Strategic Financial Management

Chapter V

Real Options
After reading this chapter, you will be conversant with: Financial Options and Real Options Compared Various Types of Real Options The Black-Scholes Model Decision Tree Analysis Application of Real Options Drawbacks of Real Options

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Let us start with refining the basic concept of real options. In a narrower sense, the real options approach can be viewed to be an extension of the financial option theory. In case of the real options the underlyings are real assets unlike financial assets in the case of financial options. The difference lies in the fact that the financial options are detailed in their contract; the real options that are embedded in strategic investments must be identified and specified. The real option approach provides the managers with opportunities for the way they have to plan and manage strategic investments.

COMPARING FINANCIAL AND REAL OPTIONS

The basic difference that exists between a financial option and a real option lies in its underlying. The underlying that exists in case of the former is a security such as a share of a common stock or a bond, whereas the underlying for the latter is a tangible asset, say for example, a business unit or a project. It is to be noted that both types of options give the right but not the obligation to take an action. Financial options are written on traded securities, whose price is usually observable and one can estimate the variance of its rate of return. In the case of real options, the underlying risky asset is usually not a traded asset, thus one estimates the present value of the underlying without flexibility by using traditional net present value techniques. A further difference exists between the two. Most financial options are not issued by the companies on whose shares they are contingent, but rather by the independent agents who write them and buy those that are not written. As a result of which, the agent that issues a call option has no influence and control of the company and its share price. The real options are different in this aspect because here, the management controls the underlying real assets on which they are written. As an example, a company might have the right to refer a project and it may choose to do so if the present value of the project is low. Now if the company comes up with an innovative idea that has the potential to enhance the NPV of the project, the value of the right to refer may fall and the company may decide not to defer. As a matter of fact, the act of enhancing the underlying real assets value also increases the value of the option. A point of similarity that exists between a financial option and a real option is that in both cases, the uncertainty of the underlying, i.e. the risk is assumed to be exogenous. The uncertainty concerning the rate of return on a share of a stock, is beyond the control and influence of individuals, who are the actual traders of the stock. In case of real options, the actions of the company that own it may influence the action of its competitors, and consequently the nature of uncertainty that the company faces.

TYPES OF REAL OPTIONS

The very first step in valuing a project lies in identifying the options that are embedded within the project. It may happen that though two projects are exactly identical, there may be the presence of several types of real options.

Investment Timing Options

The conventional type of Net Present Value (NPV) analysis is based on the implicit assumption that the project will either be accepted or rejected. This has a simple implication, that a project will be undertaken now or never. Though in practice, companies may even go in for a third choice. They have the option to relay the decisions until at a later point of time when more information is available. Such investment timing options (ITO) result in altering the projects, estimated profitability and risk.

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Box 5.1: Different Methods of Valuing Options BusinessWeek, the Indian financial magazine worked to determine the bottomline impact of the various methods for valuing options. It then came out with five possible ways to value options. It used a hypothetical grant of 5.3 million options which is median number of options granted by S&P 500 companies in 2001, and approximately the number granted by several wellknown companies, including Aetna, Walgreen, Scientific-Atlanta, and CVS for this purpose. It plotted two different performance scenarios: One in which the stock price increased 15% a year over three years and the second in which it decreased 15% a year. For each scenario, it examined the impact on earnings using two types of accounting: Fixed accounting, which values options on the grant date and expenses them over time regardless of changing stock price and options value, and variable accounting, which values and expenses options every year. The five methods are briefly described and evaluated below. Black-Scholes How it works: Uses formula based on dividend yields, volatility, and other factors to estimate option value. Advantage: Accounts for most factors affecting future option value. Disadvantage: Doesnt discount for vesting and other restrictions, so it overestimates option value. Impact on earnings: If stock increases in value: $66.5 mn (fixed), $96.6 mn (variable). If stock decreases in value: $66.5 mn (fixed), $31.7 mn (variable). Verdict: Thumbs down. Companies would overpay for underwater options; formula easily manipulated to boost earnings. Binomial How it works: Uses Black-Scholes variables, but assumes options will be exercised when optimally profitable. Advantage: Reflects how options really are exercised. Disadvantage: If company pays dividends, this model results in bigger hit to earnings than Black-Scholes. Impact on earnings: If stock increases in value: $67.3 mn (fixed), $97.3 mn (variable). If stock decreases in value: $67.3 mn (fixed), $31.8 mn (variable). Verdict: Thumbs down. No improvement over standard Black-Scholes. Minimum Value How it works: Calculates Black-Scholes value assuming zero volatility. Advantage: Of the Black-Scholes variants, this model requires the smallest earnings charge when companies can escape with no charge by using variable accounting. Disadvantage: No public company stock has zero volatility. Impact on earnings: If stock increases in value: $26.4 mn (fixed), $69.3 million (variable). If stock decreases in value: $26.4 mn (fixed), $472,230 (variable). Verdict: Thumbs down. Purification. 56

