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The Quarterly Review of Economics and Wnance, Vol.

38, Special Issue, 1998, pages 675-694
Copyright 8 1998 tistees of the University of Illinois
All rights of reproduction in any form resewed
ISSN 1064-9769

Multi-stage Real Options:
The Cases of Information Technology Infrastructure
and International Bank Expansion

SYLVIA PANAYI
Johns Hopkins University

LENOS TRIGEORGIS
University of Cyprus and
University of Chicago

This paper examines multi-stage real options ap@cations that have strategic import beyond that
captured by standard DCF valuation a#roaches. After reviewing the concept of multi-stage
options in the case of R&D, the paper analyzes two a&al case studies: the info&ion technol-
ogy injkstructure decision by a telecommunications au&&y; and the international expansion
option by a bank. It is shown that options valuation can justify making such strategic investment
decisions even if NPV suggests otherwise.

It is by now well-recognized that real options are able to capture management’s
flexibility to adapt its future strategy in response to unexpected market develop-
ments. Similar to options on financial securities, these “real options” involve dis-
cretionary decisions or rights, with no obligation, to acquire or exchange the
value of one asset for a specified value/price. Valuation of real options, such as
the option to defer, expand, contract, abandon, switch use, or alter a capital
investment or a contingent decision plan, has brought a revolution to modern
corporate resource allocation.
Among the most important real options are those involving multi-stage deci-
sions or compound growth options, that is, options whose exercise brings forth
additional options as well as generating cash flows. Research and development
projects, infrastructure investments, a decision to enter a new market (domestic
or overseas), or the acquisition of another company are examples of investments
that are likely to open the door to future opportunities. Traditional discounted
cash flow (DCF) methods often ignore the value of this embedded flexibility.

675

rather than a right or option). By investing in a strategic project. Management’s flexibility. for example to defer. Myers and Majd (1990) focused on the option of permanently abandoning a project for its salvage value. and Kulatilaka and Trigeor- gis (1994) analyzed options to switch use. Management may then have the flexibility to alter its operating strategy. Pindyck (1988). recommends accepting a project immediately if its NPV is greater than zero. and Smith (1988) examined the option to defer in valuing offshore petroleum leases. It is thus more like a commitment to invest (that is. A value-creating strategy may be directed at invest- ments that include a bundle of sequential. Kester (1984). expand or abandon its operating strategy. Trigeorgis and Mason (1987) and Pindyck (1988) analyzed the option to expand (or contract) plant scale. the future competitive position of a firm is critically determined by today’s creation of future investment opportunities. Kensinger (1987). In the real world. Traditional NPV makes implicit assumptions that management cannot react to deviations from the expected scenario of cash flows. As well-recognized by strategists and financial economists alike. adds value to the NPV of expected cash flows (based on initial management expectations). in order to maximize its upside future potential or limit losses. Finally.676 QUARTERLY REVIEW OF ECONOMICS AND FINANCE The traditional net present value (NPV) approach. contract. which may often yield a low return when considered in isolation. Siegel. however. and Brennan and Schwartz (1985) dealt with the option to shut down and restart operations in natural sesources. Trigeorgis and Mason (1987). while growth options have been exam- ined by Myers (1977). Majd and Pindyck (1987). McDonald and Siegel (1985). A strategic investment may better be seen as a contingent plan of interrelated decisions designed to build a strategic position in new or growing markets. and Chung and Charoenwong (1991). presuming management’s passive commitment to a certain operating strategy. McDonald and Siegel (1986). based on the new information that emerged. Carr (1988). Brealy and Myers (1991). multi-stage projects. Many academics dealt with several kinds of real options applications. for example. the expected scenario of cash flows will likely not be realized when new information arrives and uncertainty in the marketplace gets resolved. A value-creating strategy . a futures contract. calling for an expanded or strategic NPV criterion that reflects both value components: the traditional NPV of expected cash flows and the option value of operating and strategic flexibility: Expanded (Strategic) NPV = Traditional NPV + Value of option flexibility. and Paddock. Kulatilaka (1988). and Trigeorgis (1993a) analyzed sequen- tial or staged investments. the firm essentially acquires a foothold in the market in the form of options to invest in a stream of valuable follow-on investment opportunities. A passive application of NPV fails to consider the value of flexibility that management has when it undertakes a project to adapt and revise its deci- sions in the future as new information comes out.

