Real options valuation

9
9.1 Introduction
The real options valuation is a dynamic approach to valuation in terms of flexibility
and growth opportunities. The real options approach is an extension of financial
options theory. Options are contingent decisions that provide an opportunity to
make decisions after uncertainty become relevant. Uncertainty and the firm’s ability
to respond in terms of flexibility are the sources of value of an option. The invest-
ment opportunities can be considered as corporate real options, which are integral
for corporate resource allocation and planning. The opportunity to invest can
be considered as a call option, which involve the right to acquire an asset for a
specified price (investment outlay) in a future period. The underlying asset can be
embedded corporate real options to expand production scale, delay the production,
or abandon a project. The values derived from the options pricing help the
management to set the course for future plans to capitalize on favorable investment
opportunities by expansion. Similarly, if the situation is undesirable, the investment
can be abandonment. The option to delay flexibility for a firm is an important
criteria for the evaluation of many investment opportunities under uncertainty. The
decision to delay an investment project would be based on the assumption that new
information would affect the desirability of the investment and the value of the
project increases if the option to delay is exercised. If the market conditions turn
out to be unfavorable, then management has the option to discontinue the project.
The option to delay a project is valuable when the project have a premium over the
zero NPV value. The ability of the option-pricing theory to quantify flexibility in
strategic investment projects is advocated by practitioners. A number of strategic
decisions can be considered as real options. Investments in computer business,
valuation of an aircraft purchase option, development of commercial real estate are
all examples for real options before firms. Mining companies might acquire rights
to an ore mine, which could be turned profitable if the price of products increases.
The development of a worn-out farmland would become a strategic option for a
real-estate developer to build a shopping mall if a new highway becomes feasible
in the region (Brealey et al., 2008). The acquisition of patent to market a new drug
is a viable strategic option for a pharmaceutical company.
The value of flexibility of an investment project is basically a collection of real
options, which can be valued with the techniques estimated for financial options.
Strategic investment options by pioneering firms like development of technology
provide such firms with cost or timing advantage, which could lead into value
creation. Valuation of a gold mine concession license to develop a mine can be
considered as considered as analogous to the valuation of a simple call option.
The multistage R&D Investment can be considered as a compound option.

Valuation.
© 2016 Elsevier Inc. All rights reserved.
228 Valuation

Pioneering firms that make strategic investments on a large scale in a new

geographic market have first mover advantage and competitors would have to
overcome entry barriers to reach out to the market. In this context, the option before
the competitor firms is to delay its entry into the market or stay out to avoid market
share war. In this context, the strategic project can lead to higher term profits for
the pioneer firm. In high-effort R&D projects, flexibility effect is a relevant factor
in option valuation. The scenario in which management has to wait to invest in
business under uncertain conditions results in flexibility effect. Flexibility is
an integral component of value for many investment projects and option pricing
framework is a useful tool for analyzing such flexibility.

9.2 Real options as strategic investments

Strategic investments facilitate firms to invest or divest in subsequent periods of
time on the basis of new opportunities. Similar to financial options, these strategic
investments provide the firms different options on the future market conditions.
These strategic options which are based on value of real assets called strategic real
options. Unlike financial options, real options require the purchase the sale or
restructuring of the real or nonfinancial assets. These investment opportunities also
involve investment in intangibles like Intellectual Property Rights and Patents.
Amazon has the ability to adapt rapidly to the digital business environment.
Amazon is more than an Internet book seller as it delivers a broad range of products
to customers. Amazon provided a wide range of IT-based business initiatives in
collaboration with other firms. Amazon developed the ability to acquire strategic
digital options and nurture them by capitalizing on those likely to prove successful
while exercising discipline to eliminate nonprofitable ones. Lotus’s development of
notes illustrates the importance of organizational architecture as a strategic initiative
to capture the value of options (Kulatilaka and Venkatraman, 2001).
Future growth opportunities are considered analogous to ordinary call options
on securities. Derivative options give the owner the right (no obligation) to buy a
security at a fixed predetermined price (exercise price) on or before the fixed date
(maturity date). By way of analogy, an opportunity to undertake capital investment
in productive assets like plant, equipment, or brand names at some future point in
time is termed as call option on real assets or growth option. The cost of investment
is the option’s exercise price. Current investment may affect future opportunities
by creating growth opportunities. The value of the option is the present value of
the expected cash flows plus the value of new growth opportunities. The value
of growth options can be estimated as the difference between the total market
capitalization of a firm and its capitalized value of its earnings, which includes
estimated earnings. Growth options are more valuable for small high-growth
companies that market innovative products. At the time of its Initial Public
Offering (IPO), Genentech had revenues of $9 million. The IPO was priced at $35
Real options valuation 229

