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www.elsevierbusinessandmanagement.com/locate/telpol

applying real options

Fotios C. Harmantzis, Venkata Praveen Tanguturi

Stevens Institute of Technology, School of Technology Management, Telecommunications Management,

Castle Point on Hudson, Hoboken, NJ 07030, USA

Abstract

The wireless industry is one of the most capital intensive high-technology industries. This paper applies real options

techniques to estimate investments under uncertainty in two new ventures: (a) deferral of the expansion from 2.5G to 3G

networks; and (b) expansion of a 2.5G network using Wi-Fi as an alternative technology. The cases are examined and

analyzed both qualitatively and quantitatively, using realistic assumptions and parameters. Investment cost, number of

subscribers, pricing of services, and risk are at the core of investment decision processing. In both cases, sensitivity analysis

of the value of the (real) option considering the above key parameters was conducted, to extrapolate useful ﬁndings that

should be taken into consideration by the decision makers in wireless companies.

r 2007 Elsevier Ltd. All rights reserved.

Keywords: Wireless networks; 3G; GSM; UMTS; Wi-Fi; Real options; Investment decisions

1. Introduction

The cellular industry has experienced unprecedented growth in the last 25 years and is still growing. In the

United States, service providers migrated from AMPS (advance mobile phone system) to TDMA (time

division multiple access) and CDMA (code division multiple access), which became the two most popular

technological choices. In the meantime, GSM (global system for mobile communications—the European

variant of second generation (2G) systems, became the most widely adopted mobile system in the world. 2G

networks opened the door for offering new data products (e.g., browsing, email, and interconnection to

private networks) and high-quality voice services.

With gradual improvements to 2G systems, two competing third generation technologies (3G) emerged: the

UMTS (universal mobile telephone system) (3GPP, UMTS Forum, UMTS World) and the CDMA2000

(Code Division Multiple Access 2000) (3GPP2, CDG, Qualcomm). As 3G mobile systems, they both promised

to offer improved voice and broadband access to users. The challenge of providing broadband Internet

services and extending coverage areas, while improving quality of service, remains a challenge for operators

even today.

Corresponding author. Tel.: +1 201 216 8279; fax: +1 201 216 5385.

E-mail addresses: fharmant@stevens.edu (F.C. Harmantzis), vtangutu@stevens.edu (V.P. Tanguturi).

0308-5961/$ - see front matter r 2007 Elsevier Ltd. All rights reserved.

doi:10.1016/j.telpol.2006.02.005

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108 F.C. Harmantzis, V.P. Tanguturi / Telecommunications Policy 31 (2007) 107–123

Increasing demand for high-speed wireless data services, subscribers’ demand for integrated solutions (voice

and data) and higher mobility, coupled with the operators’ need to improve on average revenue per user

(ARPU) and provide high-quality wireless services, caused operators to migrate to 3G systems. These systems

required additional spectra, resulting in severe competition among service providers. Spectrum auctions for

3G networks started to take place at the end of 2000. In Europe, the ﬁrst spectrum auctions took place in the

United Kingdom (Klemperer, 2002a). Various applications of policy attempted to maximize economic rents

from bidders (network operators) and governments across Europe raised revenues ranging from 20 to 650

Euros per capita in Switzerland and the United Kingdom, respectively (Klemperer, 2002a). This prohibited

operators from rolling out networks as scheduled. Despite the hype surrounding 3G, operators have not been

able to develop a business model that will attract subscribers and garner high revenues. This is evident from

the fact that, at the end of the third quarter of 2005, there were only 37.9 million UMTS subscribers in the

world (GSM World).

Operators are faced with challenges regarding the cost of deploying new infrastructure. How and when

should new applications that will enhance the market be released? Several studies (Klemperer, 2002b; Mansell,

Samarajiva, & Mahan, 2002; Ure, 2002) provide enough pointers about what went wrong in European 3G

auctions. Bidders knew about the risks involved in bidding for 3G licenses. It was also pointed out that the

telecom managers overestimated (hence, overbid) the value of the 3G license (Klemperer, 2002b; Mansell

et al., 2002; Ure, 2002). Furthermore, it was shown that the complexity of rules, opacity of information, lack

of trust and understanding among strong bidders and concerns about stock market perceptions were some of

the key contributors to the outcome of the European 3G auctions.

In the wireless industry, a high percentage of the invested capital goes to network infrastructure. Operators

must evolve their infrastructure in a cost effective manner, while meeting forecasted demand due to subscriber

growth.

In order for operators to gain markets, they need to exercise ﬂexibility in investment decision making, while

taking into consideration uncertainty, which is inherent in high-tech industries and modern capital-market

economies. For example, an operator can choose a small scale deployment test to initially gauge the market

perception and then either opt for large scale deployments (as encouraging information arrives from economy/

markets), or abandon the project (if the investment turns out to be bad).

This paper applies real options methodology to the investment-making process of two wireless companies.

The objective of this study is to highlight the strengths of applying the real options valuation approach as a

decision-making tool in expanding or delaying 3G network deployments. Real option methods are in vogue

because they provide more accurate valuations in different areas, e.g., equity valuation, mining projects, etc.

(Alleman & Noam, 1999; Damodaran, 2002; Mun, 2002; Schwartz & Trigeorgis, 2001; Trigeorgis, 1996). The

outcome of real options analysis is heavily dependent on the input parameters and the assumptions made, just

as in traditional discounted cash ﬂow (DCF) analysis. In this paper, the assumptions are realistic and based on

norms widely accepted by the industry and conversations held with executives and technical staff.