the earlier of which are prerequisites for the ones to follow. The concept of a multi-stage decision (option) is reviewed first through a conceptual discussion of the R&D case in Section I. when new information arrives and future cash flow uncertainty is gradually resolved. management can decide to proceed with further instalments on the staged capital commitment (if V. but which may also have a high probability of failure. contingent and uncertain cash flows or in a wide range of applications at some future stage. Invest- ing in such projects involves acquiring options for future company growth. If the technology is proven at future time t. V. instead of ignoring the new technology (even in certain cases when it seems to have a neg- ative NPV).. having as the underlying asset the project value (the present value of expected cash inflows from the completed and operating follow-on project). Other important multi-stage decisions include infrastructure investments (such as information technology) that serve as platforms for the development and exercise of future options. AN ILLUSTRATION OF MULTI-STAGE DECISIONS: THECASEOFR&D This section serves to review the concept of multi-stage decision options through the familiar example of R&D. for example. The rest of the paper is organised as follows. I. and international expansion (growth) options examined below. Such multi-stage or compound real options are of a strategic import to those firms that possess them. today’s investment (11) in R&D or in information technology infra- structure creates opportunities that will enable the firm to exercise a specific strategy in the future (at a follow-up cost of 12). for example. with the exercise price being the necessary investment outlay. Many companies invest in the research and development of new products or technologies. leading to the exercise of follow-on discretionary investment opportunities at subsequent stages. and international expansion (growth) by a bank in Section III. The next two sections illustrate the multi-stage option concept through two actual case-study applications: an information-infrastructure invest- ment by a state telecommunications company in Section II. An R & D investment is a case of a com- pound real option. management can decide not to make the follow-on investment (IT) and avoid further losses. > 12). MULTI-STAGE REAL OPTIONS 677 starts with up-front investments in strategic projects in a certain business and extends with cash-generating opportunities in a later stage of the market. Such multi-stage investments can thus be viewed as (compound) call options. But if the technology turns out to be unprofitable. The firm can take advantage of staged capital commitment in the technology investment and pay a small fee (11) to acquire the right to make future commercialization investments. They cannot simply be seen as independent investments but instead should be seen as links in a chain of interrelated projects. In the two-stage case. that may result in remote. The last section concludes. before actual case studies of other similar deci- .

STAGE I: Research First.678 QUARTERLYREVIEWOFECONOMICSANDFINANCE \ I Abmdm NOR&D StageI StageIt srage III Figure 1. but only if things turn out favorably in each stage. If research fails to produce the new product or technology. That is why when management eventually decides to go ahead with an R & D investment. the R&D project can . Research 8c Development of a new technology can be viewed as a series of sequential decisions. Indeed. A. bet- ter-informed decisions can be made after uncertainty gets resolved over time. with research as the first stage. Multi-stage Decisions (Options) Embedded in R & D in Various Stages sions are analysed in the following sections. it often decides to finance it with a staged series of investment instalments. An early investment gives the right to make further instalments and proceed to subsequent stages. This often depends on whether manage- ment finds such an investment of strategic import for the company’s future growth. Naturally. yet research has become an increasingly costly and time-consuming undertaking. management has to decide whether to engage in research for the dis- covery of a new product or technology. followed up with decisions on technical construction and commercial- isation/implementation in subsequent stages (see Figure 1). success in many industries (for example. in high tech) demands a steady flow of new and innovative processes or products.

