College 5 Real Options: Valuing flexibility

Berk & DeMarzo, Chapter 22

Microsoft KIN

$ 1bln

Deepwater Horizon (BP)

$ 37.2bln

Iridium Communications

$ 6bln

From Financiering 1.5, we know about Capital Budgeting (Chapter 7 of Berk & DeMarz0)
Year Free Cash flow Cost of Capital Discount factor 0 -1000 10% 1 1/1.10=0.91 455 0.83 413 0.75 376 1 500 2 500 3 500

PV of Free Cash -1000 Flow NPV 243

1. Example of an Investment decisions for which YOU are asked to give an opinion
Invest in a new factory to produce 3D-printers
Investment $10 mln

When completed, cash flows of $5 mln p/y

The cost of capital is 20%

1. Should we do it? 2. What other information would you like to have?

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Investment Decision

Iridium Communications

$ 6bln

Agenda

22.1 Real versus Financial Options 22.2 Decision Tree Analysis

22.3 Option to Delay

22.4 Growth and Abandonment Options 22.5 Applications to Multiple Projects
Only second part: Staging Mutually Dependent Investments

22.7 Key Insights from Real Options

To obtain intuition for the impact of delay, grow, abandon on valuation, we build decision trees
Decision trees
Visualize outcomes in a visual way

There is uncertainty (round nodes)

There are decision moments (square boxes) There are payoffs / cash-flows

Options
Contingent payoffs Option valuation methodology Put a number on real options embedded in investment projects

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A decision tree for Megan (page 740)

Assume Megan is financing part of her MBA education by running a small business. She purchases goods on eBay and resells them at swap meets.

Swap meets typically charge her $500 in advance to set up her small booth. Her revenues are $1100 per meet.

Expected profits: $600

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Megan is aware that attendance at swap meets is weather-dependent.

In good weather her profits are $1500. In bad weather, she will incur a loss of $100.

There is a 25% chance of bad weather.

Expected profits: $600

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Figure 22.3 Megans Decision Tree When She Can Observe the Weather Before She Makes the Decision to Go to the Meet

Expected profits: $625 => $25 more than without the flexibility to wait

Example: How much should you pay for an opportunity to open a restaurant?

Assume you have negotiated a deal with a major restaurant chain to open one of its restaurants in your hometown.
You can choose to do it immediately, or in exactly one year.

It will cost $5 million to open the restaurant, whether you open it now or in one year. If you open the restaurant immediately, you expect it to generate $600,000 in free cash flow the first year.
Future cash flows are expected to grow at a rate of 2% per year.

The cost of capital for this investment is 12%. The NPV if you invest now is $ 1 mln. (why?)

Should you wait to decide next year?

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The option to wait as a call option

The payoff if you delay is equivalent to the payoff of a one-year European call option on the restaurant with a strike price of $5 million.

Assume
The risk-free interest rate is 5%. The volatility is 40%. If you wait to open the restaurant you have an opportunity cost of $600,000 (the free cash flow in the first year). In terms of a financial option, the free cash flow is equivalent to a dividend paid by a stock. The holder of a call option does not receive the dividend until the option is exercised.

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Table 22.1 Black-Scholes Option Value Parameters for Evaluating a Real Option to Invest

Computation of the real option to wait

The current value of the asset without the dividends that will be missed is:

The present value of the cost to open the restaurant in one year is:

$0.6 million S PV (Div) $6 million $5.46 million 1.12

$5 million $4.76 million 1.05

PV (K )

C S x N (d1 ) PV (K )N (d 2 ) ($5.46 million) (0.706) ($4.76 million) (0.557) $1.20 million

Which is more than the $1 mln NPV of investing now. So we should wait!