The structure of the paper is as follows: in Section 2, the basic theoretical work of the investment decision

process (discount cash ﬂow analysis, ﬁnancial and real options), as well as examples from the literature, where

real options have been proposed for strategic and technical problems in the telecommunications industry, are

reviewed. In Section 3, two hypothetical cases regarding the wireless industry are studied and real options

theory is applied to both cases. Finally, Section 4 summarizes the results and concludes. It was found that

investment cost and uncertainty about subscriber growth are the key parameters in the analysis. Furthermore,

volatility plays a key role in the valuation of the two cases.

2. Background

Traditional DCF analysis values an investment in present value terms, assuming that future cash ﬂows are

known and discounted at a risk-adjusted factor, e.g., the weighted average cost of capital (WACC) of the

company (Damodaran, 2002).

For example, consider a project that has a life of ﬁve years, and an initial investment cost K. Initial

investments in projects generate cash ﬂows during the project life cycles, which are discounted at a respective

discount rate. To value an asset, the net present value (NPV) is needed. The NPV is the difference between the

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present value of the future cash ﬂows and the initial investment cost. Therefore, the NPV today is given as

follows:

X

5

NPV ¼ F n ðP=F ; i%; nÞ K ¼ V K; (1)

n¼1

where Fn is the expected cash ﬂow at the end of the nth period and i is the discount rate per period (in this

study, it is assumed that the discount rate remains constant during the life of the project). The project should

commence if V4K, i.e., if it has a positive NPV, and should be abandoned if VoK.

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying

asset, at a speciﬁc price, on a certain future date (Hull, 2003). There are basically two types of options: call

options and put options. A call (put) option gives the holder the right, but not the obligation, to buy (sell) the

underlying asset at a certain date for a certain price. That ﬁxed price in the contract is known as the exercise or

strike price; the date is known as the expiration date or maturity. American options can be exercised at any

time up to the expiration date, whereas European options can be exercised only on the expiration date itself.

If K is the strike price and ST is the ﬁnal price of the underlying asset, the payoff from a long position in a

European call option is: maxðS T K; 0Þ. The payoff to the holder of a long position in a European put option

is maxðK S T ; 0Þ. The payoffs of the different positions are shown in Fig. 1.

In order to price options, the Black–Scholes–Merton partial differential equation (PDE) is used. There are

several ways to solve this PDE: numerically (lattices), in discrete-time via binomial/trinomial trees, or via the

Black–Scholes formula, if it is a European option (Black & Scholes, 1973).

Real options theory is a methodological approach within which an investment can be analyzed while

factoring in uncertainty and flexibility. Real options have been applied already in valuations in different

industries, e.g., pharmaceutical, energy, mining, telecommunications, information technology, etc. (Mun,

2002; Schwartz & Trigeorgis, 2001; Trigeorgis, 1996). In the telecommunications sector, a real options

framework has been proposed for several investment decisions: equity and ﬁrm valuation, cost analysis,

forecast bandwidth demand, etc. (Alleman, 2002; Alleman & Noam, 1999; Alleman & Rappoport, 2002;

Athwal, Harmantzis, & Tanguturi, 2005; Harmantzis & Tanguturi, 2004a, b; Tanguturi & Harmantzis, 2005).

The telecommunications sector has historically been a domain where high-cost technological investments

have been made; in addition to that, it has become a highly volatile sector, due to increased competition,

deregulation, etc. Therefore, it is highly suitable for applying real options in valuations. Valuing a project that

ST K ST

K

Long Put

Long Call

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Table 1

Mapping between investment opportunities and ﬁnancial (stock) options

Present value of the assets S0 Stock price

Time to expiration T Time to expiration

Riskiness of underlying assets s2 Variance of returns

Time value of money rf Risk free rate

requires a signiﬁcant irreversible investment up-front cost to develop networking equipment or a telecom

service is a risky decision due to inherent uncertainty in the ﬁeld. Traditional NPV analysis proves to be

limited for a number of reasons, e.g., lack of capturing uncertainty and lack of changing the course of action

when new information becomes available. The real options framework has proven to be suitable for

valuations, assuming that the models are calibrated to realistic (e.g., market) conditions.

Pricing techniques developed for ﬁnancial options can generally be mapped to investment options, as shown

in Table 1. Table 1 helps managers identify the parameters in ﬁnancial options and map them to real options

in order to model the investment problem. For example, projects require capital investment, in order for

products to be bought or built. This is analogous to exercising an option in which the amount invested is

equivalent to the exercise price K, and the present value of the asset is the current stock price S0. The length of

time the ﬁrm can wait is the time of expiration T and the riskiness of the project is reﬂected in the volatility

(standard deviation) of the asset s. The time value of the money is given by the risk-free rate rf.

Next, two of the real options used here in the analysis are discussed: the option to defer (delay) and the option

to expand.

The option to defer (delay) refers to delaying an investment decision for a certain period of time. In this

paper, a wireless company that has purchased the spectrum required to deploy 3G networks is studied. The

ﬁrm has exclusive rights to the license, which gives it the option of deferring deployment. Taking up the project

today might have a negative NPV. By exercising the option to defer, the company can commence at a time that

maximizes the project value. In other words, the value of waiting can be viewed as a call option on the project,

with an exercise price that equals the investment cost. In this case, the uncertainty is due to the number of

subscribers adopting the new technology and to market conditions in general.

