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Real Options

Ch 13Fin 5387

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The traditional NPV rule is a passive approach because … The traditional NPV approach

assumes mangers do not have influence over the

cash flows the assets produce in the future. once the cash flows are estimated in the

beginning of investment horizon, they cannot be varied in the future.

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The Real Option Approach

Real options occur when managers have the opportunity to influence the cash flows of a project before and after the project has been implemented.

More realistic and flexible approach

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Real Option Examples Timing option or option to “delay”

Delay investment until the firm gets a better idea of the size of the market. (e.g., real estate, construction)

Abandonment option or option to “kill” Desert investment in the future if optimal. (e.g., A small

computer software has an option of selling its patent to a Microsoft.)

Expansion option or growth option Option to expand into new geographic markets Option to increase volume of existing product line

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Timing Option: Tropical Sweets ExampleTropical Sweets, Inc. is a mid-sized California company

that specializes in creating exotic candies from tropical fruits. Tropical Sweets is considering a project that will cost $70 million and the life of the project is 3 years. The cost for this type of project 10 percent and the risk-free rate is 6 percent. Demand forecasts for candies are as follows:

Demand Probability Annual Cash FlowHigh 30% $45Average 40% $30Low 30% $15

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Tropical Sweets Example (continued) Suppose Tropical Sweets will know what

level of demand will be realized if it waits one year.

Then, Tropical Sweets faces two options. Produce candies now, or Wait one year and implement the project only

if optimal. That is, proceed only if the level of demand produce positive NPVs. (Timing Option)

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Tropical Sweets:Two approaches to value real options Decision Tree Analysis

Each possible outcome is shown as a “branch” on the tree.

Black-Scholes Option Pricing Model More mathematically challenging approach Originally developed to value financial options

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Tropical Sweets:NPVs for different demand levels

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Decision Tree Analysis If we immediately proceed with the project, its

expected NPV is $4.61 million. However, the project is very risky: If demand is high, NPV = $41.91 million. If demand is low, NPV = -$32.70 million.

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Decision Tree Analysis: Wait one year

If we wait one year, we will gain additional information regarding demand.

If demand is low, we won’t implement project.

If we wait, the up-front cost and cash flows will stay the same, except they will be shifted ahead by a year.

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Decision Tree Analysis: Wait one year

Cost NPV this

2001 Prob. 2002 2003 2004 2005 Scenarioa

-$70 $45 $45 $45 $35.7030%

$0 40% -$70 $30 $30 $30 $1.7930%

$0 $0 $0 $0 $0.00

Future Cash Flows

Discount the cost of the project at the risk-free rate, since the cost is known. Discount the operating cash flows at the cost of capital. Example: $35.70 = -$70/1.06 + $45/1.12 + $45/1.13 + $45/1.14.

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Decision Tree Analysis: Wait one year E(NPV)

= [0.3($35.70)]+[0.4($1.79)] + [0.3 ($0)]= $11.42.

Decision tree NPV is higher ($11.42 million vs. $4.61). In other words, the option to wait increases NPV to $11.42 million. If we implement project today, we gain $4.61 million but lose the option to delay which makes NPV even higher to $11.42 million.

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Decision Tree Analysis: Wait one year

Therefore, we should wait and decide next year whether to implement project, based on demand.

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Why timing option is valuable? We can reduce future uncertainty by waiting.

That is, more information (about future demand conditions) is uncovered by waiting.

Timing option explains why some corporations delay their capital investments in unfavorable macroeconomic environments.

Real estate or construction example

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Other Factors to Consider When Deciding When to Invest Delaying the project means that cash flows

come later rather than sooner. Waiting may allow you to take advantage of

changing conditions.

Note: However, it might make sense to proceed today if there are important advantages to being the first competitor to enter a market.

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Using financial option approach to value real option in capital investment We can use financial option to analyze real option.

This is where the Black-Scholes Model comes in. The option to wait resembles a financial call option--

we get to “buy” the project for $70 million in one year if value of project in one year is greater than $70 million.

This is like a call option with an exercise price of $70 million and an expiration date of one year.

We will not do this in this class!

