by the value of the financial options made available to the firm by its choice of capital structure. Interaction between financial and operating options can be strong -- especially for long-term investment projects with a lot of uncertainty. The option valuation framework is particularly useful to the corporate strategist because it provides an integrative analysis of both operating and financial options associated with the combined investment and financing decisions. Example: Precious Metal Mining Four silver production sites, each with different layout and extraction technologies. The price of silver has been very volatile. To value firm based upon forecasts of silver prices (traditional NPV approach) could grossly underestimate the value. Value is enhanced by: (i) (ii) Operational flexibilities Switching options (shut down, reopening, abandonment).
Insight can be gained into the opening-up and shutting-down decision. If the mine is already open, it might be optimal to keep it open even when the marginal revenue from a ton of output falls below the marginal cost of extraction. Intuitively, the fixed cost of closing an operation might be needlessly incurred if the price rose in the future.
The logic is just the opposite for the closing-down decision. Due to the cost of reopening the mine, the optimal decision might be to keep it closed until the commodity price rises substantially above the marginal cost of production
Implication of real options in case of analyzing the project. When we analyze any project, Real options plays an important role in quantifying the real value of the investment done in any project. Real Options are the new techniques used for the accurate valuation and management of investments done strategically. In today’s world where the uncertainty level is very high and there are rapid changes in the economic environment, the traditional formats like NPV etc cannot help to identify the real or accurate value of the investment in project and that is where Real Options are used as to accurately measure or quantify the value of the investment. Suppose if NPV of any investment in the particular project is negative then a firm will cancel the project but it is not the case and if the NPV of investment of same project is Positive then the firm will accept the project because they assume that there will be positive cash flows when NPV is positive, but this is also not the case. This is where the Real Options comes into picture because while calculating the NPV all factors are not considered which may affect the NPV of the project, whereas Real Options measures or considers each and every factor related to the project and then the decision is made which is known as strategic decision and the option is known as Strategic Option. Rationale Implications of Real options Strategic Considerations/Options
In many acquisitions or investments, the parent firm believes that the transaction will give it competitive advantages in the future. These competitive advantages have a higher range and may be as follows:
Entry into another market: Technological Updation Big Brand Image etc.
The above competitive advantages are not taken into consideration while measuring actual value of the project as they can affect the real value of the project. But a Real option takes everything into consideration
Research, Development and Test Market Expenses Some firms spends a lot in R & D and test marketing but they cannot evaluate the actual expenses incurred in R & D or test marketing and even if they evaluate these expenses they assume that they will have profits in future with the experiments but there is possibility that the research or test marketing may turn into scrap because of uncertainty of economy or market. Multi-Stage Projects/ Investments While entering into new venture or new investment, it may happen that investment is done in various stages. By doing this a firm can reduce the downside risk and here come Real Options as a tool to measure the value of project accurately as it will be done in various stages and by doing this we can have a option to go for another stage or not. There may be two possibilities which are:
It may happen that the projects which were not looking worth for full investment can seems to be good looking by investing in various stages.
It may also happen that the projects which seems worth on full investment may seem time wasting after some stages
Financial Flexibility Looking one option as financial flexibility, it generates valuable insights on when financial flexibility will be most valuable. But there are some instances which can be argued and are as under:
⇒ If the business has higher returns or margins like any IT firm, other
things remaining equal, then there will be more financial flexibility as they hold more cash reserves and can easily excess debt tool and if it is vice versa than firm with low margins or returns will have less financial flexibility. And the value is generated according to that.
⇒ Since a firm’s ability to fund these reinvestment needs is determined
by its capacity to generate internal funds, other things remaining equal, financial flexibility should be worth less to firms with large and stable earnings, as a percent of firm value. Firms that have small or negative earnings, and therefore much lower capacity to generate internal funds, will value flexibility more.
⇒ Firms with limited internal funds can still get away with little or no
financial flexibility if they can tap external markets for capital – bank debt, bonds and new equity issues. Other things remaining equal, the greater the capacity (and willingness) of a firm to raise funds from external capital markets, the less should be the value of flexibility. This explains why private or small firms, which have far less access to capital, will value financial flexibility more than larger firms. The existence of corporate bond markets can also make a difference in how much flexibility is valued. In markets where firms cannot issue bonds and have to depend entirely upon banks for financing, there is less access to capital and a greater need to maintain financial flexibility. Conclusion
Option pricing theory has wide applicability in corporate finance. Real options can find out or measure the real value of any investment in the project. Certain factors which comes out after the real option implication proves to be very important and crucial and needs an eagle eye to value any investment. I came to know that Identifying, managing and exercising Real Options can also be used for creating the shareholders value which is compounded by their investment portfolio. The real options method represents the new stateof-the-art technique for the valuation and management of strategic investments. The real option method enables corporate decision-makers to leverage uncertainty and limit downside risk. A firm has always one or more options to take strategic decisions during lifespan of a project.