The option to expand provides the ability and the right to expand into different market segments. In this

paper, a 2.5G network operator has the right to expand its network from 2.5G to an integrated network, i.e., a

2.5G network with Wireless LANs (WLANs). This allows the company to be competitive, hold onto its

existing subscriber base, and attract new subscribers.

Both the above cases can be formulated as an American call option because the option can be exercised any

time up to the expiration date. The pricing of the American option is usually done numerically (using ﬁnite

difference method, trees, Monte Carlo simulations, etc.). The Black–Scholes closed form solution for

European options can be used as an approximation. In this paper, the value of the option to defer can be

estimated by using a modiﬁed Black–Scholes formula (Damodaran, 2002):

c ¼ S0 eyT Nðd 1 Þ Kerf T Nðd 2 Þ, (2)

d1 ¼ pﬃﬃﬃﬃ , (3)

s T

pﬃﬃﬃﬃ

d2 ¼ d1 s T , (4)

where S0 is the current price of the asset, K is the exercise (strike) price, T is the time to expiration, rf is the risk-

free rate of return, s is the annualized standard deviation (volatility), y is the dividend yield, or annual cost of

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delay given by

1

Divident Yield or Annual Cost of Delay ðyÞ ¼ , (5)

T

and N(d) is the cumulative normal density function.

It is not uncommon to use the Black–Scholes formula, as an approximation, in valuations of real options.

Amram and Kulatilaka (1999) explain the use of the Black–Scholes model in one of the cases analyzed in their

work. Bowman and Moskowitz (2001), as well as Benninga and Tolkowsky (2002) apply Black–Scholes in

valuing R&D investments in the pharmaceutical industry. Finally, Basili and Fontini (2003) apply the same

model to value the aggregate option value of the UK 3G telecom license.

In the last decade, the telecommunications industry has experienced high volatility, as evidenced by the

Internet bubble and the telecom crash. In this context several cases exist in which real options have been

proposed in the wider area of telecommunications, e.g., telephony, broadband, Internet, cable, wireless, etc.

(Alleman & Noam, 1999).

Alleman (2002) shows how real options theory can be helpful to the telecommunication industry for issues

related to strategic evaluation, estimation and cost modeling. Alleman and Rappoport (2002) use real options

analysis in an attempt to quantify regulation issues, demonstrating the impact of regulatory constraints on

cash ﬂows, and therefore in the investment valuation process.

Economides (1999) studied the economic principles on which cost calculations should be based. d’Halluin,

Forsyth, and Vetzal (2002a, 2002b) studied the risks faced in the bandwidth market using real options to

determine optimal times of investing to increase network capacity. In a more recent paper, the same authors

apply options methodology to value wireless network capacity (d’Halluin et al., 2002a, 2002b).

Herbst and Walz (2001) adopt real options to analyze the value of auctioned UMTS-licenses in Germany,

the largest European market. Their model is based on the option to abandon and the growth option.

Edelmann, Kylaheiko, Laaksonen, and Sandstorm (2002) use real options to shed light on the complicated

issues of strategic alternatives in the telecommunications industry. Kulatilaka (2001) explains the current situation

in 3G deployment with the help of fundamental critical management questions such as what, why, when and how

the real options approach helps in the decision-making process in a comparative manner. Kulatilaka and Lin

(2004) ﬁnd the investment threshold at which the ﬁrms are indifferent between investing immediately or postponing

the investment. Their analysis shows that the licensing fee plays an important role in technology adoption. High

license fees yield to the development of incompatible technologies; low fees to single standard adoption.

Finally, Paxson and Pinto (2004) examine the timing issue of a Portuguese telecom carrier in 3G investment,

using real competition option models. They showed that although traditional NPV calculations point to an

immediate investment and entry of all the players in the market, this is not the case. Their options models

suggest a delay of entry for the follower.

In the current section the strengths of the real options valuation approach as a decision-making tool are

highlighted, by considering two cases of hypothetical wireless companies. Company A has the option to defer

expansion of 2.5G to 3G wireless networks for a predetermined time period. Company B has the option to

expand its 2.5G network using alternative technologies, such as WLANs. Several cellular service providers have

shown interest in WLAN deployment, since they are hesitant to invest in 3G networks e.g., SK Telecom,

T-Mobile, etc. The assumptions made in both cases are sound and realistic, both technologically and ﬁnancially.

In this case, a company has already acquired the required spectrum to deploy 3G wireless networks and has

the exclusive rights to provide services.

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112 F.C. Harmantzis, V.P. Tanguturi / Telecommunications Policy 31 (2007) 107–123

Certain assumptions have been made in order to perform the analysis:

The maturity of the option T is ﬁve years (FCC1 auction rules typically require companies to have their

network partially developed and deployed after ﬁve years). The current price of the underlying S0 is the

present value of future cash ﬂows. The strike price K is the present value of the investment cost, consisting of

capital and operational expenditures. The annualized standard deviation, i.e., volatility s, is calculated from

the historical price movements of the company and estimated at 37.68% annually. The risk free rate rf of

3.64% is consistent with the US Treasury bond rates at the time of study; the maturity of the bonds

corresponds to the life of the project.

For the DCF valuation, cash ﬂows were discounted using the average WACC of the wireless industry.

A WACC of 10.8% was assumed at the time the project was valued (Katz & Junqueira, 2003).

The company covers a geographic area of 1250 square miles; it is assumed that 40% are urban and that the

rest are suburban. A typical urban cell site covers approximately 3.14 km2, whereas a suburban cell site covers

an area of 19.5 km2. Based on the above assumptions, a total of 512 cell sites covering the entire geographic

area was estimated.

