Real Options in

Investment decisions
Yields on projects must consider all value
adding propositions
Real Options
❑ Opportunities to modify projects as the future
unfolds are known as real options
❑ It could be –
1. Follow-on Option
✓ Option to make follow-on investments
2. Deferral Option
✓ Option to wait (and learn) before investing
3. Abandonment Option
✓ Option to abandon
4. Flexibility Option
✓ Option to vary the firm’s output or its production methods
Narain 2
Types of Real Options

Option to Expand
Option to Contract
Option to Abandon
Option to Wait
Option to Switch

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Deferral Option
❑ Also called Investment Timing Options
❑ A call option on the investment projects exercisable
when firm commits to the project
❑ It is often better to defer a positive-NPV project in
order to keep the call alive.
❑ Deferral is most attractive –
– For firms with barriers to entry reducing competition
– When uncertainty is great
– During volatile interest rates being lowered overtime
– Immediate cash flows of postponement is small

Narain 4
Illustration
M Ltd. is considering a new patented device for fast
video streaming. The expected cashflows are below:

Should it accept the project if cost of capital is 14% and

risk free rate is 6%. Determine its risk level.
If the firm can delay the project by 1 year to observe
the market demand before proceeding.
Narain
Illustration
Y Ltd. own an unused gold mine that will cost Rs
10 lac to reopen. If mine is opened, it is
expected to be able to extract 1000 oz. of gold
annually for 3 years. After that the deposit will
be exhausted. The price of gold is currently Rs
5000/oz. and each year the price is equally likely
to rise or fall by Rs 500 from its level at the start
of the year. The extraction cost is Rs 4600/oz.
Cost of capital is 10%. Should the company
open the mine now or delay it by one year in the
hope of a price rise. Narain 6
Follow-on Options

❑ Also called Growth Options or Expansion

Options
❑ Strategic value when taking on negative-NPV
projects.
❑ A call options on follow-on projects in
addition to the immediate projects’ cash
flows.
❑ Today’s investments can generate tomorrow’s
opportunities.
Narain 7
 Illustration
M Ltd. is considering a new device for fast video
streaming. The expected cashflows are below:

Should it accept the project if cost of capital is 14% and

risk free rate is 6%. Determine its risk level.
If the project is having average or high demand, it can
be launched with second generation with same cost and
cash inflows. How expansion alters the value? Narain
Illustration
B. Ltd. is considering a project requiring initial
outlay of Rs 5 Lac. The expected cash inflow
from operation is Rs 85,000 annually for 15
years. Cost of capital is 18%. Find NPV.
(PVAF18%, 15 = 5.092)
The consultancy group believe that the Govt. is
considering change in its industrial policy. Under
this, they shall have an option of making further
investment of Rs 1 lac at the end of 4th year.
The new investment will result in CFAT of Rs.
85,000 for year 5 to 15. Value the option.
Narain 9
 Illustration
U Ltd. is considering a project with initial outlay of Rs 12
lac. The project is expected following annual cash inflow
for 2 years. Cash Inflow 12 lac 8 lac 1 lac
Probability 0.24 0.45 0.31
1. If cost of capital is 16%. Find NPV.
2. The experience gained by implementing the project
will provide the company an option to start a new
venture at the end of 2nd year. The investment
required would be 8 lac. The new venture is expected
to generate annual cash inflow for year 3 & 4 as
follows: Cash Inflow 10 lac 9 lac 2 lac
Probability 0.20 0.45 0.35

Value the option. 10

Abandonment Option
❑ Provides insurance against failure.
❑ It is a put option whose exercise price is the
value of project’s assets if sold or shifted to a
more valuable use.
❑ Could be an option to –
– Shutdown operations
– Prepay e.g. recall bonds or refinance
loans

Narain 11
Illustration
M Ltd. is considering a new patented device for fast
video streaming. The expected cashflows are below:

Should it accept the project if cost of capital is 12% and

risk free rate is 6%. Determine its risk level.
If the equipment can be sold for $14m after taxes at
year 1 if customer acceptance is low. Should the project
be accepted? Narain
 Illustration
S Ltd. is considering an investment of Rs. 250 lac in a
new technology. The total amount has to be paid
initially, though its installation will take one year.
There is only 7% probability that the new technology
will work. If it works, it will generate a cash flow of
Rs. 2700 lac at the end of each of the 2nd & 3rd year.
If the technology does not work, the investment will
be a dead loss. Cost of the capital is 10%.
1. Should the investment be made?