per share. After listing, its market capitalization value was $262 million, which was
basically attributed to the value of the growth option (Kester, 1984).
Myers (1987) suggests strategic investment opportunities as growth options.
Dixit and Pindyck (1994) provide various expositions to the real options approach
to investment.

9.3 Limitations of discounted cash flow methods

The major drawback of discounted cash flow valuation is that discounted cash flow
valuation assumes that the future firm decisions are fixed at the beginning and
ignores the flexibility in decision making during the course of the investment
project. Moreover when there are exit options in the investment project, the choice
of an appropriate discount rate for NPV calculation is a challenging task. The risk
neutral valuation or certainty equivalent approach can effectively capture the
flexibility embedded in real options valuation. The NPV method have major
shortcomings in analyzing projects when future decisions are contingent on
intermediate developments in a uncertain environment. Option theory provides a
better analytical tool to evaluate such projects.

9.4 Different types of real options

Real option analysis deals with investments in real tangible assets where the sponsors
have multiple options to continue or abandon the project. Basically, there are three
main types of options associated with investment projects. They are the option to
postpone or delay, the option to expand, and the option to abandon. Another variation
of abandonment option is to temporarily suspend an investment.

9.4.1 The option to delay

The option to delay becomes valuable when an investment project that has a
negative NPV presently will have a positive NPV in future as the riskiness of the
project and cash flow may change due to new changes in the scenario. A project
with exclusive rights that have negative NPV today might still be valuable on
account of the option characteristics. The option to delay can be valued using the
binomial option pricing model. Generally, the Black Scholes model is applied for
valuation of options to delay. Examples include patents for pharmaceutical firms.
A product patent provides a firm with exclusive right to develop and market a prod-
uct and can be considered as a real option. The value of the firm can be estimated
as the value of commercial products plus the value of existing patents plus the value
of options to obtain new patents in future minus the cost of obtaining these patents.
The strategic decision to develop the undeveloped reserves of the natural resource
oil and mining companies can also be considered as options. In this case, the
230 Valuation

variables required for estimation of value of option include available reserves of the
resource, estimated cost of developing the resource, time of expiration of option,
variance in value of underlying asset, and the cost of delay. By using the Black
Scholes model, the value of the option to delay can be estimated as a call option.

9.4.2 Option to expand

Firms can exercise options to expand for further investments or enter into a new
market. Entering a large market or acquisition of a proprietary technology can be
viewed as an option to expand. Options to expand are valued as call option.
Consider the case of a firm with two projects—one initial project and the other
the final project. The initial project may result in negative NPV, but the second
project may be conditional on the initial project as it is a project for expansion.
In another case, if the initial investment becomes successful, the firm can exercise
the option to expand its market by entering into a new geographic market. An initial
investment could serve as a platform to extend a company’s scope into related mar-
ket opportunities. For example, Amazon’s huge investment to develop its customer
base, brand name, and information infrastructure for its core book business created
a portfolio of real option for expansion into a variety of businesses (Rappaport and
Michael, 2001).

9.4.3 Abandonment option

The option to abandon a project is valuable in research and development as it
provides the flexibility to abandon a project in the presence of negative results. An
abandonment option can be applicable in the valuation of pharmaceutical firms
on account of procedures used by pharmaceutical researchers and high costs involved
in the development stages. In the context of dotcom bubble, many dotcom firms exer-
cised abandoned options. In abandonment option, firms have to bail out and recover
the value of the project’s plant, equipment, or other assets. The option to abandon is
equivalent to a put option. The abandonment option is exercised when the value
recovered from the disposal of project’s assets is greater than the present value of
continuing the project. Abandonment options can be valued with binomial method.

