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Real Options

We will maintain our highly disciplined approach to capital
spending. Our objective remains to maximize return on every dollar
we invest - and to invest where we find the very best growth
opportunities.
- Richard C. Notebaert, ex-Chairman and CEO, Ameritech

Finance theory properly applied, is critical to managing in an
increasingly complex and risky business climate... Option analysis
provides a more flexible approach to valuing our investments... To
me all kinds of business decisions are options.
- Judy Lewent, CFO, Merck
-
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What is a Real Option?
Traditional discounted cashflow approaches (such as the NPV rule)
cannot properly capture managements flexibility to adapt and revise
later decisions in response to unexpected market developments.
Traditional approaches assume an expected scenario of cashflows
and presume managements passive commitment to a certain static
operating strategy.

The real world is characterized by change, uncertainty and competitive
interactions =>
As new information arrives and uncertainty about market conditions is
resolved, management may have valuable flexibility to alter its
initial operating strategy in order to capitalize on favorable future
opportunities or to react so as to mitigate losses.
This managerial operating flexibility is like financial options, and is
known as Strategic Options, or Real Options.

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Source of value in an option
Financial Options:
A call option gives the owner the right, with no obligation, to acquire the underlying asset by
paying a prespecified amount (the exercise price, X) on or before the maturity date.


Value of a Call Option
on the
Maturity Date





Stock Price on the Maturity Date

Source of value in an option: The asymmetry from having the right but not the obligation to
exercise the option.

X
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Different types of real options
Occurring naturally.
Example: Option to defer a capital investment.

Planned for and created.
Example: Option to invest in a new technology-based
service/product, as the result of a successful R&D effort.

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Traditional Approaches To Dealing with Uncertainty
and Complexity in Capital Budgeting - 1
Sensitivity Analysis

Considers effect on the NPV of varying one variable at a time.
Useful in identifying key drivers in a project.
Indicates how large the forecast error on a key driver can be tolerated,
before the project becomes unacceptable.

Pro: Easy to implement and understand.

Con: Ignores interdependencies among variables (at a point in time),
and over time.



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Traditional Approaches To Dealing with Uncertainty
and Complexity in Capital Budgeting - 2
Simulation
Steps:
1. Equations specify relationships among variables.
2. Specify probability distribution of underlying variables.
3. Random draws from distributions; compute NPV.
4. Repeat steps 1, 2, and 3 many times.

Pro: Takes into account interdependencies among variables.

Cons:
A. Difficult to interpret a distribution of NPVs. Traditional view of NPV as "increase
in shareholder wealth from accepting the project" not applicable.
Solution: Use simulation to assess the distribution of the net cashflows.
B. Problems in specifying interdependencies in step 1.
C. Cannot handle well asymmetries in the distributions introduced by
management's flexibility to revise its prior operating strategy as more
information about project cashflows becomes available over time: Real Options.


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Traditional Approaches To Dealing with Uncertainty
and Complexity in Capital Budgeting - 3
Decision tree analysis

Helps structure the managerial decision problem by mapping out
feasible managerial alternatives in response to future events.

Pro: Forces management to recognize its implied operating strategy
and the interdependencies between the initial and subsequent
decisions.

Cons:
A. Number of different paths on the tree increases geometrically.
B. Choice of discount rate: Risk of project may change over time.
(Options based approach circumvents the discount rate
problem by constructing a riskfree hedge.)


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Traditional Approaches To Dealing with Uncertainty
and Complexity in Capital Budgeting - 4


Traditional capital budgeting procedures cannot properly
capture managements flexibility to adapt and revise later
decisions in response to unexpected
regulatory/technological/market developments.


The real option techniques can conceptualize and value
managerial flexibility to alter its initial operating strategy in order
to capitalize on favorable future opportunities or to react so as to
mitigate losses.


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Example of Real Options
The SuperCom Project:
A large telecommunications company faces an opportunity to invest in an R&D project that
will revolutionize the way consumers use telephones, internet, and TV.

Real Options in the SuperCom Project
R&D Stage Commercialization Stage
0 (Years) 3 5 7
T = 15
I
1
I
c
Defer
( up to 1 year)
I
E
I
3
Expand
Switch Use
(Abandon for salvage) Contract
( save I
c
)
I
2
Abandon
(forgo I
2
)
I
1
: Required investment in the
R&D project.

I
2
: Required investment in the
commercial-scale plant,
marketing, and distribution - if the
R&D effort is successful, and if
market conditions are favorable..

