Real Options

Introduction
• Standard capital budgeting decisions is solved by the discounting
the cash flows at an appropriate discount rate to arrive at NPV.

• If this happens to be +ve we go ahead with the project, else reject

it.

• Traditional capital budgeting assume no action once the project is

accepted or rejected on the basis of discounted Cfs.

• In fact, the firm has an option of whether to invest now or not, if

yes when to escalate the investment. If the initial option is not on
expected lines, the firm decide whether or not to abandon the
project.
Real options
• Allows managers to make decisions in the future that
alter the value of Capital budgeting decisions made
today.

• Real options are like financial options except they are

made on real assets instead of financial assets.

• Real options entail a right not obligation.

• Real options are contingent on future events.

 Example of Real Options

The XYZ 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.
I1: Required investment in the R&D
project.

I2: Required investment in the

commercial-scale plant, marketing,
and distribution - if the R&D effort
is successful, and if market
conditions are favorable..

I3: Final investment in the project;

can be decreased by Ic if the
market is weak.

IE: Flexibility in the design of the

production process allows for
output expansion with an outlay of
IE .

V: Gross present value of the

completed project’s expected
 Example of Real Options in the XYZ Project - 1
• Option to Defer Investment
Our Govt is currently debating the viability and the process by which to allocate or auction the
airwaves that are crucial to the commercial success of XYZ. Our lobbyist in India 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 - I1, 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 market’s response to XYZ 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 - IE, 0).

The option to expand also applies to complementary markets: Investing in XYZ 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.
Example of Strategic Options in the XYZ
Project - 2
• Option to Default during Staged Construction ( Time-to-Build-Option) Investing in the
R&D project, or investing I1, provides the opportunity to invest in the commercial stage
by investing I2 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 XYZ as expected, management can reduce the scale of
operations by c%, thereby saving Ic of the planned investment outlays. This option to
mitigate loss has value max (Ic - cV, 0).

• Option to Abandon for Salvage Value

If XYZ 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).
Option Description Examples
To wait before taking an action When to introduce a new product, or
until more is known or timing is replace an existing piece of
Defer expected to be more favorable equipment

To increase or decrease the Adding or subtracting to a service

Expand or scale of an operation in response offering, or adding memory to a
contract to demand computer

To discontinue an operation and Discontinuation of a research project,

Abandon liquidate the assets or product/service line

To commit investment in stages Staging of research and development

Stage investment giving rise to a series of valuations projects or financial commitments to
and abandonment options a new venture

To alter the mix of inputs or The output mix of

Switch inputs or outputs of a production process telephony/internet/cellular services
outputs in response to market prices

To expand the scope of activities Extension of brand names to new

Grow to capitalize on new perceived products or marketing through
opportunities existing distribution channels
 Quantifying Strategic Options using the Binomial approach
The XYZ 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 XYZ. There is an
equal probability (q = 0.5) that market penetration and intensity of use of XYZ will increase or decrease each
year. Hence, if XYZ 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 XYZ’s cashflows. The expected rate of return on W is
20%. The riskfree rate is 8%.

Traditional (or, Passive) NPV Analysis

St = = 100.

XYZ’s NPV = 100 - 104 = - 4.

In the absence of real options, traditional
NPV analysis would have rejected the
XYZ project.
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,
I1 = (104 * 1.08) = $112.32

Value of XYZ under favorable circumstances (in year 1): S+ = max (V+ - I1, 0)
= max (180 - 112.32 , 0) = 67.68

Value of XYZ under unfavorable circumstances (in year 1) : S - = max (V- - I1, 0)
= max (60 - 112.32 , 0) = 0.
Value of XYZ now (in year 0) : S0 = 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
Option to Defer Investment - 2

Hence, S0 = = 25.07

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

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

S0 = 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.
Flexibility Real Options
• Sackley AquaFarms estimated the NPV of the expected
cash flows from a new processing plant to be – $0.40
million.