9.5 Solution approach to option valuation

The three main solution methods for option valuation are the dynamic programming
approach, partial differential equations, and the simulation approach. The dynamic
programming techniques involve finding out possible future outcomes and the value
of the optimal future strategy using the risk neutral distributions. The partial differ-
ential equations (PDE) is a flexible method in which the PDE has to be solved
numerically. Simulation approach to option valuation is applicable for American
option. The most important tool for valuing real options valuation problems is the
Real options valuation 231

simulation approach. Simulation approach can be easily applied to multifactor

models and path-dependent problems. The real options approach are applicable to
natural resource investments and pharmaceutical R&D investments. Option-pricing
methods were first developed to value financial options. Then it was applied to
value options on real assets.
Schwartz (2013) proposed a model on the Black Scholes option pricing
framework which was extended by Merton (1972) and Cox and Ross (1976) to
value commodity-linked bonds.

9.6 Real options in different industry sectors

Real options valuation in R&D Investment projects is mainly applicable in pharma-
ceutical industry. The new drug development in the pharma industry is characterized
by a number of public policy issues like financing of research, cost of product devel-
opment, prices charged for its products, and patent protection. There exist a trade-off
between promoting innovative efforts and securing competitive market outcomes.
Regulation also has important effects on the cost of innovation in the pharmaceutical
industry. The average span of new drug development is between 10 and 12 years. In
the United States, the average time from discovery to Food and Drug Administration
approval is around 15 years. The odds of a compound making it through this process
are around one in 10,000, while the cost of getting it through is around $200 million.
The cost of research process is increasing significantly as many of the drugs are
focusing on complex and difficult targets. There is also a high probability of failure
for either technical or economic reasons. Approximately, 80% of projects that start
clinical trials are later abandoned. The economic reasons comprise the high cost of
production and inefficacy of the drugs. Even if the drug have been approved, there is
uncertainty about the level and duration of future cash flows as the time to complete
and length of the patent are also uncertain.
Real options valuation is applicable in natural resources investment projects. The
valuation of mining and other natural resources project have option characteristics
as traditional valuation methods are difficult on account of uncertainty of output
prices. The techniques of continuous-time arbitrage and stochastic control theory
may be used to value natural resources investment projects and to determine
optimal policies for development, management, and abandonment of such projects.
In natural resources, industries price swings in the range of 25
40% is commonly
observed.
In technological innovation-based firms, investors’ expectations are formed on
the basis of timings and significance of future innovations. Firms in the technology
market have the option to adopt the new innovation or wait to adopt new technolo-
gies that are evolved in the near future, which could be more valuable. Firms in the
rapidly changing high-technology markets are faced with valuable innovations,
which are undergoing volatile and unpredictable change. These types of changes
are relevant in a number of sectors like computer and semiconductor industry.
232 Valuation

A firm have the option to choose a current version of innovation or wait to respond
to future technological innovations. Bypassing a current innovation to wait for
future innovation can result in the firm losing important learning that results from
using the technological innovations (Grenadier and Weiss, 1995).
Offshore oil and gas industry often faces decision problems with respect to
timing option. Companies buy licenses from government to explore and develop oil
fields. The exploration phase involves the estimation of the amount and quantity of
oil and gas reserves within that sector. The license for exploration usually expires
after a certain time. When the exploration time expires, the oil companies have
three possible option strategies. The firm can abandon the project and return the
field to the government. The next strategy of action could be to start and develop
the reserve immediately. The third strategy would be to postpone development and
thus extend the exploration phase. In order to extend the exploration phase, the
company have to undertake further drilling at additional costs. The first two options
can be analyzed on the basis of NPV analysis as it does not contain any real option.
The third alternative provides an option to the management to postpone the invest-
ment and wait for the oil prices to increase. The deferment of investment could
lead to higher NPV in the future due to increase in oil prices. If the NPV is negative
initially, the firm could exercise the option to wait, which finally may result in posi-
tive NPV. Discounted cash flow analysis assumes that project starts immediately
without considering future NPV. The risk of an option changes over time with
changing prices. Decision tree analysis (DTA) can be used as a basic framework to
determine the value of options embedded in the investment project (Kemna, 1993).
When the oil company decides to postpone the investment, it is exercising the
option to delay by incurring the costs of extra drilling. The oil firm buys the right
to start development at the expiration date of the extended license. The benefit of
exercising the option at the expiration date is the market value of the developed
project. The cost is equal to the investment outlay. The option to wait is similar to
a European call option on an installed project with maturity date.
Consider a case in which the management have decided to abandon crude
distiller in a refinery as the supply of distillates from crude oil has exceeded the
demand. This case can be considered as an option to abandon and valued as a
put option.

