CORPORATE FINANCE

22. Real Options

 Topics Covered

 The Value of Follow-On Investment Opportunities

 The Timing Option
 The Abandonment Option
 Flexible Production and Procurement
 Investment in Pharmaceutical R&D
 Valuing Real Options

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0. Introduction: Corporate Options

Four Types of “Real Options”

1 - The option to expand if the immediate investment project
succeeds.
2 - The option to wait (and learn) before investing.
3 - The option to shrink or abandon a project.
4 - The option to vary the mix of output or the firm’s production
methods.

Value “real option” = NPV with option - NPV w/o option

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1. The Value of Follow-On Investment
Opportunities: Microcomputer Forecasts
Example – Mark I Microcomputer ($ millions)
Hurdle rate: 20%
Standard deviation: 35%
Annual interest rate: 10%

Year
1982 1983 1984 1985 1986 1987
After-tax operating cash flow (1) 110 159 295 185 0
Capital investment (2) 450 0 0 0 0 0
Increase in working capital (3) 0 50 100 100 -125 -125
Net cash flow (1)-(2)-(3) -450 60 59 195 310 125
Hurdle rate 20%
NPV -46

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Example – Mark II Microcomputer ($ millions)
Forecasted cash flows from 1982
Apple call option:
Mark I Microcomputer
Year
1982 1983 1984 1985 1986 1987
After-tax operating cash flow (1) 110 159 295 185 0
Capital investment (2) 450 0 0 0 0 0
Increase in working capital (3) 0 50 100 100 -125 -125
Net cash flow (1)-(2)-(3) -450 60 59 195 310 125
Hurdle rate 20%
NPV -46

Mark II Microcomputer
Year
1982 ………. 1985 1986 1987 1988 1989 1990
After-tax operating cash flow 220 318 590 370 0
Increase in working capital 100 200 200 -250 -250
Net cash flow 120 118 390 620 250
Present Value @ 20% 807,1
Investment required (Exercise Price) 900,0
Forecasted NPV in 1985 -92,9
Hurdle rate 20%
Annual interest rate 10%
Present Value (Expected Cash inflows)@ 20% 467,1 in 1982
Investment, PV @ 10% (PV(EX)) 676,2 in 1982
NPV in 1982 (commitment to invest in Mark II) -209,1

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1. The Value of Follow-On Investment
Opportunities: Microcomputer Forecasts
Example – Mark II Microcomputer ($ millions)

Mark II Microcomputer
Forecasted cash flows from 1982
Year
1982 ………. 1985 1986 1987 1988 1989 1990
After-tax operating cash flow 220 318 590 370 0
Increase in working capital 100 200 200 -250 -250
Net cash flow 120 118 390 620 250
Present Value @ 20% 807,1
Investment required 900,0
Forecasted NPV in 1985 -92,9
Hurdle rate 20%
Annual interest rate 10%
Present Value (Expected Cash inflows)@ 20% 467,1 in 1982
Investment, PV @ 10% (PV(EX)) 676,2 in 1982
NPV in 1982 (commitment to invest in Mark II) -209,1

NPV(1982) = PV(inflows) – PV(investment)

= 467 – 676
= – $209 million

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1. The Value of Follow-On Investment Opportunities:
Microcomputer Forecasts
Example – Mark II Microcomputer Option

900
PV (exercise price) = 3 = 676
1.1

OC = [N (d1 ) × P ] − [N (d 2 ) × PV(EX)]

d1 = log[ P / PV(EX)] / σ t + σ t / 2
= log[.691 / .606] + .606 / 2 = −.3072
d 2 = d1 − σ t = −.3072 − .606 = −.9134
N (d1 ) = .3793 N (d 2 ) = .1805
Call value = [.3793 × 467} − [.1805 × 676] = $55.12 million

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1. The Value of Follow-On Investment
Opportunities: Microcomputer Forecasts
Example – Mark II Microcomputer (1985)
Distribution of possible present values

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1. The Value of Follow-On Investment
Opportunities: Microcomputer Forecasts
Example – Mark II Microcomputer (1985)
• The NPV of a commitment to invest in Mark II is clearly
negative:
PV(Cash inflows)-PV(Investment) = $467-$676 = -$209 m
Option is out of the money
• However, if project evolves in a good way, actual value
could exceed $2 billion.
• In normal DCF analysis, the expected income (average
downside against the average upside) is discounted
(bad outcomes against the good).
• The value of a call option depends only on the upside.
• Decision rule in an option valuation framework (Adjusted
PV):
APV = -$46 + $55 = +$9 million => accept Mark I
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2. Option to Wait