If these problems are surpassed and technical construction and subsequent commercialisation are seen to be essential for the competitiveness of the firm. The technical feasibility of the technology needs to be ascertained. C. even if the firm may not have discovered a new technology. Of course. STAGE III: Implementation/Commercialisation The final stage is the implementation or commercialisation of the new tech- nology in the market. Management will eventually decide what is best for the firm according to the new information that arrives. Technical knowledge for the construction is not only difficult to find but also costly. Meanwhile. it is prevalent in many (if not most) strategic situations. If the implementation phase fails. Technical construction requires considerable capital as well as human resources to be com- mitted. Success will largely depend on whether the resulting benefits for the firm can be kept proprietary or are diffised to the industry (shared with compe- tition). construction will commence. if technological construction is success- ful management can go on to the next phase of implementation and commer- cialisation. the firm may still abandon the project and potentially sell the technology or its plant and equipment for salvage value. In fact. Besides. At this phase the new product or technology typically faces competition from substitutes and management has to make sure that it has properly anticipated competitive reaction and its impact on profit value before launching the product into the market. The basic structure of multi-stage decision making is not unique to R&D. B. II. new infoOrmation that arrives may prove that such an invest- ment is not profitable enough for the firm to justify its research and construc- tion expenses. INFORMATION TECHNOLOGY INFRASTRUCTURE INVESTMENT This section describes an actual application of multi-stage real options in an information-technology infrastructure investment setting involving the state tele- . If the con- struction phase of the technology fails. Management considers the possibilities that the new prod- uct or technology might be successfully launched in the marketplace. as the following two case applications illustrate. management may decide to start the technical construction resource and development phase. MULTI-STAGEREALOPTIONS 679 stop at this phase. STAGE II: Technical Construction/Development Once the research stage is proven to be a success. management can abandon the project in order to avoid mrther losses. The project in this phase is dominated by technical construction uncertainty. it may still have gained significant knowledge that may be useful in some other areas.

guiding the daily running of the company’s future activities. high-quality (adhering to ITUKET standards) and sufficient telecommunications network to meet at least 98% of expected demand at any given point in time. What was more important was that further net- work expansion wholly depended on the development of the new Information System.’ The development of the new information-technology system involved high initial costs that were not expected to be fully recovered from the cash inflows of the following years. more liberalised and more volatile environment.680 QUARTERLY REVIEW OF ECONOMICS AND FINANCE communications authority of Cyprus.* Nevertheless. CYTA is a state monopoly. A more ambitious IS plan to increase the level of achievement (more business sys- tems earlier) by using more resources and by straining the task dependencies . many of which were achievable only with IS support. but offers one of the best telecommunication services internationally. the information system was considered by management to be critical for the company’s future. the Authority faced the risk of not being able to meet business objectives and targets. The development of its Information Systems (IS) was a parallel investment program which was needed to support the telecommunications development plan. the level of resourcing and the constraints of task dependencies. The Authority in 1992 started a major project for its network expansion and by 1996 it was planning to expand further its telecommunications network. Not having such a system would hamper further expansion. It was developed by considering the risks for the many planning alternatives in terms of the level of achievement. when Cyprus was expected to be part of the European union with its policies and institutions adhering to the new. especially service quality and customer satisfaction.3 The Information Systems (IS) plan was based on a set of medium-term objectives that resulted in a practical yet demanding plan. but rather from its ability to adapt in the future and take advantage of future development opportunities and follow-on projects in an uncertain environment. as the volume and complexity of information grew in proportion to the business expansion. Without automation. The new information- technology system that CYTA was considering in 1992 was intended to gradually replace its old inefficient system and would enable CYTA to better achieve its long-term global objectives. Delaying the implementation of the Information Systems would also have a compounded effect each year. Without the necessary information systems. The telephone network expan- sion aimed at the development of a modern. the inability to obtain accurate and current infor- mation would steadily worsen business performance in terms of achieving objectives. It would allow the company valuable flexibility and adaptability and would Mfil the company’s needs for at least the next decade and beyond. would severely depress the target level of achievement and would result in downgraded service levels. By investing in this information system now the firm would not gain so much from immediate cash inflows. The long-term effect would be greater difficulties in implementing the ever-growing volumes of infor- mation.

