Agenda

Real Options: Overview
James Alleman
University of Colorado & PHB Hagler Bailly, Inc.

Investment Theory Real Options Approach Uncertainties Implications for Economics Conclusions

Copyright © 1998 & 1999, James Alleman. All Rights Reserved. James Alleman University of Colorado

Overview

Agenda

"The new view of investment opportunities as options …. has shown that the traditional "net present value" rule can give very wrong answers."
Dixit & Pindyck Investment under Uncertainty, page ix
James Alleman University of Colorado

Investment Theory
Olde Tyme View Decision Tree Analysis

James Alleman

University of Colorado

Investment Theory: Olde Tyme View

Investment Theory: Olde Tyme View

Investment Valuation:
Net Discounted Present Value Jorgenson's User cost of capital Tobin's q

Traditional DCF
Management's flexibility not captured
Adapt Revise decisions

Dixit & Pindyck Investment under Uncertainty, Chapters 1 & 2
James Alleman University of Colorado James Alleman University of Colorado

1-6

summed over t = 0. "r" Constant Constant discount rate over time Opportunity cost of capital James Alleman University of Colorado James Alleman University of Colorado 7-12 . invest Also called NDPV or DPV or PV DPV = ΣCF /(1 + r) t=0 i T t James Alleman University of Colorado James Alleman University of Colorado Olde Tyme: Discounted Value Investment Theory: DCF Discounted Present Value DPV = ΣCFi /(1 + r)t . T What is the appropriate risk-adjusted discount rate? One based on a comparable security.Investment Theory: Olde Tyme View Investment Theory Traditional DCF Management's flexibility not captured adapt revise decisions Traditional DCF Real world Change Uncertainty Competitive interactions DCF Static operating strategy Cash flows are projected with certainty Discount rate accounts for uncertainty James Alleman University of Colorado James Alleman University of Colorado Investment Theory Investment Theory: Olde Tyme View Traditional DCF Real world New information Flexibility to alter strategy Flexibility similar to financial options Modelled with financial option tools Traditional Discounted Present Value DPV > 0.

Investment Theory: DTA Investment Theory: DTA q2 q1 1 .q1 I0 = $ 104 rf = 8% ra = 20% q1= .q3 James Alleman University of Colorado James Alleman University of Colorado 13-18 .q1 Σ(CFj )/(1+ra)t University of Colorado James Alleman University of Colorado ∞ James Alleman Investment Theory: DTA q2 Investment Theory: DTA.q1 1 . example go q1 q1 1 .q1 1 .q2 q3 1 .q3 Investment Theory Olde Tyme View Decision-tree Analysis (DTA) James Alleman University of Colorado James Alleman University of Colorado Investment Theory: DTA Investment Theory: DTA <I0> q1 Σ(CFi )/(1 + ra)t t=1 t=1 ∞ Ex Ante Decision Expected Value of DTA Risk-adjusted Rate? 1 .q2 stop q3 1 .5 1 .

08)] = $ 67.$104 =<$4> James Alleman James Alleman University of Colorado Investment Theory: DTA.$ 104(1.Investment Theory: DTA q1 = .5 1 Investment Theory: DTA.5($240)/(1+.q1 t=1 Σ($60)/(1+.2)1 = = $100 .68 max[$ 60 .2)1 t=1 1 . example T=1 <$104> q1 Σ($180)/(1+. example Opportunity Cost of Capital Wait one period: max[$180 .2)1 University of Colorado 1 DCF = .08)] = $ 0.$ 104(1.$ 104 + .00 James Alleman University of Colorado Divine Discount Rate!? Options Pricing Model Security of equivalent risk Calculate implied rate James Alleman University of Colorado Real Options Approach Real Options Approach Investment Theory Real Options Approach Definition Characteristics Investment characteristics Option definition The "right" to purchase an asset in the future but not the obligation Uncertainty of future Asymmetry of returns James Alleman University of Colorado James Alleman University of Colorado 19-24 .