2. If the technology does not work, its supplier has

given an option to return Rs. 180 lac at the
beginning of 2nd year. What is its NPV? Value this
option. 13
 Illustration
L Ltd. is considering a R&D project with initial outlay of Rs.
10 lac and Rs. 8 lac at the end of 1 year. The project will
generate cash inflow only after two years from today & will
depend upon the state of economy: Good (G) & Bad (B). The
probability of good state in 1st year is 75%. The probability
of good state in 2nd year as well is 78%. There is only 30%
probability of a good state following a bad state. The cash
inflows at the end of 2nd year will be:
CFGG = +99 lac CFBG = +5 lac
CFGB = +58 lac CFBB = – 48 lac
1. If cost of capital is 10%. Find NPV
2. The company has the option of abandoning the project
at the end of 1st year. The scrap value of Rs. 4 lac will be
realized and no further investment will be required. Value
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the option.
 Illustration 5.25
4.5 0.5
0 4.50
K Ltd. is considering a
project lasting 2 years. 3.00
The cost of capital is 10%.
1. Find NPV. 4.50
2. The company has an
option of abandoning – 4.5 0.5
0 3.0 0.5
0
3.00
the project for Rs.
2.25 lac at the end of 1.50
1st year. Recompute
NPV and value the
option.
3.00
1.5 0.5
0
1.50
0.00
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Flexibility Option
❑ Flexibility in production facilities to use the
cheapest raw materials or produce the most
valuable set of outputs e.g. –
– To have capability to change
technology depending on future input
costs
– a production facility that can produce
multiple products or change mix of
outputs
❑ An option to exchange one asset for another.
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 Illustration
SA Ltd. estimated the NPV of the expected cash
flows from a new processing plant to be –40 lac.
SA is evaluating an incremental investment of
30 lac that would give management the
flexibility to switch between coal, natural gas
and oil as an energy source. The original plant
relied only on coal. The option to switch to
cheaper sources of energy when they are
available has an estimated value of 120 lac.
What is the value of the new processing plant,
including this real option to use alternative
energy sources ?
Project NPV = -40 lac -30 lac + 120 lac = 50 lac Narain 17
Valuing Real options
❑ Each real options brings its own issues & trade –
offs.
❑ Real – option valuation cannot replace DCF
valuation
• NPVProject = NPVRegular + Value of Options – Cost of
option
❑ Real – option valuation can be done via –
➢ As if financial – option
• Black Scholes Merton model or Binomial Option Pricing model
➢ Decision trees, simulations & ad hoc approaches
❑ BSM suffices to value expansion options
❑ Binomial trees can tackle the problems of
Investment timing & Abandonment
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Valuing Real options
❑ Real options valuation is complex
– At least recognise it and articulate
❑ Real option valuation is high
– Maturity is longer
– Volatility is high
– PVCI is higher relative to IO
❑ These valuations are at best an
approximation
– Particularly with decision trees
Narain 19
BSM model for Real Options

Black-Scholes Option Value Parameters for

Evaluating a Real Option to Invest
Financial Option Real Option Example
Stock Price S Current Market Value of Asset
Strike Price K Upfront Investment Required
Expiration Date T Final Decision Date
Risk-Free Rate rf Risk-Free Rate
Volatility of Stock σ Volatility of Asset Value
Dividend Div FCF Lost from Delay

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 Illustration
P Ltd. is a pharma firm that possesses patent on a drug
called Acidex. It is an approved drug and P ltd. can
produce & market it. The firm has the patent on the
drug for 15 years and after this period, any pharma
company can produce it. The firm estimates that it will
have to incur Rs 12.5 crore to develop and market the
drug. Based on the estimates of potential market and
price, the present value of expected cash inflow from the
sale of the drug is 16.7 crore. A simulation study shows
that the average variance in the value of the project is
0.268. The current yield on 15-year Govt. bonds is
7.8%. What is the value of the patent to the company if
cost of delaying is 6.67% (1/15).
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THANKS FOR YOUR TIME!

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