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Growth and Discount How it works: Instead of volatility, this method relies on assumptions of future stock gains to determine option value. Advantage: Simpler than Black-Scholes, and allows companies that use variable accounting to avoid charge when options plunge underwater. Disadvantage: Difficult to determine future stock gains with 100% accuracy. With fixed accounting, an expensive alternative. Impact on earnings If stock increases in value: $86.1 mn (fixed), $120.7 million (variable). If stock decreases in value: $86.1 mn (fixed), $24.4 (variable). Verdict: Thumbs down. Too pricey, and too easy to manipulate. Intrinsic Value How it works: The stock price, minus the exercise price, is the value of the option. Since grant date value is zero, fixed accounting cannot be used. Advantage: The simplest method of all, impervious to manipulation, and underwater options are free. Disadvantage: As with any variable accounting treatment, earnings charge could fluctuate wildly with stock price. Impact on earnings If stock increases in value: $52.9 mn (variable). If stock decreases in value: $0 (variable). Verdict: Thumbs up. This method accurately tracks true options value over time. Uses no assumptions that can be tweaked to boost earnings. And its cheap: With stock gains, other methods would result in much bigger charges, and with a depreciating stock, theres no charge at all. Data: BusinessWeek; Earnings impact calculated by Towers Perrin Note: For the purposes of this illustration, BusinessWeek assumed the options were granted on June 30, with the exercise price set at a current stock price of $30, and vested in equal installments on the grant date anniversary in 2003, 2004, and 2005. Calculations assume 40% volatility, 1.5% dividend yield, 1.1 beta, 4.5% risk-free rate, and 10.5% market return. Impact on earnings is the cumulative earnings reduction over three years, not adjusted for taxes. Source: ICFAI Reader, March 2003. Say for example, a particular company has plans to introduce an innovative mobile set with a lot of added features. Your company may be left with two alternatives. 1. 2. To immediately start of with providing the services that are compatible with the mobile sets. To delay the investments in the projects until one gets a better idea of the size of the market for the innovative mobile sets.

Well, here one should prefer in delaying the investment on the project implementation. It should be borne in mind that the option to delay will only be valuable if it more than compensates any harm that might arise from delaying. It might happen that if one delays, any other company may take advantage of it and create a strong loyal customer base that in turn might make it difficult for the company to enter the market at a later point of time. The option to delay projects is usually most valuable to the firms with proprietary technology, patents, licenses or other barriers to entry, because these factors tend to lessen the threats of competition. Further it is also valuable when the market demand is uncertain, at 57

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the same time it is also valuable during periods of volatile interest rates, since the ability to wait aids in allowing the firms to delay the raising of its capital for the projects until the interest rates are lower.

Growth Options
A growth option lets a company to increase its capacity of operation if the market conditions are better than expected. They may be of different types. In one type of growth option, a company may resort to increase the capacity of an existing product line. Another type allows a company to expand into new geographic markets. The third type may deal with the opportunity to add new products that even includes the complementary products and successive generations of the original product.

Abandonment Option
There may be many projects that contain abandonment options. When one goes for evaluating a potential project, the standard DCF method is used. The DCF assumes that the assets that are involved in the project will be used over a specified economic life. Though it is correct to say that some projects can be operated over their full economic life, though the market conditions can get adverse and lower the expected cash flows, there may be other projects that may be abandoned. Say for example, some contracts between the automobile manufacturers and their suppliers mention the quantity and the price of the parts that must be delivered. If the labor cost of the supplier increases, then he might as well lose money on each part he ships. Thus the inclusion of the option to abandon such a contract might be quite valuable.

