Real Options Finance Theory II (15.402) – Spring 2003 – Dirk Jenter 2 • • • • • • • • • • • • • Finance Theory II (15.402) – Spring 2003 – Dirk Jenter The Big Picture: Part II - Valuation A. Valuation: Free Cash Flow and Risk April 1 Lecture: Valuation of Free Cash Flows April 3 Case: Ameritrade B. Valuation: WACC and APV April 8 Lecture: WACC and APV 1 April 10 Lecture: WACC and APV 2 April 15 Case: Dixon Corporation 1 April 17 Case: Dixon Corporation 2 April 24 Case: Diamond Chemicals C. Project and Company Valuation April 29 Lecture: Real Options May 1 Case: MW Petroleum Corporation May 6 Lecture: Valuing a Company May 8 Case: Cooper Industries, Inc. May 13 Case: The Southland Corporation3 Real Options: Valuing Flexibility • • • Example: •  Finance Theory II (15.402) – Spring 2003 – Dirk Jenter The “Real Options Approach” assess the value of managerial flexibility in responding to new information. Managers have many options to adapt and revise decisions in response to new and unexpected developments. Such flexibility is clearly valuable and should be accounted for in the valuation of a project or firm. Often, managers can expand or contract production in response to changes in demand. The firm would be less valuable if they had to choose a fixed production level before knowing the level of demand. 4 • • • Valuation • • • Finance Theory II (15.402) – Spring 2003 – Dirk Jenter Two Steps in Real Options Analysis: Identification Are there real options imbedded in a given project? What type of options? Are they important? How do we value the (important) options? How do we value different types of options? Why can’t we just use NPV?Finance Theory II (15.402) – Spring 2003 – Dirk Jenter Step 1: Identifying Real Options 6 • • • → → • Finance Theory II (15.402) – Spring 2003 – Dirk Jenter Identifying Real Options It is important to identify the options imbedded in a project. There are options imbedded in all but the most trivial projects. The most crucial skill consists of: Identifying those options that are “significant”, if any. Ignoring those that are not. Identifying real options takes practice, and sometimes “vision”.Example: Oz Toys’ Expansion Program • Oz Toys’ management is considering building a new plant to exploit innovations in process technology. • About three years out, the plant’s capacity may be expanded to allow Oz Toys’ entry into a new market. Oz Toys' Initial Calculations for Phased Expansion Program 2000 2001 2002 2003 2004 2005 2006 EBIT * (1 -t) 2.2 4.0 -10.0 11.5 13.7 17.4 Depreciation 19.0 21.0 21.0 46.3 48.1 50.0 CAPX 120.0 8.1 9.5 307.0 16.0 16.3 17.0 ∆NWC 25.0 4.1 5.5 75.0 7.1 8.0 9.7 FCF -145.0 9.0 10.0 -371.0 34.7 37.5 40.7 TV (5% growing perpetuity) 610.5 NPV (at 12% WACC) -19.8 Finance Theory II (15.402) – Spring 2003 – Dirk Jenter 8 Is There An Option? • • • • • information? Finance Theory II (15.402) – Spring 2003 – Dirk Jenter Two conditions: (1) News will probably arrive in the future. (2) When it arrives, the news may affect decisions. Identify the uncertainty that managers face: What is the main thing that managers will learn over time? How will they exploit the new information? What decisions will change as a function of the new 79 • • : • • • Finance Theory II (15.402) – Spring 2003 – Dirk Jenter Oz Toys: Is There An Option? (1) Oz Toys might learn (or not) about: The demand for the current and/or new products. The possibility of rivals entering the market. •Etc. (2) The information might affect (or not) Oz Toys’ decisionWhether or not to undertake expansion phase 1 at all. Whether to undertake phase 2 (or subsequent phases…). Whether to push one new product or the other. •Etc. 10 • • • → → → → Timing option → Finance Theory II (15.402) – Spring 2003 – Dirk Jenter Identifying Real Options (cont.) Look for clues in the project’s description: “Phases”, “Strategic investment”, “Scenarios”, … Examine the pattern of cash flows and expenditures over time. For instance, large expenditures are likely to be discretionary. Taxonomy of frequently encountered options : Growth option Abandonment option Option to expand or contract scale Option to switch (inputs, outputs, processes, etc.)11 • information. • • → R&D Î → Î Sequel. Finance Theory II (15.402) – Spring 2003 – Dirk Jenter Growth Options An investment includes a growth option if it allows to undertake a follow on investment, and the decision whether to undertake the follow-on investment will be made later on the basis of new When valuing such an investment, one should (also) take the value of the growth option into account. Such projects are often presented as having “strategic value”. •Examples: Developing applications if R&D is successful. Movie Production 12 Growth Options (cont.) • • → Rocky 1 Î Rocky 2 Î Î … • → → j→ Finance Theory II (15.402) – Spring 2003 – Dirk Jenter Growth options are akin to Call options: You have the option, not the obligation, to get something by incurring a cost. Growth options can be “nested”, i.e., series of related choices: Rocky 3 Growth options can be very valuable and account for over half of the market value of some industries. industries with heavy R&D. industries with multiple pro ect generations (e.g. computers, pharmaceuticals). Industries with multinational operations.13 Abandonment Options: • • • Finance Theory II (15.402) – Spring 2003 – Dirk Jenter The Option to Shut-down An investment includes an abandonment option if, under certain circumstances, it may be preferable to shut down current operations permanently and realize the resale value of capital equipment and other assets in secondhand markets. Sometimes, abandonment options are hidden in aggregated forecasts: While it may be preferable to continue operations on average, shutting down may be better under some scenarios. Abandonment options are akin to Put options: You have the option (but no obligation) to get rid of something and receive a payment (the liquidation value). 14 Option to Expand or Contract Scale • utilization. • • → → Finance Theory II (15.402) – Spring 2003 – Dirk Jenter If conditions are more favorable than expected, the firm can expand the scale of production or