An option on a negative-NPV-investments can be attractive, as long as the uncertainty is large enough

NPV Value

$ 5mln

Current value of an operating restaurant

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The option to wait becomes less attractive if the operating cash flow increases.
Alternative for FCF = $700.000 In that case,
NPV of investing now = $7 mln - $5 mln = $2 mln
C=$1.91

NPV-now is higher than option value, so we should invest now! Why does a change in operating CF change the wait/invest decision?

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The option to delay an investment opportunity is a first type of real option

When you have the option of deciding when to invest, it is usually optimal to invest only when the NPV is substantially greater than zero.
You should invest today only if the NPV of investing today exceeds the value of the option of waiting. Given the option to wait, an investment that currently has a negative NPV can have a positive one.
arrival of new information / resolution of uncertainty

Role of volatility The option to wait is most valuable when there is a great deal of uncertainty.
Role of dividends Absent dividends, it is not optimal to exercise a call option early. In the real option context, it is always better to wait unless there is a cost to doing so. The greater the cost, the less attractive the option to delay becomes.

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Real option theory applied to power plant investments: coal vs. gas-fired power plants
Coal-fired plant
Cheap ($ per megawatt)

Large capacity
Slow startup (a few days) Positive NPV

Gas-fired plant
Expensive ($ per megawatt) Small capacity Quick startup Negative NPV

Where is the option value?

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Real options are used a lot by oil and gas companies

Decision to bid for an area to explore
Uncertainty about finding oil Option to delay exploration

Decision to drill or not

Uncertainty about potential The value of geological surveys (costly)

Decision to explore the oil

The variable costs of exploration are also costly Example: Tar sands in Alberta (Canada)

Decision to invest in technology

Timing of the investment
Strategic considerations, such as potential spin-offs. What does the industry do?

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Exploring tar sands in Alberta by Shell ( Alternative to book case StartUp Inc (p.748-750) )

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The decision to explore tar sands

Investment: $1bln Discount rate 10%

At current oil price of $75 p/barrel, yearly Cash-flow of $90 mln (indefinite)
What is the value of the project? The option:
The project may be abandoned after one year, but $250 mln cannot be recouped In that year, the oil price may change to either $50 or $100 Oil price = 100 CF = $140 mln Oil price = 50 CF = $50 mln Rf = 0% What is the value of this option?

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The option to expand (growth options)

Consider an investment opportunity that requires a $6 million investment today. In one year you will find out whether the project is successful and generate $1 mln per year. If failed, the CF is 0 The risk neutral success probability is 50% The discount rate is 10% What is the NPV?

The option There is an option to grow: after one year, we can double the size of the project on the original terms. (NPV of this option is $1.82 mln)

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Market leaders and followers from a real-option perspective

Market leader (Apple)

experiment

option to abandon
option to grow

Follower (Samsung)
option to wait
make an iPad-look-a-like only if the iPad turns out to be succesful

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Why Farmland close to the city is so expensive (page 748: Why Are There Empty Lots in Built-Up Areas of Big Cities?)

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22.5: Staging mutually dependent investments.

Spijker considers developing an electric car

1. Develop light-weight materials

2. Advance battery technology

Technology Materials Battery

Cost $100 mln $100 mln

Time 1 yr 4 yr

Prob. success 50% 25%

What should it do first? Rf = 6%

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Technology Materials Battery

Cost $100 mln $100 mln

Time 1 yr 4 yr

Prob. success 50% 25%

Approach: compare expected costs for each order

1. Materials, then Battery: $147.2 mln

2. Battery, then Materials: $119.8 mln

What if the probability of success of battery goes up to 70%? (EC $155 mln)

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Learning objectives

1. 2. 3. 4. 5. 6.

Define the term real option. Draw decision trees to represent alternative decisions and potential outcomes in an uncertain economy. Describe three types of real optionstiming, growth, and abandonmentand explain why it is important to consider those options when evaluating projects. Illustrate how, given the option to wait, an investment that currently has a negative NPV can have a positive value. Describe situations in which the option to wait is most valuable. Decide the order of investment in a staged investment decision.

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