Flexibility Options
There are many projects that offer flexibility options which allow the firm to alter operations depending on how the conditions change during the life of the project. It may happen that either the inputs or the outputs can be changed. The electric power plants provide a good example of the input flexibilities.

Valuing Real Options

Let us now try to focus on the valuation of real options. Let us first consider a simple project that consists of a single risk-free cash flow that is due one year from today. The pure DCF value of the project can be calculated as follows. DCF value of the project = Cash flow 1+ k RF

Where kRF denotes the risk-free rate of return at which the cash flow is discounted. The inputs are the cash flow and the risk-free rate that help in accurate estimation of the projects DCF. In contrary, valuing real options calls for a greater level of judgments in areas of both formulating the model as well as in estimating the values of the inputs. This implies that the value of the project using real options will not be as accurate as it had been stated in a simpler DCF model for valuation. There can be five possible procedures that can be used in order to deal with real options. They are: a. b. c. d. e. Use of DCF valuation and ignoring any real option, with the assumption that their values are zero. Using the DCF valuation and including a qualitative recognition of any real options value. Use of decision tree analysis. Using a standard model for a financial option. Developing a unique, project specific model with the help of techniques in financial engineering. 58

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Let us now try to understand each of these with the help of some examples. Opportunistic India Ltd. is considering a project for an innovative set up device that will enable cable users to view satellite channels according to their own wish. The total estimated cost of the project is Rs.5 crore, but the future cash flows of the project depend on the demand of the conditional access system (CAS) that is to be provided by the government, which is not very certain. The company feels that there lies a 25 percent chance that the demand for the new set up device is very high, in which case the project will be able to generate a cash flow of Rs.3.3 crore for each of the following three years. It also feels that there lies a 50 percent chance for the demand to be average with subsequent generation of cash flows that will amount to Rs.2.5 crore per year, along with that the chances that the demand will be low is 25 percent in which case the cash flow generation will be only 50 lakhs. A basic analysis reveals that the project is somewhat riskier than any other average project, as a result of which the cost of capital that would be used to discount its cash flow is 14 percent. Opportunistics India Ltd. enjoys patent rights on the devices core modules, so instead of implementing the project immediately, it can also choose to delay the decision until the coming year. The cost of the project will still amount to Rs.5 crore if it waits, and the project will still generate the expected cash flows that have been stated earlier. But each of the expected cash flows will be delayed by one year. It should be remembered that if the company waits, it will be able to know which of the demand conditions, and in return which of the set of cash flows, will exist. Thus on delaying the project it will go in for investments only if the demand is sufficient enough to provide a positive value of net present value. Type 1: Using DCF Valuation and not Considering any Real Option by Assuming that their Values are Nil Demand for the device High Average Low Probability (Pi) Annual Cash Flows (cf) (crore) 3.3 2.5 0.5 Expected Cash Flows (Pi x cf) (crore) 0.825 1.250 0.125

0.25 0.50 0.25

2.200 So, as calculated above, the expected annual cash flow per year is Rs.2.2 crore. If we do not take into account the investment timing option, then the traditional value of the net present value will be NPV = Rs.5 crore + = 10,80,000 So, based on the discounted cash flow method, the company should go in for the project. It is to be noted here, that if the expected cash flow had been slightly lower, say for example Rs.2.15 crore, the NPV would have been negative and this would have resulted in rejection of the project. Farther the project is risky, as there lies 25 percent chance that the demand for the devices may be low, in which case the net present value would turn out to be a negative Rs.3.84 crore. 2.2 cr. 2.2 cr. 2.2 cr. + + +10,80,000 (approx. value) 2 (1+ 0.14) (1+ 0.14) (1+ 0.14)3