00 3500.00 3150.00 Stock Reduction 0.00 Overtime Reduction 17.00 728.00 42.50 52.00 3395.00 4.00 900.00 42.00 980.50 3876.00 1224.00 35.99 630.50 Subtotal 698.00 2716.85 628.00 1380.00 364.00 1015.00 42.00 936.00 3937.00 Productivity Improvement 77.25 1529.00 1680.75 8.50 1653.00 1470.75 35.00 3 staff costs 1365.50 262.50 35.00 2061.25 1048.50 2618.00 1530.00 35.00 945.60 592.00 612.550 455.00 490.00 4445.75 2023.50 350.00 Resource Savings 140.00 COSTS 5 Investment Costs 5075.00 728.35 948.00 4200.00 1440.35 69.50 52.50 2558.50 2110.00 2340.00 35.00 3640.00 546.50 910.00 245.50 4095.50 556.00 10692.00 42.00 546.00 ii Subtotal 6512.50 2201.00 52.00 3780.Table I.00 262.00 42.50 570.50 52.50 Increased Revenue 182.50 2109.00 1032.75 535. Summary of Cash Flows (Costs and Benefits) for the Development of CYTA’s Information Systems (IS) (All in dEThousands) Year 1994 1993 1994 1995 1996 1997 1998 1999 2000 4001 BENEFITS Network Utilization 455.00 -1438.00 35.00 35.80 & ifi L .00 1620.00 1050.00 35.00 900.90 581.00 Improved Finance Management 8.00 455.00 547.00 262.00 42.00 2681.50 606.50 52.00 1438.50 262.00 2940.00 42.00 1080.00 $ Running Costs 72.00 546.20 F NET CASH FLOW -6512.00 700.00 900.00 1740.00 525.65 455.

689: QUARTERLY REVIEW OF ECONOMICS AND FINANCE A. From information System Development + -7000 1 I Y-r B. CYTA’s Expected Cash Flows . From Stage-II Network Expansion -6oaJo’ Year Figure 2.

and Cg = 225000 (thousand). The benefits derived mainly from the better network utilization that would be provided by the new information system. Running costs included costs for the daily running of the computer system and general maintenance costs. MULTI-STAGE REAL OPTIONS 683 would result in a more-than-proportional level of risk. Since the traditional net present value of the Information System development project considered in isolation was negative (- &1703 thousand). C6 = &2023. C.5. c7 = &19200. IS development seemed at first glance to be an unattractive investment in itself. this results in a negative NPV of - &1830 (thousand) when considering this as ‘a stand-alone’ project. Total costs covered investment costs. application packages. involving only a moderate risk premium of 3% above the risk-free rate (r = 7%). we consider the first-stage investment in Information Systems devel- opment as an entry fee for acquiring a right or option to later expand the net- work. Cs = &20400. investment costs mainly included costs for mainframe computers (hardware and software). and development support. workstations. stock and overtime reduction etc. the follow-on network expansion project that depended on the Information Systems development did not seem promising on its own either. subtracting the required out- lay of f66000 and discounting back to time 0. On the other hand. . Ca = 22110. one would add the NPVs of the two phases to arrive at a combined total NPV of . = f14500. and staff costs. Here. we estimated a relatively low cost of capital of k = lo%. Cs = &455. C7 = $2061. a less ambitious plan (involving less risk) would decrease the level of achievement. Table 1 gives a summary of the various expected benefits and costs from IS development and the resulting annual net cash flows over the next 9 years (until the year 2001).5. it would be able to exercise the option (pay the second-stage investment cost for the network expansion of I” = 266000 thousand) and receive the value of cash flows from the expansion project. This initial investment would position CYTA such that. wide area networks @VANS). CFj = &1654. resource savings. Cd = S948. Of course. if future developments turned out favourably. Since CYTA is a state company partly supported by the gov- ernment (and currently protected from competition). V4.5.&3533 (thousand). This expansion plan called for an investment of I4 = -di66000 (thousand) to generate expected cash flows (shown in Figure 2B) of C5 = &8200. Thus. the traditional method does not adequately take into account the embedded option value of the second-stage expansion project. is &63320. local area networks (LANs). pro- ductivity improvement. running costs. using traditional NPV for calculating the value of both project stages would lead to project rejection. and Cg = 22110 (thousand).4 Furthermore. The gross PV of these cash inflows as of year 4. Under the traditional approach. The investment outlays and expected net cash inflows for the development of the Information Systems plan (shown in the last row of Table 1 and in Figure 2A) are as follows: an initial cost 10 = 565 12 (thousand) followed by I1 = 51439 (thousand) were expected to gen- erate cash inflows for the following eight years of C2 = f70.