Determining the cell capacity in a multi-service 3G system such as UMTS is a challenging task (detailed

calculations can be found in Appendix A). The capacity is estimated based on the following assumptions: all

users are equidistant from the cell sites, transmit the same amount of power, and transmit at the same bit rate.

The theoretical estimate for the number of subscribers that the system can serve at a particular time is 98,310.

An over-booking factor of two, i.e., an over-subscription of 196,620, is assumed. This factor is important to

wireless packet data services from a networking aspect, since it allows the network operator to sell the same

amount of bandwidth many times, e.g., in multiples of 10 to 20 times multiple. The higher the over-booking

factor, the better. The over-booking factor will play an important role in the project. The major source of

uncertainty in this project is the number of subscribers that will subscribe to the new services. This will be

analyzed further in the following section.

Finally, it is assumed for Case A that both the subscriber base and the number of cell sites grow at a constant

rate of 6% per year (a realistic, conservative assumption; sensitivity analysis performed on the factor).

Table 2 shows the investment cost breakdown for capital expenditure (CapEx) and operational expenditure

(OpEx), as well as the ﬁgures used to calculate the present value of the investment cost K.

Capital expenditure is the amount of money required to acquire and build the infrastructure. It is assumed

that capital expenditure comprises the cell site construction, base station equipment, antenna, and integration

cost. Operational expenditures are the expenses incurred in operating the network and keeping it functional.

They comprise the costs of the cell site lease, power supply to the site, T1 lines, and cell site software.

The amount of capital required to build the 3G network for the life of the project is based on the number of

cell sites the company has in the coverage area each year. The cost of building a single cell site is approximately

$355,000,2 assumed to be constant during the life of the project. The company is assumed to construct 512 cell

sites in the ﬁrst year, adding new cell sites in subsequent years, based on subscriber growth. The yearly cash

ﬂows for CapEx and OpEx are calculated as shown in Appendix B. Given the yearly cash ﬂows from Table 2,

the present value of the investment cost K is $274.5 million, using a discount factor of 10.8%, i.e., the WACC.

Table 3 shows the revenue projection for subscribers to the 3G network and calculates the present value of

future cash ﬂows S0. The revenue stream consists of both voice and data subscribers. It is assumed that the

base number of subscribers starts at 196,620 in Year 1, as noted, and grows at 6% per year. The revenue

ﬁgures are calculated by charging a price of $803 per user in the ﬁrst year. Furthermore, it is assumed that this

charge, i.e., the ARPU, will decrease by 5% each year for the next ﬁve years.

1

Federal Communications Commission (FCC) Home Page—http://www.fcc.gov/.

2

Based on private discussion with a faculty member at Stevens Institute of Technology who is also a senior consultant to a leading

wireless service provider in United States.

3

Based on Vodafone UK’s 3G roll out press release on offering two different bundled packages to British subscribers on November

10th, 2004.

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F.C. Harmantzis, V.P. Tanguturi / Telecommunications Policy 31 (2007) 107–123 113

Table 2

Company with option to defer: investment cost projections

CapEx $181.76 million $10.90 million $11.55 million $12.25 million $12.98 million $13.76 million

OpEx $14.33 million $15.19 million $16.10 million $17.07 million $18.08 million $19.18 million

Table 3

Company with option to defer: revenue projection for 3G

Revenues $0 $15.72 million $15.83 million $15.95 million $16.06 million $16.17 million

Discounting future cash ﬂows with a WACC of 10.8%, the present value of future cash ﬂows S0 is

calculated to be $53.4 million. From Eq. (1), the static NPV (no option) of the project is

Static NPV ðNo optionÞ ¼ S0 K ¼ $221:1 million. (6)

Clearly, the project has a negative NPV and therefore should not be undertaken.

Within ﬁve years the company must make a decision whether or not to invest. The goal is to determine the

value of the option to delay the investment (provided by the license). Knowing the option’s parameters—the

present value of future cash ﬂows is $53.4 million, the present value of investment costs is $274.5 million

(strike price), the volatility is 37.68%, the risk-free rate is 3.64%, and the expiration time is ﬁve years—the

value of the option to delay developing the 3G network is calculated to be $0.027 million using Black–Scholes

(2). Such a low value was to be expected, since this call option is ‘‘deeply out of money’’ i.e., the underlying

price is much less than the strike price. The (positive) value of the option to delay slightly improves the static

(no option) ﬁgure:

NPV ðwith optionÞ ¼ Static NPV þ Value of the option to delay ¼ $221:07 million. (7)

Therefore, even with the value of the option to delay, the project has a negative present value of $221.07

million. The option to delay is not of great value for this company.

The effect of the parameters that can increase the value of the option to defer and turn this project into one

with a positive NPV is worth investigation. The real options toolkit can help management identify different

scenarios and answer ‘‘what needs to be true’’ in the particular case for the investment to become attractive.

For example, the value of the option to delay increases with an increase in the subscriber base.

In this section, the effect of key parameters such as investment cost, volatility, and number of subscribers

are studied.

Fig. 2 shows the effect of investment cost ﬁgures on the two valuation methods: the traditional DCF and

real options. The investment cost is varied from $100 to $500 million, while the rest of the parameters are kept

unchanged.

Both NPV1 (no option) and NPV2 (with option) decrease with an increase in the investment cost, as

expected. The value of the option to defer is the difference between NPV2 and NPV1. The value of the option

decreases as the investment cost increases. This is expected because the call option becomes less valuable as the

strike price increases. Even when the investment cost reduces to half its current value, the NPV in both

approaches is negative. Therefore, exercising the option is not a viable choice, since the investment cost is so

high for that particular project.