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Type 2: Using the DCF with Qualitative Recognition of the Real Options Value As it is suggested by the discounted cash flow analysis, the project should be barely accepted, and it ignores the existence of a possible value of real option. If the company goes in for immediate implementation of the project, it gains the expected cash flow of 0.108 crore but at the cost of the risk that is involved with the chances of its low demand. Nevertheless, accepting the project now implies that it is also foregoing the option of waiting for some more time to gain more market information before it makes any commitments. So, the decision has to be made on whether the company would be sacrificing worth that is more or less than Rs.0.108 crore. If it is worth more, then it should not go in for immediate implementation of the project and defer it for some point of time later, and it would do just the opposite in case it is worth less than this value. This brings us to another point of discussion: Should the company go ahead with the project now or wait for sometime? While considering this decision, one should note that the value of an option is higher if the current value of the underlying asset is high relative to its exercise price, other things remaining unchanged. Say, for example, a call option with an exercise cost of Rs.50 on a stock with the current price of Rs.50 is definitely worth more if its value were Rs.20. The DCF valuation is also suggestive of the fact that the underlying value of the asset will be closer to the exercise price, as a result the value of the option will be valuable. It is also known that the value of the option increases with the increase in its time to expire. In our example, the option has life of one year, which is fairly a long time for an option. This too implies that the option is valuable. Finally, it is to be said that an options value increases with the risk of an underlying asset. Here, it is seen that the project is quite risky, which again suggests that the option is valuable. Thus based on this qualitative approach, it is advisable to delay the project, though the NPV would result in earning Rs.108 crore on immediate implementation. Type 3: Use of Decision Tree Analysis Let us here take two ways of using the decision tree analysis. One being the scenario analysis, and the other being the other decision tree. The scenario analysis can be used in the following way. Case 1 Scenario analysis on immediate implementation of the project 2003 2004 2005 2006 NPV of this Scenario 2.661 0.804 3.839 Prob Prob x NPV 0.25 0.50 1.00 Expected NPV = (0.665) + (0.402) + (0.960) = 0.107 In the above diagram, each possible outcome is shown as a "branch" on the tree. The branch resembles the cash flows and the probability of the individual scenarios. As is evident from the above example, in the high demand scenario, the NPV of the project is 2.661 crore, for analysis demand scenario it is 0.804 crore, whereas in case of low demand, the project yields a negative NPV of 3.839 crore. So, the company will suffer a loss to this extent in case of low demand, and as 60 0.665 0.402

High 5 Average Low

0.25 0.5 0.25

3.3 2.5 0.5

3.3 2.5 0.5

3.3 2.5 0.5

0.25 0.960

Strategic Financial Management

there is a 25 percent chance of the demand being weak, the project can be considered to be a highly risky one. The expected NPV of the project is the weighted average of the three possible outcomes, with the weight for each outcome being its probability. The expected NPV comes to 0.108 crore, same as one estimated using the DCF valuation. Let us now see the decision tree analysis in valuing the project. Case 2 Decision tree analysis project implementation in the next year if optimal. 2003 2004 2005 High Wait Average Low 0.25 0.5 0.25 5 5 0 3.3 2.5 0 2006 2007 3.3 2.5 0 3.3 2.5 0 NPV of this Scenario 2.335 0.705 0 Prob Prob x NPV 0.25 0.50 0.25 1.00 Expected NPV of the Project = (0.584) + (0.353) + (0) = 0.937 The above diagram can be viewed similar to that of the scenario analysis, the only difference being that the company delays the decision and implements the project only if demand turns out to be high or average. Say if the cost is incurred in the year 2003, then the only action that can be taken is to wait. Then, if the demand turns out to be average or high, the company may spend around 5 crore in 2004 and receive either 3.3 crore or 2.5 crore per year for each of the following three years. Say, if the demand is low, the company will spend nothing in the year 2004, and will receive no cash flows in the following years. The NPV of the high demand situation is 2.335 crore and that of the average demand situation is 0.705 crore. Now, as all the cash flows under the low demand situation is zero, the resulting NPV will also be zero. So, if the company delays the project, the expected NPV comes to 0.936 crore. This clearly shows that the expected value of the project will be much higher if the company delays the project than if it implements the project immediately. Added to this, as there is no possibility of losing money under the option to delay, this decision also lowers the projects risk. This clearly indicates that the option to wait is definitely volatile, so Opportunists India Ltd. should wait till 2004 before taking any decision to proceed with the investment. Case 3 What if, a different discount rate is taken, other than 14 percent? In both the cases (case 1 and case 2) above, we have used the same cost of capital i.e. 14 percent. But this may not be advisable and feasible to do so, mainly because of the following reasons. a. As there seems to be any possibility of losing money if the company delays the project, the investment under the plan is clearly less risky than if it charges ahead today. The cost of capital of 14 percent may be appropriate for the risky cash flows, yet the investment of the project in the year 2004 in case 2 is known with certainty. May be then one should discount it at the risk-free rate. The cash inflows of the project are different in the second case because of the elimination of the low demand cash flows. This is suggestive of the fact that if 14 percent is the appropriate cost of capital in the first case, some lower 0.584 0.353 0