I
3
: Final investment in the project;
can be decreased by I
c
if the
market is weak.

I
E:
Flexibility in the design of the
production process allows for
output expansion with an outlay of
I
E
.

V: Gross present value of the
completed projects expected
operating cashflows.

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Example of Real Options in the Supercom
Project - 1
Option to Defer Investment
Congress is currently debating the viability and the process by which to allocate or auction
the airwaves that are crucial to the commercial success of SuperCom. Our lobbyist in
Washington advises us that the debate would be resolved within a year. We could initiate
the R&D project immediately, or wait a year to see what Congress does. The option to
defer investing in the R&D project is similar to a call option whose value is max (V - I
1
, 0).

Option to Expand
Given an initial design choice, management may deliberately favor a more expensive
technology for the built-in flexibility to expand production/sales if and when it becomes
desirable. If the markets response to SuperCom is better than expected, management can
accelerate the rate or expand the scale of production by x% by incurring a follow-on cost I
E
.
The option to expand has value max (xV - I
E
, 0).

The option to expand also applies to complementary markets: Investing in SuperCom in a
new geographical area allows for the possibility to expand to other similar markets; for
example besides local and long-distance tele-communication, the market for telephone-via-
internet could be explored in the new geographical area.

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Example of Strategic Options in the
Supercom Project - 2
Option to Default during Staged Construction ( Time-to-Build-Option)
Investing in the R&D project, or investing I
1
, provides the opportunity to
invest in the commercial stage by investing I
2
or to abandon the project if the
R&D and initial test-marketing is unsatisfactory.

Option to Contract
If the market does not respond to SuperCom as expected, management can
reduce the scale of operations by c%, thereby saving I
c
of the planned
investment outlays. This option to mitigate loss has value max (I
c
- cV, 0).

Option to Abandon for Salvage Value
If SuperCom does significantly worse than expected in the market,
management may choose to abandon the project permanently in exchange for
its salvage value: the resale value of the capital equipment, license, etc. for A.
This flexibility to abandon the project has value max (V, A).


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Defer
Expand or
contract
Abandon
Switch inputs
or outputs
Grow
To wait before taking an action
until more is known or timing is
expected to be more favorable
To increase or decrease the
scale of an operation in
response to demand
To discontinue an operation and
liquidate the assets
To commit investment in stages
giving rise to a series of valuations
and abandonment options
To alter the mix of inputs or
outputs of a production process
in response to market prices
Stage
investment
To expand the scope of activities
to capitalize on new perceived
opportunities
Examples Description Option
Adding or subtracting to a service
offering, or adding memory to a
computer
When to introduce a new product, or
replace an existing piece of
equipment
Discontinuation of a research
project, or product/service line
Staging of research and
development projects or financial
commitments to a new venture
The output mix of
telephony/internet/cellular services
Extension of brand names to new
products or marketing through
existing distribution channels
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Quantifying Strategic Options using the
Binomial approach
The SuperCom project requires an initial investment of I
0
= $104. Each year, the gross value of this project
can move up by 80% or down by 40%, depending on market penetration and intensity of use of SuperCom.
There is an equal probability (q = 0.5) that market penetration and intensity of use of SuperCom will increase
or decrease each year. Hence, if SuperCom is successful, the gross value next year is $180, and $60 if it is
not successful.
Let W be the price of a twin security that is traded in the financial markets and has the same risk
characteristics (that is, is perfectly correlated) with SuperComs cashflows. The expected rate of return on W
is 20%. The riskfree rate is 8%.

SuperComs gross cashflows, S
t
, and the value of the twin security,
W
t
, move through time as:
(324, 64.88)
(180, 36)
(100, 20) (108, 21.6)
(60, 12)
(36, 7.2)
Year 0 Year 1 Year 2
Traditional (or, Passive) NPV Analysis

S
t
= = 100.

SuperComs NPV = 100 - 104 = - 4.
In the absence of real options, traditional
NPV analysis would have rejected the
SuperCom project.