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$100

Call Value

$50 NPV (No Option)

$0

T = 5 Years

−$100 σ = 37.685%

−$150 rf = 3.64%

−$200

−$250

−$300

−$350

−$400

−$450

$100 $150 $200 $250 $300 $350 $400 $450 $500

Investment Cost (K) (In Millions)

Fig. 3 shows how changes in the volatility (uncertainty) affect the option value and therefore the decisions.

The volatility is varied from 10% to 100%; remaining parameters are unchanged.

While DCF does not incorporate risk, i.e., NPV1 remains constant, the value of the option, and therefore

the NPV2, increases with an increase in volatility. However, even a 100% annual volatility cannot make the

project attractive.

Finally, the effect of the number of clients subscribing to new 3G services on the valuation process is

studied. Subscribers, who contribute to the magnitude and volatility of future revenues, are key players in the

decision process. In this case, only the revenue generated from new 3G subscribers4 is considered. In Fig. 4, the

effect of changes in cash ﬂows due to changes in the subscriber base is illustrated. The initial subscriber base is

varied from two-fold to 13-fold; all other parameters remain unchanged.

As expected, both NPV1 and NPV2 increase as the number of 3G subscribers increases. The option value

also increases with an increase in the number of subscribers. As the current price of the underlying asset

increases while the strike price remains constant, it is found that NPV2 ﬁrst becomes positive when there is a

10-fold increase in the subscriber base. Below this point, both NPV1 and NPV2 are negative, because the

investment cost is high and the operator is not able to generate enough revenue. The project is not worth

exercising. Thus, it is up to the management team of the wireless company to judge if a 10-fold increase in the

number of 3G clients in ﬁve years is a realistic assumption, given the prevailing market conditions.

3.2. Case B: option to expand a 2.5G network to WLANs (as an alternative to 3G)

3G technology has promised to provide data rates up to 384 Kbps with a maximum speed of 120 Km/h.

There has been a delay in the rollout of 3G networks—3G spectrum auctions have not even taken place in the

United States (as of Summer 2006)—even though researchers have long proposed operators integrate their

2.5G networks with WLANs to provide 3G-like services to their subscriber base (Salkintzis, Fors, &

Pazhyannur, 2002). WLAN technology is simpler, cheaper, and easier to deploy. WLANs offer data rates

between 11 and 54 Mbps, compared to the 171 Kbps offered by GPRS networks (Salkintzis et al., 2002).

4

Subscribers who are ﬁrst time buyers subscribing to new 3G services or switching from a different cellular provider. This assumption is

part of a conservative analysis.

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$100

Call Value

$50 NPV (No Option)

$0

NPV and Call Value (In Millions) S0 = $53 40m

−$50

K = $274.46m

−$100 T = 5 Years

rf = 3.64%

−$150

−$200

−$250

−$300

−$350

−$400

−$450

10 20 30 40 50 60 70 80 90 100

Volatility (%)

$100

NPV (No Option)

$50 NPV (With Option)

$0 K = $274.46m

T = 5 Years

−$50 rf = 3.64%

σ = 37.68%

−$100

NPV (In Millions)

−$150

−$200

−$250

−$300

−$350

−$400

−$450

200 400 600 800 1000 1200 1400

Number of Subscribers (In Thousands)

Integration can be a valuable option for network operators who are currently at 2.5G, because they already

have a data subscriber base. By offering the new integrated service, they can provide enhanced services and

hold onto their subscriber base. They could also generate additional revenue by attracting customers to their

WLAN network.

Users have a clear advantage as they will have the choice of transmitting their data over two different

networks. With a 2.5G network, they can obtain wider transmission coverage but lower data rates, whereas

with WLANs, subscribers get higher data rates but a smaller coverage area. Deploying WLANs in strategic

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locations such as coffee shops, shopping outlets, and ﬁnancial centers in major cities and airports, allows the

operator to cover vital areas with high-speed data services.

This paper advocates the deployment of WLANs as a complement to 2.5G networks. Instead of waiting,

operators can integrate WLANs with their existing 2.5G networks and provide 3G-like services.

To proceed with the analysis of the investment, the pricing model proposed by Harmantzis et al., is used for

the integrated network (Yaipairoj, Harmantzis, & Gunasekaran, 2005). The model calculates the additional

revenue generated due to integration. First, the NPV of the integration project, i.e., integration of WLANs

with 2.5G network, is calculated. Second, the real options method is used to value the option. The proposed

approach is based on the option to expand.

The assumptions made in carrying out the analysis are related to particular wireless companies and the

feasibility of wireless technologies and networks.

Downtown Manhattan, an area of 23 square miles, was considered. There are two scenarios regarding the

revenue stream in the integrated services setting: Scenario A: The company collects revenues from its existing

customer base, i.e., a percentage of existing data subscribers. Scenario B: The company considers revenues

coming from both integrated network subscribers and Wi-Fi (new) subscribers.

Regarding the option parameters, assumptions and notation similar to those in Case A are followed.

However, the life of the option, i.e., the life of this project, is three years. This assumption is based on a

common belief concerning the timing of 3G spectrum auctions in the United States. The annual volatility,

calculated using historical price movements of the US Telecom Index for the past three years, is at 31.225%5

(lower than the ﬁve years of Case A). The US Treasury bond (i.e., risk-free) rate prevalent at the time of study,

was 2.62%, corresponding to the life of the option here (United States Department of Treasury).

