V O L U M E 1 7 | N U M B E R 2 | SP R I N G 2005

Journal of

APPLIED CORPORATE FINANCE
A MO RG A N S TA N L E Y P U B L I C AT I O N

In This Issue: Real Options and Corporate Strategy
Realizing the Potential of Real Options: Does Theory Meet Practice? Real Options Analysis: Where Are the Emperor’s Clothes? Real Options: Meeting the Georgetown Challenge
8 17 32

Alexander Triantis, University of Maryland Adam Borison, Stratelytics Thomas E. Copeland and Vladimir Antikarov, Monitor Group

A Response to “Real Options: Meeting the Georgetown Challenge” Valuing Assets Using Real Options: An Application to Deregulated Electricity Markets

52 55

Adam Borison, Stratelytics Gregory P. Swinand, London Economics and Indecon, Carlos Rufin, Babson College, and Chetan Sharma, Cinergy Corporation

The Challenge of Valuing Patents and Early-Stage Technologies The Decline and Fall of Joint Ventures: How JVs Became Unpopular and Why That Could Change Managing Operational Flexibility in Investment Decisions: The Case of Intel

68 82

Martha Amram, Growth Options Insights Dieter Turowski, Morgan Stanley & Co. Limited

87

Peter Miller, London School of Economics and Political Science, and Ted O’Leary, University of Manchester (UK) and University of Michigan

Taking Real Options Beyond the Black Box The Option Value of Acquiring Information in an Oilfield Production Enhancement Project

94 99

Simon Woolley and Fabio Cannizzo, BP Margaret Armstrong, École des Mines de Paris, and William Bailey and Benoît Couët, Schlumberger-Doll Research

Value-Based Management in Biosciences Research and Development Valuing Pharma R&D: The Catch-22 of DCF

105 113

Gill Eapen, Decision Options, LLC Ralph Villiger and Boris Bogdan, Avance

While my model is simple. In my review. I considered these adjustments in my review. or for any other assets or liabilities. along the lines mentioned by Copeland and Antikarov. not an adjusted security or a portion of a security. Copeland and Antikarov describe adjustments that could be made to these approaches to align their results. Most importantly. but these are not substantially different from those outlined by other authors. and Copeland himself (in the second edition of his book Valuation). Use of “Undocumented Adjustments” The primary purpose of my article is to provide practitioners with a critical review of well-established real options approaches that are extensively documented in the academic and professional literature. there is nothing in the documentation by Amram and Kulatilaka or other authors that calls for this adjustment. different sources of data. Lenos Trigeorgis. different ways of treating uncertainty. and variable costs using reasonable. There is no reference to any adjustments to this security. In addition. including Martha Amram and Nalin Kulatilaka. use different techniques. Copeland and Antikarov note the difficulty in the classic “twin security” approach of finding “a priced security” that is perfectly correlated with the investment. As instructed. In this case. and none includes an adjustment for “equity” rather than an “entity” value. These differences in approach produce A Morgan Stanley Publication • Spring 2005 . A key observation of my article is that these approaches make different assumptions. however. The simplest example involves the classic approach using a twin security and the Black-Scholes algorithm. I followed the steps described by Copeland and Antikarov in their Real Options book. perhaps supported by history. and then to use its unadjusted price and volatility. A key step is the development of a cash flow NPV model of the underlying asset based on subjective data. However. there is nothing in the assumptions of the classic approach that calls for this adjustment. Amram and Kulatilaka discuss adjustments to the cash flows of the real asset for “leakage” and sizing the asset relative to the security. the assumption is that there 52 Journal of Applied Corporate Finance • Volume 17 Number 2 is a traded twin security for the underlying asset. Furthermore. it is unclear to me why one would choose a more complicated approach (such as their MAD approach) over a simple one (such as the “classic” approach). This model produces a different (lower) valuation that is more in line with the other approaches. their paper includes several misunderstandings that I want to correct. However. these adjustments are problematic. Their examples rely on the prices of traded securities. There is nothing in the assumptions or documentation of the MAD approach that argues for the use of a particular NPV cash flow model or a particular piece of data for that model. In their Real Options book. subjective data. Copeland and Antikarov “adjust” my analysis by using the “entity” value of the twin security (with debt) instead of the “equity” value. Specifically. Copeland and Antikarov “adjust” my analysis by developing their own more detailed cash flow model. Given the contradictory assumptions underlying the different approaches. In my article. and a key step is specifying that security and using its market data. Stratelytics I appreciate the attention that Copeland and Antikarov have given my article. The documentation is quite clear that a key step is to identify a traded security or portfolio that most closely resembles the underlying asset.A Response to “Real Options: Meeting the Georgetown Challenge” by Adam Borison. However. different ways of calculating the value of the underlying asset. the approaches are significantly different. their use of “undocumented adjustments” misses my basic point: when applied in a straightforward manner as instructed by their proponents. and more. I developed a simple model of revenues. if the various approaches actually produce comparable results when used properly. The approach presumes the existence of a traded twin security or portfolio for the underlying asset. This approach has been widely publicized and recommended by leading real options authors. I follow the steps described by Amram and Kulatilaka in their Real Options book. and they imply strongly that I (and practitioners as well) should be aware of the need for such an adjustment. The bottom line is that the five approaches I reviewed reflect different assumptions about capital markets. there is no reason to believe that it is biased and no rationale for rejecting it in favor of the cash flow model proposed by Copeland and Antikarov. The MAD approach provides another example. In this case. and produce different results. they do not propose any adjustment to the security for debt. fi xed costs.