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Another example (Growth Option): Another example (Growth Option): Cost is $75 Million Now, No Option Cost is $75 Million Now, No Option

to Waitto WaitCost NPV this

2001 Prob. 2002 2003 2004 Scenario

$45 $45 $45 $36.9130%

-$75 40% $30 $30 $30 -$0.3930%

$15 $15 $15 -$37.70

Future Cash Flows

$36.91 = -$75 + $45/1.1 + $45/1.12 + $45/1.13.

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Expected NPV of New Situation

E(NPV) = [ 0.3( $36.91 ) ] + [ 0.4( ─$0.39 ) ] +

[ 0.3 ( ─$37.70 ) ] E(NPV) = ─ $0.39.

The project now looks like a loser.

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However, if we assume that the firm has a growth option

Growth Option: “You can replicate the original project after it ends in 3 years.”

Then, the firm would implement replication, only if demand is high.

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Decision Tree Analysis

Notes: The 2004 CF includes the cost of the project if it is optimal to replicate. The cost is discounted at the risk-free rate, other cash flows are discounted at the cost of capital.

Decision Tree: Implement the repeated project only if demand is high.Cost NPV this2001 Prob. 2002 2003 2004 2005 2006 2007 Scenario

$45 $45 -$30 $45 $45 $45 $58.0230%

-$75 40% $30 $30 $30 $0 $0 $0 -$0.3930%

$15 $15 $15 $0 $0 $0 -$37.70

Future Cash Flows

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Expected NPV of Decision Tree

E(NPV) = [0.3($58.02)]+[0.4(-$0.39)] + [0.3 (-$37.70)] E(NPV) = $5.94.

The growth option has turned a losing project into a winner!

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Another example (Abandonment Another example (Abandonment Option): Cost is still $75 Million, No Option): Cost is still $75 Million, No Option to Wait, No Option to GrowOption to Wait, No Option to Grow

Cost NPV this2001 Prob. 2002 2003 2004 Scenario

$45 $45 $45 $36.9130%

-$75 40% $30 $30 $30 -$0.3930%

$15 $15 $15 -$37.70

Future Cash Flows

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However, if we assume that the firm has an abandonment option, Abandonment Option: Desert investment

in the future if optimal. For example,

A small computer software has an option of selling its patent to a Microsoft.

A real estate developer sells the property, if demand turns out to be low.

A NFL player can be traded off with another players with more potential.

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Abandonment Example

Suppose the project can be sold for $20 million after first year, if demand is low.

Then, in the first year, the project earns $35 (=$15 + $20)

In subsequent years, cash flows will be zero.

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Abandonment Option

Cost NPV this2001 Prob. 2002 2003 2004 Scenario

$45 $45 $45 $36.9130%

-$75 40% $30 $30 $30 -$0.3930%

$15 $15 $15 -$37.70

Future Cash Flows

$35 $0 $0 -$43.18

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Expected NPV of Decision Tree Before abandonment option,

E(NPV) = -$0.39.

With abandonment, E(NPV) = 0.3($36.91) + 0.4(-$0.39) + 0.3 (-$43.18)

= -$2.04.

The abandonment option has turned a losing project into a more loser! Do not sell!

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What if the company can sell it off for $30M?

Cost NPV this2001 Prob. 2002 2003 2004 Scenario

$45 $45 $45 $36.9130%

-$75 40% $30 $30 $30 -$0.3930%

$15 $15 $15 -$37.70

Future Cash Flows

$45 $0 $0 -$34.09

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Expected NPV of Decision Tree Before abandonment option,

E(NPV) = -$0.39.

With abandonment, E(NPV) = 0.3($36.91) + 0.4(-$0.39) + 0.3 (-$34.09)

= $0.69

The abandonment option has turned a losing project into a winner by a slight margin!

The minimum selling price is approximately $28M.

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Conclusion Real options exist when managers can influence the

size and risk of a project’s cash flows by taking different actions during the project’s life in response to changing market conditions.

Alert managers try to look for real options in projects.

Real option allows managers to incorporate strategic decisions into quantitative analysis more precisely.

Examples: licensing, M&A, outsourcing, spin-off, to name a few.