Table 4 breaks down the investment cost into CapEx and OpEx for Case B (detailed formulae are given in

Appendix C).

The CapEx ﬁgures are the costs associated with the installation of Wi-Fi Access Points (APs). The cost of

installing a single Wi-Fi AP is $500 (Boingo Wireless). One Wi-Fi AP can cover 0.0102 square miles. It is

assumed that in the ﬁrst year, the operator, selecting strategic locations in downtown Manhattan, will install

WLANs in one-sixth of the total coverage area. At the end of the life of the project, the company would cover

one-ﬁfth of Manhattan. Thus the ﬁrm starts with 375 APs in Year 0, with a plan to increase this number to 450

by the end of Year 3. It is assumed that the network expands by adding 25 APs per year.

The cost of a single business DSL line is approximately $75 per month, while the maintenance cost is $50 per

month (Boingo Wireless). The OpEx numbers shown in Table 4 are based on the total number of Wi-Fi APs at

the end of each year.

Discounting at a WACC rate of 10.8% as in Case A, the present value of the investment cost K is $2.1 million.

Based on telecommunications trafﬁc information for Company B, the subscriber base in downtown

Manhattan is 120,000 people. As in Case A, it is assumed that this base will grow at 6% per year. The

percentage of data users starts at 7.5% and increases to 15% towards the end of the project. Among the data

subscribers, 70% use the integrated network, while the remaining 30% use the GPRS network only.

In this ﬁrst scenario, revenues come only from subscribers to the integrated network.

For the services of the integrated network, customers are charged according to the model proposed by

Harmantzis et al. (Yaipairoj et al., 2005). This model calculates the additional revenue that can be made due to

integration. The cost of transmitting one megabyte over a GPRS network is high compared to Wi-Fi. The

proposed scheme uses a demand function to calculate the percentage of users who accept the pricing of the

integrated network. The total revenue made by the operator is the sum of the revenue made from the

5

The proposed integration model can be deployed by any operator irrespective of current cellular technology in use. The Telecom index

is used as a measure of volatility for the proposed integration model. The IYZ index has, as a major component, 70% of public companies

that offer cellular telephony services.

ARTICLE IN PRESS

F.C. Harmantzis, V.P. Tanguturi / Telecommunications Policy 31 (2007) 107–123 117

Table 4

Company with option to expand: investment cost projections

CapEx $187,500 $12,500 $12,500 $12,500

OpEx $562,500 $600,000 $637,500 $675,500

percentage of customers using the GPRS network and the percentage of customers using the Wi-Fi network.

In this paper, the additional revenue made per connection is calculated.6

Figures in Table 5 are calculated on the assumption that each subscriber makes 30 connections per year (this

is a conservative estimate). Each connection contributes $1.30, due to the pricing model. (The reader may refer

to Appendix C for detailed calculations.)

The NPV of the revenues for Scenario A, S01, is calculated to be $1.23 million, discounting with a WACC of

10.8% for the time of the project. The (static) net present value NPV1 for the project turns out to be negative,

i.e., $(1.232.1) ¼ $0.87 million.

The company has the option to expand to an integrated network (GPRS and WLAN) in downtown

Manhattan any time within the next three years. From the Black–Scholes option pricing model, the option to

expand by integrating GPRS and Wi-Fi is calculated to be $0.09 million. Such a small option value is unable

to make the project attractive. The NPV with option NPV2 is still negative, i.e., $0.78 million.

From the valuation of both DCF and real options, the management of the ﬁrm sees that it is not proﬁtable

to integrate the network when the current type of subscriber is the only revenue stream generator. If the ﬁrm

thinks it can only retain the existing type of customers and not attract new types of customers, then the

decision should be negative, and the project should be reconsidered.

For Scenario B, revenue projections consist of revenue from both Scenario A and the Wi-Fi subscriber base.

Revenue ﬁgures in Table 6 are based on a connection fee of $5 to the Wi-Fi subscribers, and a total of 10

connections made per year by each subscriber (AT&T Wireless). In order to calculate revenue, a conservative

Wi-Fi subscriber base of 8000 has been assumed, which remains constant during the life of the project. (For

details about this calculation, the reader may refer to Appendix C.)

The present value of future cash ﬂows S02, again discounting at 10.8%, is $2.47 million, more than double

that of Scenario A. This increase in projected revenues is sufﬁcient to turn the (static) NPV of the project into

a positive one, i.e., $(2.472.1) ¼ $0.37 million.

For the option valuation, the parameters remain unchanged, except for the value of S02. The value of the

option to expand is $0.77 million. Taking into consideration the option that the company has, the project

becomes even more valuable, since NPV2 is $(0.37+0.77) ¼ $1.14 million.

The analysis demonstrates that when the operator considers revenue coming from an additional Wi-Fi

subscriber base, the expansion which results from integrating the 2.5G network with a Wi-Fi network is viable.

In the following section, the effect of key parameters in the decision-making process for the second scenario is

studied, since Scenario A is not proﬁtable.

Fig. 5 shows the effect of investment costs on the NPV for both DCF and real options. The investment cost

K varies from $1 million to $3 million (in Case B, K ¼ $2.1 millions).

From Fig. 5, it may be observed that both NPV1 and NPV2 decrease with an increase in the investment cost.

The value of the option to expand is the difference between NPV2 and NPV1. As expected with the call option,

the value of the option decreases with an increase in the investment cost. For the lower values of the

investment cost, the option is in the money i.e., the underlying price is higher than the strike price, and

6

A logged session for a duration of 24 h.

