FIN 468 Intermediate Corporate Finance Topic 12 Real Options Larry Schrenk Instructor 1 of 22 Topics What is a real option 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 always look for real options in projects Smarter managers try to create real options 3 Introduction to Real Options Alternative yet complementary approach to DCF based Capital Budgeting Many corporate investments especially strategic ones have embedded options Overlooking these options can lead to under valuing investment projects Using Real Options approach can improve project management as well as 4 Types of Real Options Wait Timing Abandonment Resolve Uncertainty Contraction Identify Temporary Demand suspension Permanent Expansion Existing Switch Transition Products New Change Geographic Product Mix Markets Change Input Mix Growth New Technical Products Obsolescence R D 5 What is a Real Option Traditional discounted cashflow approaches such as the NPV rule cannot properly capture management s flexibility to adapt and revise later decisions in response to unexpected market developments Traditional approaches assume an expected scenario of cashflows and presume management s 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 6 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 X 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 7 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 technologybased service product as the result of a successful R D effort 8 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 9 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 10 information about project cashflows becomes available over time Real 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 11 Traditional Approaches To Dealing with Uncertainty and Complexity in Capital Budgeting 4 Traditional capital budgeting procedures cannot properly capture management s 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 12 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 I1 Required investment in the R D project Real Options in the SuperCom Project R D Stage 0 Years Commercialization Stage 3 5 7 T 15 I1 Ic I3 Final investment in the project can be decreased by Ic if the market is weak Defer up to 1 year IE I3 Expand Switch Use Abandon for salvage Contract save Ic I2 Abandon forgo I2 I2 Required investment in the commercial scale plant marketing and distribution if the R D effort is successful and if market conditions are favorable IE 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 project s expected operating cashflows 13 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 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 SuperCom is better than expected