Intrinsic Value
Option price

Stock price

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2. Option to Wait

Intrinsic value + time premium = option value

Time premium = vale of being able to wait

Option price

Stock price
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2. Option to Wait

More time = more value

Option price

Stock price
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2. Timing Option Example: Malted Herring
Possible cash flows and end-of-period values for the malted herring
project are shown. The project costs $180 million, either now or later.
Currently, it has a PV of $200million. The figures in parentheses show
payoffs from the option to wait and to invest later if the project is
positive-NPV at year 1. If demand is high in year 1, the FCF will be
$25 million and the PV of the whole project, $ 250million. However,
if demand is low, the FCF will only reach $ 16million and the PV
will be $160million. Waiting means loss of the first year’s cash flows.
The problem is to figure out the current value of the option.

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2. Timing Option Example : Malted Herring

High demand generates $25 million and a value

of $250 million at the end of the year. Low
demand generates $16 million and no value.

High Demand Low Demand

(25 + 250) (16 + 160)

Total return = −1 Total return = −1
200 200
= .375 = −.12

Risk neutral
return = 5%
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2. Timing Option Example : Malted Herring
The next step requires the calculation of the probability of there
being a high demand for the malted herring project.

Expected return = (prob. of high demand) × .375 + (1 − prob. of high demand) × (-.12)
Expected return = .05
Prob. of high demand = .343

The option value is now determined as follows:

(.343 × 70) + (.657 × 0)

Option value =
1.05
= $22.9 million
It is better to keep the option open (value of $22.9 million) than to
exercise it now (value: $200m-$180m=$20m)

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2b. Option to Wait
Example – Development option: two options to invest but only
one can be exercised:

Hurdles for any project to be chosen: 1) NPV must exceed $240million; 2)Its
NPV must exceed the other project’s NPV by a significant amount.

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3. Option to Abandon
Simple Example - Abandon
Suppose the Perpetual Crusher (one of the examples given in the Financing and
Valuation part of the Course), with an WACC of 9%, whose original cost was
$12.5million and whose original expected annual perpetual cash flows were
1.125million is now providing an annual CF (still expected to last in perpetuity) of
only $ 450,000 a year.
The project may be abandoned (in one year) with a recovery of $5,5 million from the
sale of machinery and real estate (standard deviation of 30% and risk-free rate of
4%) .
Is this situation terminal for the project?

$1.125
= −$12.5 + =0
0.09
$450,000
= =$5
0.09

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3. Option to Abandon
Simple Example - Abandon
Suppose the Perpetual Crusher (one of the examples given in the Financing and
Valuation part of the Course), with an WACC of 9%, whose original cost was
$12.5million and whose original expected annual perpetual cash flows were
1.125million is now providing an annual CF (still expected to last in perpetuity) of only
$ 450,000 a year.
The project may be abandoned (in one year) with a recovery of $5,5 million from the
sale of machinery and real estate (standard deviation of 30% and risk-free rate of 4%)
.
Is this situation terminal for the project?

( ! " #) = $480,000
&
=' + ( ' ) * ' − )) & (* & − ' * &+)
$5.5
& = $0.480 + − 5.0 = $ 0.768 = $768,000
1.04

Consequently,
&ℎ * / '& = $5.0 + $0,768 = $5.768
&ℎ * / '& 0 " " " & + = $5.5

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3a: Mothball Option (Tanker Example)
Sometimes companies are allowed to abandon
projects temporarily:

Value in
Value of tanker operation

Cost of
reactivating

Value if
Mothballing mothballed
costs

Tanker rates

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4. Flexible Production and Procurement

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4. Flexible Production and Procurement

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 Aircraft Purchase Option

 If implemented at year 3, option guarantees fixed price and delivery

at year 4
 Without option, plane can still be ordered at year 3 but with uncertain
price and delivery

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 Aircraft Purchase Option

Value of aircraft purchase option—the extra value of the option

versus waiting and possibly negotiating a purchase later. The
purchase option is worth most when NPV of purchase now is
about zero and the forecasted wait for delivery is long.
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5. Investment in Pharmaceutical R&D

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6. Practical Challenges

 Practical reasons why real options are not always feasible to use:
1. Valuation of real options can be complex and sometimes it is impossible to
arrive at the “perfect” answer.
2. Real options do not always have a clear structure regarding their path and
cash flows.
3. Competitors also have real options, which can alter the value of your options
by altering the underlying assumptions and environment that serves as the
basis of your valuation.

Given these limitations, real options are not always the best approach when
valuing projects.

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 Thank You

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