ARTICLE IN PRESS

118 F.C. Harmantzis, V.P. Tanguturi / Telecommunications Policy 31 (2007) 107–123

Table 5

Company with option to expand: revenue projection for Scenario A

Revenues $245,700 $347,256 $460,114 $585,265

Table 6

Company with option to expand: revenue projection for Scenario B

New Wi-Fi subscribers 8000 8000 8000 8000

Revenue $645,700 $747,256 $860,114 $985,265

$3.5

NPV (No Option)

$3 NPV (With Option)

S02 = $2.47m

$2.5 T = 3 Years

σ = 31.225%

$2 rf = 2.62%

NPV (In Millions)

$1.5

$1.0

$0.5

$0

−$0.5

−$1

$1 $1.2 $1.4 $1.6 $1.8 $2 $2.2 $2.4 $2.6 $2.8 $3

Investment Cost (K) (In Millions)

therefore should be exercised. It is found that exercising the option is not viable for an investment cost

threshold limit of $2.924 million—the price of the option is zero for that strike.

The effect of the volatility parameter on the real options approach (DCF is unaffected by the risk factor) is

next studied. Fig. 6 shows the volatility with respect to the NPV of the project with and without the option to

expand. The volatility is varied from 10% to 100% (annually).

From Fig. 6, it may be observed that the NPV2 increases linearly with increases in volatility. Therefore, the

value of the option (NPV2NPV1) also increases linearly with respect to volatility. It can be observed that the

more volatile the industry, the more valuable the option to expand; volatility at lower percentages does not

have an impact (it is still valuable).

Finally, the effect of Wi-Fi subscribers, i.e., newly attracted clients, on the valuation of the project is

studied. This parameter directly affects S02, since future cash ﬂows are changed.

From Fig. 7, both NPV1 and NPV2 increase with the number of Wi-Fi subscribers. The value of the option also

increases with the call option. Should the Wi-Fi subscriber base hit 4000, the NPV1 plus the value of the option

ARTICLE IN PRESS

F.C. Harmantzis, V.P. Tanguturi / Telecommunications Policy 31 (2007) 107–123 119

$3.5

S02 = $2.47m NPV (No Option)

K = $2.10m NPV (With Option)

$3

T = 3 Years

rf = 2.62%

$2.5

$2

NPV (In Millions)

$1.5

$1.0

$0.5

$0

−$0.5

−$1

10 20 30 40 50 60 70 80 90 100

Volatility (%)

$3.5

NPV (No Option)

$3 NPV (With Option)

K = $2.10m

$2.5 T = 3 Years

σ = 31.225%

$2 rf = 2.62%

NPV (In Millions)

$1.5

$1.0

$0.5

$0

−$0.5

−$1

0 200 400 600 800 1000 1200 1400 1600

Number of Wi-Fi Subscribers (In Thousands)

becomes positive for the ﬁrst time. If there are fewer than 4000 Wi-Fi subscribers, both NPV1 and NPV2 are negative.

In this region, the project does not look promising, given its high investment cost and weak revenue stream.

This research was motivated by the fact that the path to 3G is dependent not only on the fee paid to acquire

the spectrum license, but on key factors such as infrastructure costs, number of subscribers, and uncertainty

ARTICLE IN PRESS

120 F.C. Harmantzis, V.P. Tanguturi / Telecommunications Policy 31 (2007) 107–123

around the market conditions and regulatory policies in future years. Real options theory provides an

appropriate framework to study investment decisions in the wireless industry.

Hypothetical cases regarding two different companies were presented and analyzed in the paper. In the ﬁrst

case, Company A owns the spectrum license for a 3G network but considers deferring expansion for ﬁve years,

until favorable market conditions develop (e.g., the company bought the license prior a market crash or an

economic recession). In the second case, Company B considers alternative technologies to 3G. More

speciﬁcally, the company considers expanding its current 2.5G network by using WLANs.

For Company A, it is found that an expansion of the current network to 3G is not a proﬁtable solution, as

both the investment cost of rolling out the 3G network and uncertainty around the subscribers are high. The

value of the option is low, given the prevailing market conditions and the high investment cost. Even in

situations of high volatility that favor the value of the option, the recommendations made to the company did

not alter (for realistic volatility levels). Uncertainty regarding the number of subscribers is a major issue in this

case. The analysis suggests that when only revenue from the new 3G subscribers is considered, expansion is not

a favorable choice. The NPV of the project with the option becomes positive for the ﬁrst time when there is a

10-fold increase in the number of subscribers.

Company B considers integrating GPRS with WLANs, as an alternative technology. It is demonstrated that

such an investment is not proﬁtable, when the operator considers revenue only from the subscribers of the

integrated network. The option to expand is more valuable when the operator is able to attract new

subscribers to its Wi-Fi network as well as its integrated network subscribers. Besides the number of

subscribers, investment cost and volatility also play important roles in this valuation. The ﬁrm could protect

its investment by choosing an alternative technology that is cheaper compared to the investment required by

3G. Expanding the current 2.5G network through integration provides a platform for offering new data-

centric services; the ﬁrm offers 3G-like services while holding onto its subscribers.

Although real options valuation is becoming popular, analysts agree that the values of the input parameters

to the model are the catalysts for the ﬁnal decision, as there is a general consensus around the methodology

that should be followed. Approximating the values of the option parameters is challenging, due to the

proprietary nature of this information. In the case considered, the assumptions made are realistic,

technologically solid, and bottom-up driven (readers should refer to the appendices for derivations such as

costing, sizing of network, pricing of wireless services, etc.). By emphasizing technological aspects in addition

to using well-known methods of pricing real options, some light has hopefully been shed on the decisions

wireless operators need to make in transitioning to 3G technology.