9.7 Factors affecting the value of real growth options

The NPV of an investment opportunity is estimated as the present value of the
project’s cash inflow minus the present value of its outflow. The major factors that
affect the value of the growth option are the length of time the project could be
deferred; project risk, level of interest rates, and the exclusivity of owner’s rights to
exercise the option. The option to delay a project gives the decision maker
the flexibility to examine the course of future events and avoid errors if unfavorable
scenarios occur. During the deferred time interval, positive turn of events can make
Real options valuation 233

the investment project more profitable. In this context it can be argued that the
longer a project can be deferred, the more valuable the growth option will be. Thus
the firm’s investment opportunity with negative NPV currently (out of money
growth option) can delay the investment (option to delay) so that in future it becomes
in the money growth option. Project risk is an important determinant of the value of
a firm’s growth option. Higher the risk or variance of a growth option, higher would
be the value of the option. Higher interest lowers the value of an option. Exclusivity
of owner’s right to exercise the option is also an important determinant of value of a
growth option. In this context, two types of growth options can be highlighted—the
proprietary and the shared options. Proprietary options results from patents possessed
by the firm or a firm’s unique knowledge of a market or a superior technology
difficult to be imitated by competitors. Shared growth options represent collective
opportunities of industry sectors, which could generate cash flow opportunities.
Proprietary growth options are more valuable than shared growth options since
counter investments in shared options by different firms can reduce or preempt
profits. Compound growth options might become more valuable than simple growth
options. A simple growth option requires the evaluation of only one cash flow from
one investment opportunity while compound growth option involves estimation
and valuation of cash flows from different investment opportunities like R&D
investments, expansion into existing and new markets.
Strategic investments, which could lead to future comparative advantage, may
be investments in research to develop new technology, advertisement investments
that increases brand awareness and recognition, organizational and logistic
planning, which would result in lower cost in building production capacity.

9.8 Real options in mergers and acquisitions

The operating synergies acquiring from a merger can be valued as a real option
(Kinnunen). The target firm’s value is equal to the value of existing assets plus the
value of the future growth opportunities. The value of these synergistic future
growth opportunities can be valued as real options (Collan and Kinnunen). The
major sources of value for the target firm are the cash flows from economic capital,
strategic capital consisting of intangibles, and human capital. The strategic capital
can be valued as real options (Luehrman, 1998). The synergies are dependent on
management decisions on the redeployments and additional investments. Real
options in mergers and acquisitions can be valued using DTA and Black Scholes
model (Kulatillaka and Perotti, 1998). The options to expand, delay, and abandon
exist for an acquirer firm. An acquirer can use the option to delay to purchase addi-
tional stakes in the target firm. If the bidding for a target firm turns competitive due
to simultaneous bidding by number of acquirers, acquirers have the option to aban-
don the bid if the proposal is not attractive. Examples of option to delay or abandon
include scenarios like an acquiring firm choosing to delay a merger due to outstand-
ing litigation or delay in regulatory approval. General Electric Honeywell deal was
234 Valuation

opposed by the European Union regulatory commission. When GE found the deal
unattractive, it abandoned the option to acquire Honeywell UK. The due diligence of
the potential target enables acquirer firms to take optimal decision regarding the
option to acquire or postpone the acquisition. The time the options are available may
be limited by the existence of competing bidders.