The gross value of the project as of time zero (the underlying asset) is the present value of the expected future cash inflows: V0 = V. The value of the option for further expansion is large enough in this case to cover the fu-st- stage investment cost (negative NPV).lj4 = &42445 (thousand). 5 Therefore. despite the negative NPV of the initial investment in IS development. in 1991. the expanded net present value of the combined decision is: Expanded NPV = NPV of the Information + Option value of future System development project network expansion = .684 QUARTERLY REVIEW OF ECONOMICS AND FINANCE When valuing the projects using expanded NPV. The total expanded NPV that incorpo- rates the growth opportunity value suggests that. Competitive pressures emphasize the need for expanding business operations away from the home country.15. once management properly considers the value of the expansion opportunity that may spawn in the future from this initial investment. but only if things then seem to be favorable. E = 1. = &66000 (thousand). However. evkt = 563320 e -(‘. the firm would benefit from developing the new information system (with an expanded NPV of +&842 thousand). This growth option can be viewed as a European call option with time to maturity t = 4 years and exercise price the cost of the investment outlay at that time. should therefore position itself to take advantage of this future growth option. Otherwise. we find (using standard option pricing) that the value of the growth option for net- work expansion is f 2545 (thousand).21703 + &2545 = +&842 (thousand). What adds value to this staged investment deci- sion is the option the lirm has to make further investment in year 5. businesses are facing revo- lutionary changes in the market place. Management.S. Estimating the uncertainty surrounding the net- work development to be represented by a standard deviation of o = 0. . realizing the potential value of further network expansion. INTERNATIONAL BANK EXPANSION (GROWTH OPTION) In this section we consider multinational expansion of operations by examining the staged-investment expansion decision of the Bank of Cyprus (BOC) in the U. The mul- tinationalization of a company is thus a significant decision that management needs to consider seriously. In an era of international liberalization. The initial negative-NPV invest- ment in Information System development should not be viewed unfavourably. the decision of CYTA’s management would be reversed. viewing the whole multi-stage situation. CYTA would choose not to proceed with further expansion in the second phase. Multinationalization entails a lot of risks and requires considerable rounds of investment over time that often make such investments at first glance seem unattractive based on traditional NPV.6 II.

The Optimistic Scenario 2 Average Deposits 6400.90 -671.50 1762.98 Other Income 24.57 398.16 563.90 -671.70 18.00 3.41 2 Total Gross Income 233.10 1116.00 90830.25 447.00 809.31 2065.07 Other Income 48.48 ii Operating Expenses (8% Growth) 1284.00 45500.10 1168.00 32000.07 Total Gross Income 166.76 3315.1117.60 708.57 116898.90 -835.51 112.30 -533.70 1639.37 Taxes 0.70 21.00 49400.17 229.00 948.07 428.70 1639.40 2762.91 446.89 2310.00 46.72 2056.00 139.40 Terminal Value 525.97 Net Cash Flow -1117.00 0.14 1094.Table 2.88 376.50 Taxes 0.40 106271.72 128588.40 438.07 2634.98 Income from Operations -1050.30 1481.06 90. The Expected Scenario Average Deposits 4900.16 478.88 3390.68 Income from Operations .06 272.60 2049.00 27900.00 145.13 2589.69 681.56 79680.60 1309.00 341.32 292.60 $ Gross Interest Income 185.50 1379.06 136.31 3878.00 301.77 2044.75 2175.73 194.52 2230.00 59600.60 1747.60 544.24 482.90 -835.11 2397.73 2541.36 96413.74 964.00 60268.00 0.00 0.50 -91.56 1233.50 1728.00 0.61 571.08 676.05 Operating Expenses (8% Growth) 1284.00 1319.08 3081.00 75692.00 0.06 3729.00 16000.80 4693.19 E Net Cash Flow -1050.40 2195.50 -91.20 -313.00 70513.80 332.86 635.00 0.32 1388.50 247.04 1259.23 797.38 566.30 -533.32 87648.80 2795.20 -313.19 140.34 353.60 928.42 1868.50 1379.39 B.13 2980.04 3278.52 2408.66 1912.30 1481.50 192.30 1658.00 38500.31 Terminal Value 1561.94 162.10 464.50 1770.50 1432.35 715.00 567.70 859.23 315.29 219.46 2709.25 412.91 4266.50 240.00 1660.67 2103.01 2220.33 i 3 .97 831. BOC’s Cash-Flow Projections Under the Expected and Optimistic Scenarios from Expanding Operations in the US ($ Thousands) YW 1 2 3 4 5 6 7 8 9 10 A.70 1903.10 -330.60 562.00 19400.10 -330.49 2398.00 1679.96 2601.19 Gross Interest Income 142.04 876.50 80.