Acknowledgements

The authors would like to thank Prof. J. Alleman and Prof L. Trigeorgis for the fruitful discussions on real

options. Dr. A. Curtis, Dr. K. Ryan and Dr. C. Smith, all at Stevens, for their valuable insights on technology

and telecommunications management issues. Finally, the editors and anonymous reviewers as well as the

participants at the following conferences, where the paper was presented at its earlier stages: 15th Biennial

Conference of International Telecommunications Society (ITS 2004, Berlin, Sept. 2004), 31st Annual

Conference of Northeast Business and Economics Association (NBEA 2004, Yeshiva University, New York,

Sept. 2004), and EURO XX Conference on Operational Research (Rhodes, Greece, July 2004).

Let us deﬁne the following variables: E b is the energy per bit, N 0 the noise power spectral density

Power per radio channel ¼ E b n Data Rate, (A.1)

ARTICLE IN PRESS

F.C. Harmantzis, V.P. Tanguturi / Telecommunications Policy 31 (2007) 107–123 121

S E b n Data Rate

Signaltonoise ratio : ¼ . (A.4)

N N 0 n Channel Bandwidth

The spreading factor (SF) is deﬁned as ratio of the chip rate to the Data Rate,

Data Rate 1

. (A.5)

Chip Rate SF

Since, Chip RateEChannel Bandwidth, the signal-to-noise ratio is given by

S

¼ ðE b =N 0 Þ n ð1=SF Þ. (A.6)

N

X users per RF channel pair leads to ðX 1Þ interferes. Hence,

S S 1

¼ n ¼ . (A.7)

N S ðX 1Þ ðX 1Þ

For X large,

S 1

. (A.8)

N X

Equating the two expressions (A.6) and (A.8) for signal-to-noise ratio,

1 Eb n 1

. (A.9)

X N 0 SF

Consider the number of users per RF pair to be X.

Thus, an approximate expression for capacity is

X ðSF Þ=ðE b =N 0 Þ. (A.10)

In order to determine cell capacity, the SF is considered to be 128 and the energy per bit to noise ratio

E b =N 0 ¼ 6 db or 4 (gain, from Decibel Table).

From Eq. (A.10), the number of users per RF channel pair equals to be 32.

Let us assume that the operator has total spectrum of 25 MHz, which is equally divided for uplink and

downlink channels. Also, a single UMTS RF channel equals 5 MHz. Therefore, total number of RF channel

pair per cell: 12:5=5 MHz ¼ 2:5 2. Hence, 2 RF channel pair per cell can exist. In this case, the wireless

operator covers a geographic area of 1250 square miles with 512 cell site. Number of users per RF

channel ¼ 32. Number of users per Two RF channels ¼ 64. Considering a three sectored cell site, total

number of users in a cell site ¼ 192. Therefore, total subscribers in 512 cell sites ¼ 98,310. The theoretical

estimate for the number of subscribers that the system can serve at a time is 98,310.

capital expenditure ðCapExÞ ¼ f½Cell Site Construction Cost=Year

þ ½Base Station Equipment Cost=Year þ ½Antenna Cost=Year

þ ½Integration Cost=Yearg n Number of Cell Sites:

For example, for Year 0:

CapEx ¼ ð$150; 000 þ $150; 000 þ $50; 000 þ $5; 000Þn 512 ¼ $181:76 million:

ARTICLE IN PRESS

122 F.C. Harmantzis, V.P. Tanguturi / Telecommunications Policy 31 (2007) 107–123

þ ½Cell Site Power Cost=Year þ ½Cell Site T1 Lines Cost=Year

þ ½Cell Site Software Cost=Yearg n Number of Cell Sites:

For example, for Year 0:

OpEx ¼ ð$20; 000 þ $3000 þ $3000 þ $2000Þ n 512 ¼ 14:33 million:

Revenue projections for case study A (Table 3):

Revenue ¼ ½Average Revenue Per User ðARPUÞ=Year n Number of Subscribers:

For example, the revenue for Year 1:

Revenue ¼ $80 n 196; 620 ¼ $15:72 million:

WiFi Access Points ðAPsÞ ¼ 1=6th coverage to 1=5th coverage of total Manhattan area:

For example, for Year 0: CapEx ¼ $500 n 375 ¼ $187; 500

operational expenditure ðOpExÞ ¼ f½Business DSL Line Cost=Month þ ½AP’s

Maintenance Cost=Monthg n Number of Months n Number of APs:

For example, for Year 0: OpEx ¼ ð$75 þ $50Þ n 12 n 375 ¼ $562; 500.

Revenue projections for case study B:

Scenario A (Table 5):

Revenue ¼ ½Average Number of Connections Per Subscriber=Year n

½Additional Revenue Per Connection n Number of Subscribers:

For example, for Year 0:

Revenue ¼ 30 n $1:3 n 6300 ¼ $245; 700.

Scenario B (Table 6):

Revenue ¼ Revenue from Scenario A þ ðPer connection fee

n

No: of connections per year n WiFi Subscribers=year.

n

½Per Connection ðFlatÞ Fee n Number of WiFi Subscribers:

For example, for Year 0:

Revenue ¼ $245; 700 þ 10 n $5 n 8000 ¼ $645; 700.

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