Real Options

Real Options
• One of the fundamental insights of modern finance theory is
that options have value.
• The phrase “We are out of options” is surely a sign of trouble.
• Because corporations make decisions in a dynamic
environment, they have options that should be considered in
project valuation.
Discounted CF and Options
We can calculate the market value of a project as the sum of the
NPV of the project without options and the value of the
managerial options implicit in the project.
M = NPV + Opt
A good example would be comparing the desirability of a
specialized machine versus a more versatile machine. If they
both cost about the same and last the same amount of time, the
more versatile machine is more valuable because it comes with
options.
Three Basic Questions
• When is there a real option embedded in a decision or an asset?
• When does that real option have significant economic value?
• Can that value be estimated using an option pricing model?
When does the option have significant
economic value?
• For an option to have significant economic value, there has to be a
restriction on competition in the event of the contingency. In a
perfectly competitive product market, no contingency, no matter how
positive, will generate positive net present value.
• At the limit, real options are most valuable when you have exclusivity
- you and only you can take advantage of the contingency. They
become less valuable as the barriers to competition become less
steep.
Determinants of option value
Variables Relating to Underlying Asset
• Value of Underlying Asset; as this value increases, the right to buy at a fixed price (calls) will
become more valuable and the right to sell at a fixed price (puts) will become less valuable.
• Variance in that value; as the variance increases, both calls and puts will become more valuable
because all options have limited downside and depend upon price volatility for upside.
• Expected dividends on the asset, which are likely to reduce the price appreciation component of
the asset, reducing the value of calls and increasing the value of puts
Variables Relating to Option
• Strike Price of Options; the right to buy (sell) at a fixed price becomes more (less) valuable at a
lower price.
• Life of the Option; both calls and puts benefit from a longer life.
Level of Interest Rates; as rates increase, the right to buy (sell) at a fixed price in the future
becomes more (less) valuable
Black and Scholes…
The version of the model presented by Black and Scholes was designed to
value European options, which were
• dividend-protected.
• The value of a call option in the Black-Scholes model can be written as a
function of the following variables:
• S = Current value of the underlying asset
• K = Strike price of the option
• t = Life to expiration of the option
• r = Riskless interest rate corresponding to the life of the option
• s2 = Variance in the ln(value) of the underlying asset
The Black Scholes Model
Real Options
The Option to Expand
• Has value if demand turns out to be higher than expected
The Option to Abandon
• Has value if demand turns out to be lower than expected
The Option to Delay
• Has value if the underlying variables are changing with a
favorable trend
Option to expand
• An entrepreneur recently learnt of an idea to open hotels made of
ice.
• Estimated that annual CF from single ice hotel = $2 million CF (50%
chance of $6 million, 50% chance of $ -2 million)
• Initial investment = $12 million
• Discount rate is 20%
• NPV = -12+2/0.2 = -$2 million
• NPV = 50%*(-12+6/0.2) + 50%*(-12-2/0.2) = 50% * 18 + 50%*1*(-22)
= -$2 million
 Option to expand
• If optimistic forecast turns out to be correct, entrepreneur would like to
expand.
• Say he can expand to 10 locations
• NPV of venture would be = 50% x 18 x 10 +50% x 1 x(-22) = $79 million
• So, entrepreneur should invest in the project because of value to
expand
The Option to Abandon: Example
Suppose we are drilling an oil well. The drilling rig costs $300
today, and in one year the well is either a success or a failure.
The outcomes are equally likely. The discount rate is 10%.
The PV of the successful payoff at time one is $575.
The PV of the unsuccessful payoff at time one is $0.
The Option to Abandon: Example
Traditional NPV analysis would indicate rejection of the
project.
Expected Payoff  Prob. Success  Successful Payoff  Prob. Failure  Failure Payoff

Expected Payoff   0.50  $575    0.50  $0   $287.50

$287.50
NPV  –$300   $38.64
1.10
The Option to Abandon: Example
However, traditional NPV analysis overlooks the option
to abandon.

The firm has two decisions to make: drill or not,

abandon or stay.
The Option to Abandon: Example
When we include the value of the option to abandon,
the drilling project should proceed:

Expected Payoff  Prob. Success  Successful Payoff  Prob. Failure  Failure Payoff

Expected Payoff   0.50  $575    0.50  $250   $412.50

$412.50
NPV  –$300   $75.00
1.10
Valuing the Option to Abandon
Recall that we can calculate the market value of a project as the
sum of the NPV of the project without options and the value of
the managerial options implicit in the project.
M = NPV + Opt
$75.00 = –$38.64 + Opt
$75.00 + $38.64 = Opt
Opt = $113.64
Option to Wait
• Hick Mining is evaluating when to open a gold mine. Mine has 48000
of gold left that can be mined, and mining operations will produce
6000 ounces per year. The required return on gold mine is 12%, and it
will cost $34 million to open the mine. When mine is opened, the co.
will sign a contract that will guarantee the price of gold for the
remaining life of the mine. If mine is opened today, each ounce of gold
will generate an after-tax cf of $1400 per ounce. If co. waits one year,
there is 60% probability that the contract price will generate an after-
tax CF of $1600 per ounce and a 40% probability that the after-tax CF
will be $1300 per ounce. What is the value of the option to wait?