9.9 Empirical studies on real options

Black and Scholes (1973) introduced the option pricing formulae for European
financial options. Myers (1977) suggests that growth opportunities can be viewed
as real options whose value depends on future investment by firms. The general the-
ory of real options have been discussed by studies of McDonald and Siegel (1986),
Majd and Pindyck (1987), and Dixit (1989). Real option valuation of interrelated
projects are found in studies by Trigeorgis (1993). The study by Ekern (1985) and
Paddock et al. (1988) apply real-option analysis to petroleum sector. Brennan et al.
(1985) discusses real option in natural resources. Benaroch and Kauffman (1999)
examines real option application in information technology. Kester (1984) suggests
that the difference between the total value of a firm’s equity and the capitalized
value of its current earnings stream estimates the value of its growth options.
McDonald et al. (1986) suggest that the option to delay investments is significant
in corporate acquisition based on a rule for timing of acquisition investment with
the practical intention to minimize the lost NPV of suboptimal investment
financing. Smith and Triantis (1995) suggest that the success of an acquisition
program is determined by the options acquired, created, or developed and the
actions taken for the optimal exercise of these options. The study suggest three
classes of real options important in acquisitions: growth options, flexibility options,
and divestiture options. Dapena and Fidalgo (2003) analyzes embedded options in
tender offers and acquisitions. The study calculates the value of control premium
and presents a model for optimal acquisition timing.
Smit et al. (2005) research the distribution of value gains in acquisitions with
a real options game model that examines the bidding process, the likelihood of a
bidding contest (war), and the expected value distribution for the acquirer. Alvarez
and Stenbacka (2006) focus on the option to divest parts of the acquired company.
The study suggest divestment option as an embedded sequential option.

9.10 Real option valuation using decision tree approach

The discrete-time approach to real option valuation has typically been implemented
in the finance literature using a binomial lattice framework (Brandão et al., 2005).
Real option valuation problems can be solved by using binomial decision tree to
determine the cash flows and probabilities that give the correct project values when
discounted to each period and to each uncertain state. Project flexibilities, or real
Real options valuation 235

options, can then be modeled easily as decisions that affect these cash flows. In the
decision tree approach, binomial lattice is augmented with decision nodes to represent
investment alternatives. A binomial lattice can be viewed as a probability tree with
binary chance branches, with the feature that the outcome resulting from moving up u
and then down d in value is the same as the outcome from moving down and then up.
Thus, this probability tree is recombining, since there are numerous paths to the same
outcomes, which significantly reduces the number of nodes in the lattice. The backward
induction is used to determine optimal exercise strategy and associated option value.
The binomial lattice model can be used to accurately approximate solutions from
the Black
Scholes Merton continuous-time valuation model for financial options, with
the added advantage of allowing a solution for the value of early-exercise American
options, whereas the Black
Scholes
Merton model can value only European options.
DTA can be used to model managerial flexibility in discrete time by constructing a tree
with decision nodes that represent decisions the manager can make to maximize the
value of the project as uncertainties are resolved over the project’s life.

9.11 Real option valuation using Black Scholes model

The basic formula for valuing a call option is given by the formula:

CðS; tÞ 5 Nðd1 ÞS 2 Nðd2 ÞKe2rðT2tÞ

2 0 1 0 1 3
1 S σ 2
d1 5 pffiffiffiffiffiffiffiffiffiffi 4in @ A 1 @r 1 AðT 2 tÞ5
σ T2t K 2
2 0 1 0 1 3
1 S σ 2
d2 5 pffiffiffiffiffiffiffiffiffiffi 4in @ A 1 @r 2 AðT 2 tÞ5
σ T2t K 2
pffiffiffiffiffiffiffiffiffiffi
5 d1 2 σ T 2 t

N(.) is the cumulative distribution function of the standard normal distribution.

T 2 t is the time to maturity. S is the spot price of the underlying asset. K is
the strike price. r is the risk free rate and σ is the volatility of returns of the
underlying asset.

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