Many authors distinguish between investment risks that can be duplicated or hedged in the capital markets (“public risks”) and those that cannot (“private risks”). most public risks have some market correlation. This distinction is critical because public risks have already been priced by capital markets. we use either historical data and assume that the future is like the past. is what to do when the truth underlying a real option problem lies somewhere in the middle—that is. which in turn create a dilemma for the practitioner: whom to believe. It requires analyzing relevant spot. Comparison of Option Pricing and Decision Analysis Copeland and Antikarov purport to demonstrate that real options analysis is superior to decision analysis for evaluating real options problems. The important question. My biggest concern with the MAD approach is that the use of an NPV model in this manner encourages. but it is quite possible to have a zero-beta public risk. A key step is the development of a cash flow NPV model of the underlying asset. A private A Morgan Stanley Publication • Spring 2005 53 . the existence of a twin security. It is not surprising that option pricing is a superior tool for evaluating a problem where all the conditions underlying option pricing hold. Copeland and Antikarov refer to the use of current and historical data to support subjective assessments. none of the five approaches I reviewed takes such a position. just as it is not surprising that decision analysis is a superior tool for evaluating a problem where all the conditions underlying decision analysis hold. Where decision analysis is used in these approaches. but they do not discuss market-priced risks. their comparison actually involves the application of option pricing and decision analysis to a pure option pricing problem in which all the standard option pricing conditions hold. it may or may not be correlated with the economy as a whole. The assumptions and documentation of the MAD approach do not make this distinction between public and private risks. If investments are evaluated using subjective. “We cannot accept any solution for real options that is not arbitrage free. it is used only when the standard conditions underlying option pricing do not hold. the evaluation of the underlying asset and the option will not be arbitrage free.” I agree. The latter include the objective of maximizing expected utility. Nothing in the assumptions and documentation of the MAD approach indicated that this was necessary or recommended. or at least allows. and what to do. come from subjective assessment and history: “In most cases. and inputs move according to non-GBM processes. my NPV model relies on a subjective assessment that gas prices will grow on average at 2% a year. when the objective is maximizing shareholder value. it reflects the arbitrage opportunity created by the use of subjective estimates of market-priced risks in the MAD approach. and option prices to determine the prices that capital markets have already established for an investment’s public risks. non-market assessments of these risks. the absence of markets in the assets under consideration. exchange rates. In practice. However. estimates made by management. Copeland and Antikarov view the 2% increase versus 4% decrease difference as my inconsistency.” There is no reference to the use of capital market data for the model variables. Copeland and Antikarov appear to misunderstand these two terms. Application of No-Arbitrage Conditions to the MAD Approach In reviewing the MAD approach. The data for the variables in this model. Journal of Applied Corporate Finance • Volume 17 Number 2 Copeland and Antikarov state in their paper. James Smith and Robert Nau refer to market and private risks. As it turns out. relevant market data is only partially available. what to believe. Certainly. In their discussion of the integrated approach. but not futures or options. I relied on the description in Copeland and Antikarov’s Real Options book. They indicate that I define a public risk as one that is correlated with the economy and a private risk as one that is uncorrelated with the economy. a public risk is one that can be hedged in the capital markets. and a GBM price process. As noted above. capital markets reflect an expectation of a 4% annual decline. Amram and Kulatilaka refer to private risks and the “tracking error” they cause when looking for a twin security. and treat them differently. the only data taken directly from capital markets is the model’s discount rate. but forward-looking. stock prices). If the investment involves any public risks (commodity prices. Instead. just such arbitrage opportunities. future. and thus do nothing to prevent this form of arbitrage. rather than “papered over” and dismissed. This is the case with most real investments.differences in results. or we use subjective. These differences need to be pointed out and analyzed. These include an objective of maximizing shareholder value. both base estimates and volatilities. and the one that my article is attempting to address. the possibility of arbitrage is introduced. This is incorrect. It is not possible to avoid this simply by comparing subjective assessments to current and historical market prices. This is based on examining historical and current prices. In my example. markets are incomplete so twin securities are largely absent. and limited relevant historical data on the risks. The comparison by Copeland and Antikarov does not really address this fundamental issue. Conclusions Regarding the Integrated Approach The “integrated” approach relies in large part on the distinction between public risk and private risk. No academic or practitioner I am aware of advocates the use of standard decision analysis to address an investment problem involving a twin security.