1.20
60) * 0.5 ( + 180) * 0.5 (
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Option to Defer Investment - 1
Management could wait for a year and invest only if the regulatory uncertainty is resolved in a
favorable manner, while it has no obligation to invest under unfavorable developments. The option to
wait is analogous to a call option on the project value, V, with an exercise price equal to the required
outlay next year,
I
1
= (104 * 1.08) = $112.32

Value of SuperCom under favorable circumstances (in year 1): S
+
= max (V
+
- I
1
, 0)
= max (180 - 112.32 , 0) = 67.68

Value of SuperCom under unfavorable circumstances (in year 1) : S
-
= max (V
-
- I
1
, 0)
= max (60 - 112.32 , 0) = 0.
Value of SuperCom now (in year 0) : S
0
= pS
+
+ (1-p)S
-

(1+r)

where p is the risk neutral-probability obtained from the price dynamics of the twin security:

p = (1 + r) W - W
-
(W
+
- W
-
)

p = (1.08 * 20) - 12 = 0.4
36 - 12


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Option to Defer Investment - 2

Hence, S
0
= = 25.07


Hence, Option to Defer = Expanded NPV - Passive NPV = 25.07 - (-4) = 29.07.



Using the NPV/Decision Tree Analysis, the value of SuperCom would have been:


S
0
= 0.5 * 67.68 + 0.5 * 0 = 28.20.
1.20


Please note the probabilities and the discount rate used in the option analysis, and the
decision tree analysis.

08 1
0 6 0 68 67 4 0
.
* . . * .
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Option to Expand (Growth Option)
Original investment opportunity: Initial-scale project + Call option on a future
opportunity

S = V + max (xV - I
E
, 0) = max (V, (1+x)V - I
E
). Or,

S
+
= max (V
+
, 1.5V
+
- I
E
) = max (180, 270 - 40) = 230.

S
-
= max (V
-
, 1.5V
-
- I
E
) = max (60, 90 - 40) = 60.

S
0
= pS
+
+ (1-p)S
-
- I
0

(1+r)

S
0
= 0.4*230 + 0.6*60 - 104 = 14.5.
1.08

Hence, value of the option to expand = 14.5 - (-4) = 18.5.


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Option to Default on Planned Staged Cost
Installments
During the R&D and construction phase, management may abandon a project if the coming required
investment exceeds the value from continuing the project (including any future options).
Suppose the investment of $104 can be staged as a series of installments: I
0
= $44 to be paid out
immediately. The remaining $60 will be placed in an account (earning the riskfree rate) to be paid out as I
1
=
$64.8 next year. Management will pay the installment of $64.8 next year only if the R&D results and the
regulatory climate looks favorable, else it will forego the investment and receive nothing. Such an option to
default translates into

S = max(V - I
1
, 0).
S
+
= max (V
+
- I
1
, 0) = max (180 - 64.8, 0) = 115.2; hence, continue.
S- = max (V
-
- I
1
, 0) = max (60 - 64.8, 0) = 0; hence, default.

The value of the investment opportunity with the option to default on future outlays is:

S
0
= pS
+
+ (1-p)S
-
- I
0

(1+r)

S
0
= 0.4 * 115.2 + 0.6*0 - 44 = -1.33

1.08
Hence, Option to abandon = -1.33 - (-4) = 2.67.

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Strategic Interactions Among Sets of
Projects - 1
Consider the base-case of a mature business unit: (in $ millions)

Sales (S) 100

Operating costs (C) (80)

Net cashflow (V) (ignoring depreciation, taxes, changes in working capital) 20

Now consider two new investment opportunities:

A. A marketing campaign of I
E
= $11 million that would expand sales by e = 50%.

B. A cost-reduction investment of I
c
= $10 million that would cut costs by c = 10%
regardless of the scale of the project.

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Strategic Interactions Among Sets of
Projects - 2
Present values for market-expansion and cost-reduction projects taken separately and in combination

Market expansion Cost reduction Both
Sales (S) 150 100 150
Operating costs (C) (120) (72) (108)
Investment (I
E
, I
c
, or I
E
+ I
c
) (11) (10) (21)
Net cashflow (V) 19 18 21

The market expansion project can be viewed as a call option:
max (eV - I
E
, 0) = max (0.50*20 - 11, 0) = max (-1, 0).
Hence, if exercised alone, the market expansion project would lower firm value by $1 million.

The cost reduction project can also be viewed as a call option:
max (cC - I
c
, 0) = max (0.10*80 - 10, 0) = max (-2, 0).
Hence, if exercised alone, the cost reduction project would lower firm value by $2 million.

The two projects undertaken jointly can also be viewed as an option:
max [(eV - Ie) + c(1 + e)C - I
c
, 0]
= max [(0.50*20 - 11) + 0.10(1 + 0.50)*80 - 10, 0] = max [+1, 0].

