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of1i!en!! -
Real Option Analysls- Entry-An Appfication
is evaluating ' '
possibi,,. ^
chinese
]]!ent
market. the#;HlL The resultr l*
ry,?1,,.
CEo CharlesDarym,
n",
::"ffffi::.T; value analysiswere .:0"-::{yorare finance team,s expected
""".ilioed from
preliminarystudiesq.oo'ouiirJ"i)osl4performed
a numberof _not,iror"o"., Lcouraging. As illus_
trated in Exhibir r,.trr".exfl;;;;;..
by a ture were estimaredro profits of the ven_
;:i'lj'#[T,;llry;m,.ei"r arsrhismarketcourd be ilfi;';ilion.
majol pruy**--*Jio-'iJ'
T. Triden
t's r
"t""oitl;h:-,'T.' ,iilfi"H#T,:Tj:
rrt ffi Revenu* *:::_,:xpected
ro follow one of two
tr1il:;;
,r,"
t'#li,fJ;,lffiIJ,T:#:l
paths_eirher trr.gl,("ppiliirn,u."r,
s\%probabitityj;iJ,i $130million ar a

il;il:Tj.ffJl;; '
l"lllit]:-T"':1*:,
revenues
a ;,i,, ataSr%oprob_
"""g-";i;;tedvarue,anirysis,
were estimated-ut srrsrror./
. :
:
$^qo
rnlrioi.--

Eeve.q!!ts- ,_Iqlg9_h$'lti_olg
High
$130 *e$-gs!p!J"?$-e-(ir_r!!lrqnrt
0.50
Low $os.oo
50 0.50
Expectedvalue 25.00
Costs $90.00
High
$teo 0.33
Medium $40.00
80 0.33
Low 26.67
40 0,33
Expectedvalue 13.33

Expectedproject gross profit = f€VsfiueS_

$8o,oo
costs = $g0 _ $go = 616.

ffi Costs were expectedto

be either high ($120mil_ As shownin Exhibit 2,after the investment
lion), medium($g0 million), or low ($a0 (or expen_
million), all diture) of the $15minion in market
with an equal 33.3%expectedprobability researchand deverop-
of occur_ ment, the firm would know
rence.The expectedvalue of costswas gg0 which of the three cost paths
million. it would be on-high, medium,or low.
What made this gL0 million gross profit Regardles,of th"
all the more expectedrevenue,still assumedto be
unattractive was that the markeideveLpment $qO_-illiorr, the firm
group was could make an intelligentchoiceto
requestingan additional $15 million either stop orproceed
for-upfroni res"arch at that point. This was,in Charles,
and development(R&D). This capital opinion, a much more
expensecould not logical way to pursue the analvsis.
be justified. The expected total
return on the project Maria Gonzalezand her finance team,
would then be a negative miltion: however, were
$5 ($15) + $10 = fb. still not convinced.Maria said, "But
The corporate finance team concluded we would st'l be
that the prolect spendingthe 915 milrion up front and
wasnot an acceptableinvestment " st'l be looking at
in its presentform. the same expected outcomes.I
Charles was clearly frustrated don,t ,"" ho* you,
with the corporate approachchangesanytJring.,,
financeteam during the presentation
of their results.After Charlescontinued,,,Itchangesa lot. After
someheated debateover individual spendingthe
valueg charles asked $15million we would know_iith addedcertainty_whar
what specificallywould be learned
if the added$15million the likely outcomewould be-If it is
in market researchand development either the medium- or
were actually spent. low-cost path, we would proceed and
Would it improve the expectedprofitability end up with a gross
of the iroject? operatingprofit of either $1,0or
After some additional analysis,the $50million,ieperrdirig on
corporate'finance revenue* If it is the high-costpath,
team concludedthat nothing signiticant wewould stip at Jort
would be rearned immediately,before incurrinj additional
about the market which woulJchange op"ruiirrg costs.
either the proba_ The expectedvarue,at least according
blt-li:r or expectedvaluesof ,"uerru"s. to my calculations,
However, after the is a positive$20million":
additional R&D expenditure,the
team felt certain that
the cost of operationswould be ExpectedValue = ($15)_
better known. [(0.333x $0)
Charles then asked the corporate + (0.333x $10) + (0.333x gsO)l=
finance team about $2o
an alternative approachto viewing
the project
"Wlat if theexpenditureof It then dawned upon Maria what
$tS million werelooked upon Charles was saying.
as the purchase of a call option The purchaseof the call option, the expenditure
on the project? Wiat I of the g15
million, would allow Tiident to avoid
ts,if we spendthe $15 million, we would the loss_making
Tean then have option (the high-costpath with an expected
the ability to identifu the actuar'cost outcome of
associatedwith negative $30 million), so the high-cost path wourd enter
undertaking the project. Even though
we still would,not the calculationof expectedvalue as
really know the revenues_westill zero.The purchaseof
have businessrisk_ the call option would indeed alrow
we would be able to decid,emore intelligently Thident to undertake
whetherto the investment,if it wished,only after
stop or proceedwith theproject at gaining additionar
thatpoint in time.,, time and knowledge.
 'ldent'fied 'Estimat0d,Gross
lf thefirminvestsan Development
Gost , Operating
Frotit
additional$15 million ' : . .
in marketresearch and
,development, it willbe Decide
toStop:
ableto identifymarket $go-$tzo:($30)
development cost.

...,.'......
Decide
toProceed:
'
$90-$80= $10
j '
. . . ,
',",
t
,,,1,
'
Decide'to
Proeeed:
599'-${S= $50

linre

Investing
inthemarket
R&Disequivalent
tobuying
acalloption.
Amounts
areinmillions,

Ciarlds and-the senior,managementteam then,con_ characteristicsthey like. Its structure acknowledeesthe

cluded that they had won the argument (as senior man_
,agernentalwayS,does)and -apqove_d the plpject.i . ,',,
,
- :
ThePotentialof Real0ptionAnalysis
Real options analysiq like DCF and other investment
analysistechniques,is nothing other than a tool. The two
techniques are complementary Management should
employ both methods in the analysisof potential invest_
ments and gather information from both.
Unlike our eiample, real option analysisis not ordi-
narily a simple technique.Thereis an enormousamount of
'the
technical "comfort" required on the:part of analystin
order to implement the technique correctlv. Like most
,:"!dgr3 derived from finao.iul th"oryi it is easily
abused.Those who will utilize the informuiio" prsvidei
by real option analysism'st be trained in the oroo", inter-
pretation of its results
But real option analysisis gaining in use and popular-
ity. consistent with the example of rfident, it-is-often
favored first by senior managementbecauseit has two
time sequenceof a project, describing cash infloivs and
outflows at different points in time.This is more consistent
with the way nanagement frequently sees a proiect
untold. Real optionanalysis alsosiems io varue..*u*ue"-
ment" by its very nature; it credits the ability of manate_
ment to gain new information and make good business
decisionsat the points in time when those Jecisionsmust
bemade. : ,
,,
GaseQuestions
1. How doesreal option analysisdiffer from traditional
expectedvalue analysiS?
2. How does real option anarysisuse infonnation gath-
' ering differently from
discountedcashflow:analysis?
3- Recalculateboth the expectedreturn analysisand the
real option analysis fo-r the Chinese market entry
assumingthat the revenue probabilitites werc Z5o/o
high and 75% low. Is the project acceptableunder
either of the decision-makingmethodologies?