Tutorial on Real Options

A company owns and operates an old inefficient power station. A major problem has just
developed at the plant which will needs to be repaired for the plant to continue operating. The
cost of repairs is $600 000, which would keep the plant running for another year, at which
time even more expensive repairs would be required. However, the operating profit (not
including the cost of the repairs from keeping the plant in operation) has a net present value of
only $500 000. If these were the only considerations then the company would shut down the
power plant as a major overhaul is required in a year’s time and the cost of this overhaul
would be larger than the NPV of the future income of the plant.

The government where the power plant is located is planning to join a multinational carbon
trading scheme in one year’s time. The power plant will need carbon credits to continue
running after that time. The amount of carbon credits it requires has a current market value of
$1 000 000. The government has promised the company that when the carbon trading scheme
starts in one year’s time that it will give the company the right to buy those carbon credits at
$1 000 000 no matter what the market price will be if the power plant is still operating.

There is nothing to stop the plant from shutting down and selling its carbon credits as soon as
it buys them or not buying them from the government if the market price drops. The price of
the carbon credits has been quite volatile. The prices at the end of each quarter that the market
has been operating are given in the table below. The risk free rate is 3%.

$30 $35 $32 $25 $29 $33 $27 $31 $36 $37

Should the company continue operating the power plant so that it retains the rights to buy the
carbon credits? Solve the problem using a binomial lattice with 4 time steps.

Solution

Effectively this problem simplifies to spending $600 000 - $500 000 = $100 000 for an
European option with an exercise price of $1 000 000 to purchase carbon credits currently
worth $1 000 000 in one year’s time.

First we need to determine the volatility. Step one is to take the ratio between successive
prices and take their logarithms:

P0 P1 P2 P3 P4 P5 P6 P7 P8 P9
$30 $35 $32 $25 $29 $33 $27 $31 $36 $37
y1 y2 y3 y4 y5 y6 y7 y8 y9
0.1542 -0.09 -0.247 0.1484 0.1292 -0.201 0.1382 0.1495 0.0274

Step two is to calculate the mean = 0.023

Engineering Economics Real Options – Tutorial Solution Page 1 of 3

Step three is to calculate the volatility:
∑ = 0.162

This is the quarterly volatility. To get the annual volatility then since there are 4 quarters in a
year we multiply it by √4 and get 0.323.

Next we work out the time step ∆ 0.25.

Now we determine the up and down movements that the value of the carbon credits could
take:
√∆ .
1.175
1 √∆ 0.851

And the probabilities of the price moving up and down

∆ . .
0.851
0.483
1.175 0.851

1 0.517

Now we set up the binomial tree. Firstly calculate the values of the carbon credits themselves
starting at the left of the tree ($1 000 000) and multiplying by u to go up in the next column or
by d to go down.
(u * d = 1, therefore all entries in, for example, the middle row are 1 000 000)

$1,909,005.92
$1,624,072.66
$1,381,667.80 $1,381,667.80
$1,175,443.66 $1,175,443.66
$1,000,000.00 $1,000,000.00 $1,000,000.00
$850,742.60 $850,742.60
$723,762.97 $723,762.97
$615,736.00
$523,832.84

Next we determine the option values. First we determine the option values in the right hand
side using the maximum of the carbon credit price minus the exercise price or zero. For
example the highest carbon credit price in the right hand column of the table above is $1 909
005. Since the company has the right to buy these credits for $1 000 000 the option value
would be $909 005. The lowest carbon credit price in the right hand column of the table
above is $523 833. This is below $1 000 000 so the option value is zero. The remainder of the
option values are determined similar to the calculations in a decision tree using P(u) and P(d)
above except that they need to be discounted for the time value of money. For example the
$617 621.65 at the top of the second last column is calculated using:

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 ∆

. .
$631544.61 $909005.92 0.483 $381667.80 0.517

Note that ert is the limit for the compound interest formula (1 + r/n)t*n as n tends to infinity (ie
interest is compounded each second) where r is the annual interest rate, t is the number of
years and n is the number of compounding periods per year. The negative sign in from of r
means we are dividing by this number (as required by the present value calculation).

Also note that ∆ is in a square root when associated with volatility, but not when associated
with the interest rate.

909005.9205
631544.6092
396555.8644 381667.804
235045.9208 182915.6078
134210.6506 87662.93417 0
42012.76271 0
0 0
0
0

Based on this the current value of the option is $134 210, which is bigger than the $100 000
from continuing to operate the power plant. Thus if the company that owns the power plant is
risk neutral then it should do the repairs and keep operating for the year so that it has the
option to buy the carbon credits if the market price is favourable at that time.

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