The strategic source of value of $1 million comes from the synergy or complementarity of the two projects undertaken jointly.


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Strategic Interactions Among Sets of
Projects - 3

Strategic interaction among a set of projects may make the set
worth significantly more than any of the individual projects or their
sum.

The LaserTalk Case
Favorable resolution of a regulatory uncertainty could make expansion
into a new market worth an additional, say, $100 million.
Favorable resolution of a technological uncertainty (for example,
internets ability to provide telephone services) could make
expansion into a new market worth an additional, say, $250 million.
Favorable resolution of both the regulatory and technological
uncertainties could make expansion into the new market worth
significantly more than $350 million.


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Investment Opportunities as Collections of
Real Options
Justification of the options analogy.

Can the standard techniques of valuing options on the basis of a no-arbitrage equilibrium, using
portfolios of traded securities to replicate the payoff to options, be justifiably applied to capital
budgeting where projects may not be traded?
Answer: Yes! The computation of NPV requires calculation (assumption) of a discount rate: The
required return on an asset (that is traded in the capital markets) of similar risk as the project.

From a practical standpoint: Calculating real option values is non-trivial.

The Real Value in Real (Strategic) Options!

From option pricing theory we know that the value of a call option increases with
Increase in variance of the underlying asset.
Increase in the value of the underlying asset.
Increase in the time to expiration.
Increase in the riskfree rate.
Decrease in the exercise price.

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Limitations of the options analogy


1. Exclusiveness of Ownership and Competitive Interaction:
Financial call option on a common stock is proprietary; only the owner can exercise it without worrying
about competition for the underlying security. Some real options (patents, licenses) are also proprietary.
Other real options are shared and can be exercised by any firm in the particular industry:
Examples:Opportunity to penetrate a new geographic market.
Opportunity to introduce a new product unprotected by possible introduction of close
substitutes.

2. Nontradability and Preemption:
Financial call options are traded with minimal transaction costs. Real options are not generally traded.
Non-tradability of real options may lead to its early exercise: A firm anticipating increase in industry
demand - and hence subsequent competitive entry - may rush to expand its own
production/sales capacity early to preempt competition. In the absence of such competition it might
have preferred to wait for the uncertainty surrounding future demand to resolve itself.

3. Strategic Interdependencies and Option Compoundness:
Financial call options are simple: their value derives entirely from the received shares of the stock. Some
real options (such as, maintenance or standard replacement projects) are simple. Other real options are
compound: R&D investments, Expansion into a new geographic market. Compound real options may
have a more strategic impact on firm value, than simple real options, and are more complicated to
analyze. Compound real options must be looked at not as independent projects but rather as links
in a chain of interrelated projects, the earlier of which may be prerequisites for those to follow.

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The Bottom Line

Options approach to capital budgeting has the potential to
conceptualize (and in some circumstances, quantify) the value of
options from active management and strategic market
interactions.

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Sources


Baldwin, C., and L. Trigeorgis, 1995, Real Options, Capabilities, TQM, and Competitiveness,
Harvard Business School Working Paper.

Capozza, D., and Y. Li, 1994, The Intensity and Timing of Investment: The Case of Land,
American Economic Review.

Dixit, A., and R.S. Pindyck, 1994, Investment Under Uncertainty, Princeton University Press.

Kogut, B., and N. Kulatilaka, 1994, Operating Flexibility, Global Manufacturing, and the Option
Value of a Multinational Network, Management Science.

Kulatilaka, N., 1995, The Value of Flexibility: A general model of Real Options, Real Options
in Capital Investments, Praeger.

Trigeorgis, L., 1996, Real Options, MIT Press.

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Real Options and LaserTalk - 1
A large telecommunications company, TCOM Inc., is considering
the real/strategic options associated with investing in a new
geographical territory: The LaserTalk Investment Opportunity
(LaserTalk).


What are the real options associated with LaserTalk?

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Real Options and LaserTalk - 2
Real options associated with LaserTalk:
Business opportunities that will become available to TCOM
only if LaserTalk were to be invested in now.
What might be the nature of these business
opportunities?
From an economic and strategic viewpoint, these
business opportunities would be in TCOMs areas of core
competencies. If TCOM has a comparative advantage at
doing something in their existing market, they probably
have a comparative advantage at doing it elsewhere.
Additionally, these business opportunities may arise as a
result of TCOMs R&D success here, or legal/regulatory
changes.
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Real Options and Financial Options
Value of Call option = V e
-yt
N(d
1
) - X e
-rt
N(d
2
) . Where,
d
1
= [ ln (V/X) + (r - y + (s
2
)/2) t ] / s(t)

.
d
2
= d
1
- s (t)

.