• Sackley is evaluating an incremental investment of

$0.30 million 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 $1.20
million. What is the value of the new processing plant
including this real option to use alternative energy
sources?
Abandonment Options
•Nyberg Systems is considering a capital project with the following
characteristics:
The initial outlay is €200,000.
Project life is four years.
Annual after-tax operating cash flows have a 50 percent probability of
being €40,000 for the four years and a 50 percent probability of being
€80,000.
■Salvage value at project termination is zero.
■The required rate of return is 10 percent.

In one year, after realizing the first-year cash flow, the company has the
option to abandon the project and receive the salvage value of €150,000.1.
Compute the project NPV assuming no abandonment. 2. What
is the optimal abandonment strategy? Compute the project NPV using that
strategy.
Black Scholes Merton Model
• Value options in continuous time and use same
assumptions of no-arbitrage.
• To derive BSM model, an instantaneously
riskless portfolio (one that is riskless over the
next instant) is used to solve for the option price
based on the same logic.
Assumptions of BSM
1. Prices of underlying assets follow a lognormal
distribution.
2. the continuous Rf is constant and known.
3. The volatility of the underlying asset is constant
and known.
4. Markets are frictionless. i.e. there are no taxes,
no transaction cost and no restriction on short
sale proceeds.
5. Underlying asset has no CF.
6. Options are European.
Value of call option as per BSM
• Co = [So x N(d1)] - [X x e^(-Rf(c) x T) x N(d2)]

• Where, d1={ln(So/X) + [Rf(c) + .5variance] x

T]} / (Std Dev. x sqrt T)

• d2 = d1 - std.dev. x sqrt T)
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Simple example
• Spot price - 100
• Exercise price - 95
• Interest rate - 10%
• Time to expiration -3 months
• SD of stock returns - 0.50
• Calculate the value of the option.

• D1 = log(100/95) + (0.10+0.5^2)0.25. / 0.5.* sq root of T = 0.43

• D2 = d1 - SD* sq root T = 0.18
• N(d1) = area under the normal curve = N(0.43) = 0.6664
• N(d2)= N(0.18)= 0.5714

• Call option = 100(0.6664) - 95 (e^ -0.10*0.25) 0.5714

• = 66.64 - 52.94
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Example of time option

• SoftBank has developed a new banking product and is uncertain about its
demand potential. Cost of launch 100 lakh and project life 4 years. Good
demand then annual CFAT is 50L and if demand is bad then CFAT is 30L.
Appropriate discount rate = 12%.
• The manger wanted to wait for 1 year for the launch before the preferences of
the customer in known with much clarity. If the demand remains good
SoftBank must go ahead with the launch else it drops it altogether.
• Assumptions:
• The firm implements the project if the dd scenario is good in year 1
• Firm abandons the project if the demand scenario is bad is year 1
• The initial outlay and CFs from the project for the next 4 years remain
same.
• The dis rate remains the same =12%
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BSM and time options.

• Option to delay resembles a call option on the stock and we can use
BSM to value the option.
• 5 inputs which are required:
• Exercise price-100L
• Expiration time- 1 years
• Risk free rate- taken from govt securities say it is 6%
• Spot price of the underlying asset- expected PV of the cash inflows
• Variance of return
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Value of put option

• p=X* e^- r t N(–d2)–S0N(-d1)
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Example of abandon
• Ganga toll Bridge company is contemplating to participate in a tender to build
a bridge. The terms and conditions of the tender specify that the bridge must
be made tool free after 25 years. The cost of building the bridge is 10 cr.
• Based on the present level of traffic it was worked out that cash flow of 1 crore
is expected evenly for the next 25 years.
• Required rate of return = 12
• Risk free rate = 6%
• The local govt has offered to buy back the project after 5 years at 6 crore. The
govt plans to build amusement park across the bridge that is likely to increase
the traffic. The company estimates that the govt plan has 60% chances to be
successful and yield CFs of 2.5 cr & 40% chance to be unsuccessful and
yielding 0.5 cr.

• It is now a project with a put option at the end of 5 year.