125 James Alleman University of Colorado Uncertainty Contingent Decision Value of stock Exercise price Expiration Uncertainty of value Riskless interest Call Options v. (1996) James Alleman University of Colorado 25-30 .Real Options Approach Value of Option Value of Options $14 $12 $10 $8 $6 $4 $2 $0 $50 $70 $90 Stock price $110 $130 Options characteristic Time limited "Killed" or exercised terminates Value: max(V . Real Options Search for Tailored solutions Way of thinking Stock price Exercise price Expiration Variance of return Risk-free RoR Specified in contract Off the shelf ` software Output: $'s Amram and Kubtibka.0) James Alleman University of Colorado James Alleman University of Colorado Non-linear Call Option v. (1996) James Alleman University of Colorado Financial v. Real Options PV of E(CF) Investment costs Opportunity goes Project value uncertainty Riskless interest Trigeorgis (1996). Investment PV of assets Expenditure Deferral Riskiness Time value of money Amram and Kubtibka. p.Ix.

8 ($20) = $36 $20 = [.5 1 .q1 =.5 James Alleman University of Colorado James Alleman University of Colorado Investment Theory: RO Comparable Security Investment Theory: RO uS = 1.5 dS = 0.q1 =.q1 =.5 S = $20 uS = 1.5 S = $20 q1 =.6 ($20) = $12 1 .8 ($20) = $36 q1 =.5 ($36) + .Types of Real Options Investment Theory: DTA Natural Option to defer a capital investment Option to abandon What is the appropriate risk-adjusted discount rate? Planned for and created Research & development New services/products Alter investment levels As state of nature revealed James Alleman University of Colorado James Alleman University of Colorado Investment Theory: DTA Investment Theory: RO What is the appropriate risk-adjusted discount rate? <$104> $180 Enter Real Options! q1 =.5 $60 1 .6 ($20) = $12 University of Colorado James Alleman University of Colorado James Alleman 31-36 .5($12)]/(1+r) dS = 0.

(1+ rf)B = $ 0.$104(1.20)} .5($60)]/(1+.5 max [V.20)} University of Colorado Investment Theory: RO Investment Theory: RO defer $180 max [V.68 q1 =.(1+ rf)B = $ 0.5($180) + .08) = $67.Investment Theory: RO $180 <$104> $60 DCF = Σ[(qit)CFit/]/(1+ r) t = {[.$104(1. & rf = 8% B = $31.0] =0 $180 go start $60 stop defer DCF = <$4> DCF = 0 DCF = ? James Alleman University of Colorado James Alleman University of Colorado Twin Portfolio Twin Portfolio m(uS) .00 uS = $36.68 m(dS) .(1+ rf)B = $67.00 m(uS) .08).5($60)]/(1+.0] = [$60 .68 m(dS) .$104 James Alleman University of Colorado James Alleman $180 <$104> $60 DCF = Σ[(qit)CFit/]/(1+ r) t = . dS =$12.82 shares James Alleman University of Colorado James Alleman University of Colorado 37-42 .(1+ rf)B = $67.$104 + {[.5($180) + .33 and m = 2.0] = $180 .

00 uS = $36.0] = $180 .(-$ 4) = $29.(1+ rf)B = $ 0.$104(1.20 James Alleman University of Colorado James Alleman defer max [V.82 shares Option Value = mS .0] = [$60 .07 James Alleman University of Colorado Value of Option to Delay = Expanded .68 q1 =.$104(1.B = $25. dS =$12.00 B = $31.0] =0 DCF = Σ[(qit)CFit/]/(1+ r)t = [.20) = $28. example m(uS) .5 max [V.5($67.Twin Portfolio Investment Theory: DTA.82 shares mS .B .68 m(uS) .33 and m = 2.08).20 University of Colorado Benefits of Option Real Options Approach: Flexibility Total Risk Addressed Avoids Mis-valuation Market Disciple Compatible Evaluation Defer Expand Abandon Start up (Shut down) James Alleman University of Colorado James Alleman University of Colorado 43-48 .(1+ rf)B = $67.static DCF James Alleman University of Colorado Twin Portfolio Investment Theory: RO m(uS) .DCF = $25.5($0)]/(1 .68) + .07 . & rf = 8% B = $31.(1+ rf)B = $ 0.08) = $67.68 m(uS) .33 and m = 2.07 > $28.(1+ rf)B = $67.