Variable (Financial) Call Option Real Option

V: Underlying asset Stock Business project
Value of V Stock price Present value of projects net cashflows

X Exercise price Present value of projects cash outflows

t Time to maturity Time over which the project decision may be
made

r Riskfree rate Riskfree rate

s
2
Variance of the stock price Variance of the present value of projects net
cashflows

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Real Options and LaserTalk - 3
We use a modification of the Black-Scholes option pricing model to value the strategic options
associated with LaserTalk :

Value of Strategic (real) option = V e
-yt
N(d
1
) - X e
-rt
N(d
2
) .
where,
d
1
= [ ln (V/X) + (r - y + (s
2
)/2) t ] / s(t)

.

d
2
= d
1
- s (t)

.

N (.) = Cumulative normal density function.

V = Present value of expected cash inflows from investing in point-to-multipoint radio
technology and/or end-to-end solutions in the new geographical territories = $2459 million.

X = Present value of the costs of investing in point-to-multipoint radio technology and/or end-
to-end solutions in the new geographical territories = $3014 million.

Hence, NPV of this project is -$555 million; that is, this project would be rejected on the basis of
just considering the traditional NPV.
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Real Options and LaserTalk - 4
Value of strategic (real) option = V e
-yt
N(d
1
) - X e
-rt
N(d
2
) .
where,
d
1
= [ ln (V/X) + (r - y + (s
2
)/2) t ] / s(t)

.

d
2
= d
1
- s (t)

.

where,

s
2
= Variance in the expected net cashflows over time, allowing for technological, legal, and
market changes = (40%)
2
.

t = Number of years during which the real option can be exercised
= 4 (given LaserTalk obtains the licenses in these new geographical markets).

y = Dividend yield.

r = Riskfree interest rate for t years = 6.40%.


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Real Options and LaserTalk - 5
Price charged as % of price in existing market = 90%
WACC = 12.63%
Life of Project (years) = 10
New Territory Market Size (fraction of TCOMs current market) = 0.3
Operating Costs (as a % of operating costs in existing market) = 120%
Capital expenditure (as a % of cap. exp. in existing market) = 110%
Cashflow standard deviation = 40%
Riskfree rate = 6.40%
Strategic Option value of investing in the new territory = $ 809 million
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Sensitivity Analysis of Real Option Value of
Investing in LaserTalk
Option Value vs. New Territory Market Size
0
500
1000
1500
0.1 0.2 0.3 0.4 0.5
New Territory Market Size (fraction of current market)
O
p
t
i
o
n

V
a
l
u
e

(
$

M
.
)

Option Value vs. Price Charged
0
200
400
600
800
1000
1200
Price (as a % of price in current market)
O
p
t
i
o
n

V
a
l
u
e

(
$

M
.
)

Option Value vs. WACC
0
200
400
600
800
1000
1200
10 12.63 14 16 18 20
WACC (in %)
O
p
t
i
o
n

V
a
l
u
e

(
$

M
.
)

Option Value vs. Life of Project
0
500
1000
1500
5 10 15
Life (in years)
O
p
t
i
o
n

V
a
l
u
e

(
$

M
.
)

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Sensitivity Analysis of Real Option Value of
Investing in LaserTalk
Option Value vs. Operating Costs
0
500
1000
1500
90 100 110 120 130 140 150
Operating Costs (% of costs in current market)
O
p
t
i
o
n

V
a
l
u
e

(
$

M
.
)

Option Value vs. Capital Expenditure
0
500
1000
110 150 200 250 300
Capital expenditure (as % of current cap.exp.)
O
p
t
i
o
n

V
a
l
u
e

(
$

M
.
)

Option Value vs. Cashflow Standard
Deviation
0
500
1000
1500
10 20 30 40 50
Std. Dev. (%)
O
p
t
i
o
n

V
a
l
u
e

(
$


M
.
)

Option Value vs. Riskfree Rate
650
700
750
800
850
900
4 5 6 7 8
Riskfree Rate (%)
O
p
t
i
o
n

V
a
l
u
e

(
$

M
.
)