-. The Pessimistic Scenario 200 I_-. The Optimistic Scenario 2ooo I--- I . The Expected Scenario ----.-..-.- 1 6 7 6 9 Year 6. ~... 686 QUARTERLY RJXVIEW OF ECONOMICS AND FINANCE A.-. . -.--.. -..II’ aboo -1wQ 5 6 7 6 9 10 11 12 -1500 ’ YNIS C. BOC’s Cash-flow Projections under Various Scenarios ._ i Years Figure 3. ....~ . -.-.-.--.

76 817.11 3283.13 54.98 Note: Stage-II cash flows ~I=Z a multiple of the Optimistic-scenario cash flows at the end of the first-stage investment: Base-case: 2 x (optimistic stage-1 cash flows) Optimistic: 3 x . the United Kingdom. Details of the cash Table 3.70 12 -1342.62 4164. while the second-stage investment option was contemplated for year 10.27 2493. then at a follow-up stage the bank might choose to expand its business activities further. in which of these two countries to expand. if so. Figure 3. and pessimistic) for the first-stage investment decision of BOC in New York. 1994). panels A. the bank may decide not to expand its operations further and just continue to oper- ate (or even close down) the first branch. optimistic. The Bank of Cyprus (BOC) recently began an expansion strategy of its ser- vices abroad.94 1700. MULTI-STAGE REAL OPTIONS 687 as we noted earlier.15 16 1133. Summary of BOC’s Projected Stage-II Cash Flows for the Next Ten Years Year Base-Case (2 x) optimistic (3 x) 11 -2101. B and C. initial expansion may open up opportunities for more profitable subsequent investment opportunities over- seas.41 18 2189. but also in the ownership of options to expand. show management’s profit and loss cash-flow projections under three likely scenarios (expected.g The first-stage investment by the bank was being considered to take place in year 1. The advantage of operating across borders relative to purely domestic operations lies not so much in being international.8 If demand at the first stage of expansion were indeed high. It has already made expansion investments in Greece.97 20 2776.19 15 544. or both.40 -2013.90 17 1662.66 4683. and its directors were now considering two countries for possible further expansion: U.93 Terminal Value 3122. and Canada. and Australia.64 3699. switch operations.S.’ In both countries there seemed to be a ready market demand for bank services to per- sons of Cypriot origin.80 -3152. if demand does not pick up significantly. Kogut and Kulatil- aka.40 -941. either by opening additional branches in other parts of the country or by extending the range of products and services it provided for its current market. At the time the bank had to decide whether and. there may be subsequent investment options tied to the potentially negative-NPV initial investment. Of course. or to coordinate flexibly multinational activities within a multinational network (see.10 14 36. for example.67 19 2466.60 13 -627.

Table 4.’ ’ The other case represents cash flows of a more opti- mistic (3 x) outcome than the base case. summarized in Table 3. NY in 1988. Evaluation of BOG’s Staged Investment in the US ($ Thousands) First-Stage Investment (NPVI) Expected scenario -1121 Optimistic scenario 3759 Pessimistic scenario -3847 Second-Stage Investment Case Base (2 x) Optimistic (3 x) NPVP 1011 2016 Total NW (NPVt + NPV*) -110 895 Expansion option value (a = 40%) 1592 2595 Expanded NPV 471 1474 . panels A and B.S. had it not been for the follow-on investment opportunities. the projections will be as in Table 2A (also shown in Figure 3A). with necessary adaptations and projections made to reflect recent information. If demand for deposits in the US turns out to be as expected. The NPV of the base case for this sec- ond-stage investment is NPV 2 = $1011 (thousand).688 QUARTERLY REVIEW OF ECONOMICS AND FINANCE flow projections under the expected and under the optimistic scenarios are given in Table 2. The base-case expected profit and loss projections most likely to occur when the BOC expands in the U. The profit and loss projections in Table :! and Figure 3 reflect management’s expectations of future cash flows over the next ten years of the expansion phase. By taking the first step of expanding its operations in NY. according to traditional NPV analysis. (Table 2A). = -&112 1 thousand for stage 1. is: Total NPV = NPV. BOC in effect would acquire a foothold in the US market for further expansion. results in NPV. The information is based on market research that BOC conducted in Astoria. discounted at an estimated cost of cap- ital of k = 17%.S.” This negative NPV of the first-stage investment would discourage the management of BOC from making the investment. A higher demand for deposits would give the projections of Table 2B (and Figure 3B) and a lower demand the projections shown in Fig- ure 3C.and second-stage investments. The expected cash flows from further expansion in stage 2 over the subse- quent 10 years. Thus. are based on two expansion scenarios. + NPV2 = -1121 + 1011 = -$llO (thousand). the total NPV of the first. With the experience gained from the first-stage investment within the US market. by year 10 BOC would have the opportunity to follow up with a second-stage investment to open new branches in other parts of the U. The base case (also shown in Figure 4) is based on the assumption that cash flows from expansion will be 2 times (2 x) the cash flows of the optimistic scenario of the first-stage investment.