Public risks are evaluated using capital market data. because of its use of decision trees. there is no single security or portfolio of securities that duplicates the risk. Finally. Thus. the integrated approach is limited to a few. First. Because the integrated approach relies in part on a cash flow NPV model. This leads to the arbitrage problems noted above. sequential uncertainties. Second and more important. thereby eliminating arbitrage. Because it allows for a greater range of stochastic processes. Instead. Copeland and Antikarov mistakenly state that it also relies on the MAD assumption. While there are similarities. In the “keeping uncertainties separate” approach. not (necessarily) sequence. not subjective assessments. make the mistake of assuming that the volatility of the asset is the volatility of any one component or that the replicating portfolio for the entire asset is the replicating portfolio for any one component. as Copeland and Antikarov contend. Components that involve private risks are evaluated using subjective assessments. This is not the case. that is. The integrated approach presumes that the best estimate of value must reflect market prices. the integrated approach can include uncertainties that are resolved simultaneously or sequentially. there are public and private risks. The integrated approach decomposes the uncertainty (or volatility) of the underlying asset into individual components. the integrated approach is more general. 54 Journal of Applied Corporate Finance • Volume 17 Number 2 A Morgan Stanley Publication • Spring 2005 . prices of assets that are actively traded. There is no reason why a subjective assessment of asset value must follow a random walk. Components that involve public risks are evaluated using capital markets. private risks—which are effectively uncorrelated with any and all securities—are treated as uncorrelated with the overall market. there are important differences. In practice. and private risks are evaluated using subjective data. public or private.risk is one that cannot be hedged in the capital markets. they assume that the value of the underlying asset must evolve according to a random walk. while Copeland and Antikarov discuss various stochastic processes for individual uncertainties. of public risks. as I mention in my article. his article is devoted entirely to “properly anticipated” prices—that is. They cite Samuelson’s article to justify this. However. Copeland and Antikarov also indicate that the integrated approach is essentially a simplified version of their own “keeping uncertainties separate” variation of the MAD approach. It does not. the two types of uncertainties are market/economy-correlated and market/economy-uncorrelated. First. the integrated approach treats uncertainties differently. In the integrated approach. the volatility of the entire asset is a function of the volatility of the components. Both are evaluated using subjective data. The MAD approach presumes that the best estimate of value is based on management’s subjective assessments of all risks. defined in terms of the ability to hedge in the capital markets. there is no (arbitrary) limit on the number of risks. Copeland and Antikarov also state incorrectly that. or on the number and timing of decisions. Second. the ordering of uncertainties in a decision tree reflects conditionality.

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