if the DCF plus the Option Value > 0. invest James Alleman University of Colorado James Alleman University of Colorado Agenda Uncertainties Investment Theory Real Options Approach Uncertainties Regulation/Legislative Competition Technologies Costs Market James Alleman University of Colorado James Alleman University of Colorado 49-54 .e.Real Options Approach: Defer Real Options Approach Investment Characteristics Irreversibility Uncertainty Timing Irreversibility Investments become sunk cost (irreversible) when: Firm or Industry specific Regulations/laws Partially irreversible. Chapters 1 & 2 James Alleman University of Colorado James Alleman University of Colorado Real Options Approach Real Options Approach Irreversibility Waiting Preempt investments preclude Cost of delay Competitive entry Foregone revenues Opportunity cost of option Include in valuation i. "lemons" Dixit & Pindyck Investment under Uncertainty.

Regulation/Legislative Competition Traditional: ATT/MFS/TPG Incumbent's reaction(s) Cable's Strategies Entry into exchange market Broadband modems James Alleman University of Colorado Uncertainties Uncertainties Regulation/Legislative Competition Technologies Wireless impact WinStar Wireless local loop Regulation/Legislative Competition Technologies Costs Spectrum costs Unbundled Network Elements Right of way Leases James Alleman University of Colorado ISP/Packet Network versus circuit James Alleman University of Colorado Uncertainties Agenda Regulation/Legislative . Costs Market Product acceptance Price and cross-elasticities Size Growth James Alleman University of Colorado Investment Theory Real Options Approach Uncertainties Implications for Estimation James Alleman University of Colorado 55-60 ...Uncertainties Uncertainties Regulation/Legislative Courts: Suspension of FCC Orders Regulation: Decisions on RBOC LD Legislative: Re-regulation of Cable etc.

Implications for Estimation Implications for Estimation Investment Function Most obvious impact Interest Rates High hurdle rates (3. not exit Price substantially above LRAC. Invest James Alleman University of Colorado James Alleman University of Colorado Implications for Estimation Implications for Estimation Specification Based on theory Available information Specification Desirable Properties Theoretically plausibility Compatible with economic theory Describes the phenomenon James Alleman University of Colorado James Alleman University of Colorado Implications for Estimation Implications for Estimation Economic Theory Basis for estimation Not data mining Lagged Variables Stock Adjustment Models Koyck Nerlove's Partial Adjustment Adaptive Expectations James Alleman University of Colorado James Alleman University of Colorado 61-66 .4 times expectation) Limited stimulation effect Specification Desirable Properties Economic Theory Shutdown point invalid Price below AVC.

James Alleman.Agenda Conclusions Investment Theory Real Options Approach Uncertainties Implications for Estimation Conclusions DPV & DTA Inadequate Economic Models Redefined Implications for Estimation James Alleman University of Colorado James Alleman University of Colorado Summary/Conclusions Summary/Conclusions DPV & DTA Inadequate No dynamics Risk adjusted rate? No Uncertainties No Options Valuation DPV & DTA Inadequate Economic Models Redefined Inadequate Specifications Alternative view of dynamics Implications for models Rethink models James Alleman University of Colorado James Alleman University of Colorado Conclusions DPV & DTA Inadequate Economic Models Redefined Implications for Estimation Inadequate Specifications Investment estimations Lagged models Others? James Alleman University of Colorado Real Options: Overview James Alleman University of Colorado & PHB Hagler Bailly. All Rights Reserved. Inc. 67-72 . Copyright © 1998 & 1999.