despite the negative NPV of the first-stage investment’s expected cash flows. MULTI-STAGE REAL OPTIONS 669 The above evaluation is summarized in Table 4. management would again be inclined to reject its multinational expansion project. now is: p2 NPVl + Expansion Option Value = -1121 + 1592 = $471 (thousand). treating investment opportunities as stand-alone investment commitments. They typically require large commitments of funds made in sequential rounds of investment and they involve investments that can be undertaken. once the second-stage opportunity is valued as an option. the more optimistic case (3 x) would result in a significantly higher expansion option value ($2595 thousand) and expanded NPV ($1474 vs. CONCLUSION Real options embedded in capital investment projects allow managers to add value to their firm through active management. As shown in the evaluation summary of Table 4. Traditional valuation approaches often ignore this flexibility value. adds value to this expansion opportunity. In reality. expanded. especially in a multi-stage decision setting. Based on this analysis. What is of particular importance is that these growth options have the potential to create new valuable investment opportunities for the firm in the future. This expanded NPV of $471 (thousand) is greater than the standard NPV of -$l 10 (thousand) since the second-stage investment was actually undervalued by a passive application of NPV. $471 for the base- case expansion. but not if worse. altered or abandoned at various points in time. Management’s flexibility to alter its operating strategy in these ways expands an investment opportunity’s value and necessitates an expanded or strategic NPV criterion. The flexibility of BOC’s management to exercise this option if things turn out as expected (or better). this traditional NPV calculation does not properly capture the option value embedded in the second-stage investment opportunity. compared to -$l 11 under passive NPV). These investments are often part of a larger capital expenditure program over a long time span. . V. many projects can be viewed as a “bundle” of interrelated investment opportunities. options-based anal- ysis may often reverse the traditional NPV-based decision by properly incorpo- rating the value of growth options and active management of the project over time. the earlier of which are prerequisites for others to follow. However. More generally. The combined value of the discounted first-stage cash flows and multi-stage expansion flexibility in this case justifies going ahead with the US project. since revised managerial decisions can improve upside value potential while limiting downside losses. The base-case ex anded NPV.

O. develop further. but if it is successful. the firm involved essentially acquires a foothold on future investment opportunities. University of Cyprus. nurture. the firm can proceed to the next stage to capitalize on future growth opportunities. This was in part due to the fact that the replacement of the old system would be made stage-by-stage.690 QUARTERLY REVIEW OF ECONOMICS AND FINANCE We have analyzed examples of multi-stage or compound real options that involve a staged capital commitment and offer the right to make future follow- on investments. once the new system was implemented. CY 1678 Nicosia. In addition. P. NOTES *Direct all correspondence to: Lenos Trigeorgis. Cyprus. Such multi-stage options are of strate- gic import to the firms that invest to acquire. Such growth option investments may have negative net present values when considered in isolation. and of the strategic window for implementing the change. (2) to upgrade and improve the telecommunication services to meet high standards of quality service. The future cost here is assumed known in the short-term and can be discounted at r = 7%. the staff had to be trained and some time would pass before they were productive enough for the system to operate efftciently and effectively. but can add strategic value to the firm by serving as the first-stage link necessary to generate profitable follow-on investment opportunities in the future. by making a costly first-stage investment. After discussing conceptually the familiar example of R&D as a multi-stage series of decision options. the firm can stop further loses by limiting or abandoning future expansion plans. so that the company could continue its operations during the replacement phase. (5) to achieve a 10% per year return on capital. . The process was cumbersome and would disturb the employees from working effectively. The Authority would lose out on the opportunity to gear-up to the information technology requirements which underpin an advanced telecommunica- tions organisation. 2. (3) to improve the utilisation of human and non-human resources (increasing efficiency by 15%). CYTA’s global objectives include: (1) to develop a modern high-quality and suf- ficient telecommunications network to meet at least 98% of expected demand at any given point in time. 3. we analyzed the actual case of an information-technol- ogy infrastructure investment decision faced by a state telecommunications authority. If the first investment proves to be unprofitable. 1. Box 537. contingent on future market developments. but only under favourable developments. and opti- mally exercise (or abandon) them over time. Department of Public and Business Administration. A further risk in not implementing the information system development plans would be loss of momentum following the strategic study. 4. and (6) to increase subscriber demand. (4) to enhance the public image of CYTA (so that positive responses in opinion surveys should be at least 80%). In both cases. We then examined the option facing a bank to expand its operations into another country as part of multinationalizing its operations.

= 18%). Dixit. New Jersey: Prentice-Hall. Princeton. From what has been found from relevant market research. C. “Optimal Sequential Investment When Capital is not Readily Reversible. (2) Under the base-case (2 x) expansion scenario. Brealey. Baldwin. and 19% for the pessimistic scenario.06 x VO = 0. the bank may decide whether to sell the branch for its salvage value or continue its base operations despite the low demand. 1996. the Canadian Greek-Cypriot community is much bigger than the one in the US. 21 in Principles of Corporate Finance. 12. 1988. OJi =0. 8. This option value can be determined as follows: (1) For the base case.” Financial Manuge- merit. MULTI-STAGE REAL OPTIONS 69 1 5. REFERENCES Agmon. option value = 0. A and R. New York: McGraw-Hill Carr. JOB= 0. Investment Under Uncertainty. 6.” Pp. . and S.07fi] = 0. 8~ = 1. so VdPV(E) = 2682/1671 = 1. P. Myers.265. l). and a 60% chance that it would remain low in subsequent rounds of investment. Ch. 232-245 in Capital Bud- geting Under Uncertainty.594 VO = 0.6. there was a 60% chance that demand for a first-stage expansion among the Cypriot community would be high. The cost of capital was derived from the CAPM using different betas for each scenario (J3* = 0.4 so that o& = 0. S. A. 1982. Ekern. The expansion investment in 10 years would only be made following an opti- mistic first-stage scenario realization.15A=0. and S. If demand is low. Subsequently.10 years. 10.85. Thus. It can be ver- ified (for example. A recent Treasury yield curve was used for the risk-free rates for periods of 1 . 1994. NJ: Princeton University Press. Bjerksund. The decision to invest was insensitive to reasonable variation in project uncer- tainty (for example.594 x 2682 = $1592 (thousand). The market return was the average of the US stock market returns for the last six years (r.” Journal of Finance. edited by R. but not otherwise. Aggarwal. Y. o = 0. P. “Capital Budgeting and the Utilization of Full Information: Perfor- mance Evaluation and the Exercise of Real Options. On the other hand.4 fi = 1.1). that the value of the call option to expand is 0. there was a 40% chance that demand would stay high in stages of subsequent expansion. 11.3. 17% for the expected (base-case) scenario. 10. “The Valuation of Sequential Exchange Opportunities. T. 1990.” Jounzal of Finance. 19(3): 65-81. 1993. = 2682 and PV(costs) = 1671. “Managing Investment Opportunities Under Price Uncertainty: From ‘Last Chance’ to ‘Wait and See’ Strategies. the Greek-Cypriot community in the US is more wealthy than the one living in Canada. V.V0/Ee-“= 42445/[66000 e(-“. 37(3): 763-78 1.06 x 42445 = &2545 (thousand). 43(5): 1235-1252. The discount rate was estimated at about k = 15% for the optimistic scenario. 7. Pindyck. 9.9. from Brealey and Myers (1996) Appendix Table 6 or from Trigeorgis (1996) Table A. The researchers believed that. C.74. despite the fact that other trustworthy banks exist in these countries. as 0 varies from 10% to 30%).

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