b.

c.

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rate may be appropriate in the latter one. So, let us take the discount rate to be 6 percent and estimate the expected NPV. 2003 2004 2005 2006 2007 NPV of this Scenario 2.004 0.379 0.00 Prob Prob x NPV 0.25 0.50 0.25 0.501 0.187 0.00

High Wait Average Low

0.25 0.50 0.25

5 5 0

3.3 2.5 0

3.3 2.5 0

3.3 2.5 0

Expected NPV = (0.501) + (0.187) + (0) = 0.688 Using 6 percent as the cost of capital, increase the present value of the cost at 2003, and lower the NPV from 0.936 crore to 0.688 crore. Valuing the Standard Model of Financial Option the Black-Scholes Model Till this point of time, one can safely say that the decision tree analysis, coupled with the sensitivity analysis, is to be a good provider of information for a good decision. But let us try to value the option using an option pricing model. In order to do this, one needs to identify a standard financial option that resembles the projects real option. The companys option to delay the project is comparable to a call option, hence the Black-Scholes option pricing model can be used. Following are the inputs required for the model. i. ii. iii. iv. v. Risk-free rate Time until the option expires Exercise price of the option Current stock price Variance of the stocks rate of return.

Let us assume that the rate on a 92-day treasury bill is 6 percent, this rate can be used as the risk-free rate to discount the cash flows. Let us further assume that the company must decide within a year whether or not to implement the project so that there is still a year before the project expires. A further assumption is that, it will cost Rs.5 crore to implement the project, so the 5 crore value can be used as an exercise price. It is also to be assumed that there is a need of a proxy for the value of the underlying asset, which in the Black-Scholes model is the current price of the stock. It is to be noted here that a stocks current price is the present value of its expected future cash flows. So, as a proxy for the stock price, one can use the present value of the projects cash flows. A final assumption in the model is that the variance of the projects expected return can be used to represent the variance of the stocks return in the Black-Scholes model. Estimating the inputs for stock price in the option analysis of the investment timing option (Millions of Dollars) Future Cash Flow 2003 2004 2005 2006 2007 NPV of this Scenario 6.721 5.091 1.018 Prob Prob x NPV 0.25 0.50 0.25 1.680 2.546 0.255

High Wait Average Low

0.25 0.50 0.25

3.3 2.5 0.5

3.3 2.5 0.5

3.3 2.5 0.5

1.00 Expected value of the present values = (1.680 + 2.546 + 0.255) = 4.480 .....(5.1) 62

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The above calculations show the estimation of the present value of the projects cash flows. One needs to find the current price of the underlying asset, which in this condition, is the project. In case of a stock, the current price is the present value of the expected future cash flows, inclusive of those that are not expected even if one does not exercise the call option. In case of the real option, the underlying asset is the delayed project, and its current price is the present value of all its future expected cash flows. Similar to that of the stock, the present value of the project also contains all its possible future cash flows. Further, as the price of the stock is not affected by the exercise price of a call option, one can ignore the projects exercise price, of cost, while estimating its present value. The present value of the cash flows as of today (2003) is 4.480 crore, and this is the input one should use for the current price in the Black-Scholes model. The final input for the model is the variance of the projects return. Variance of the Projects Return = ln(CV2 + 1) / t Where, CV = Coefficient of Variation T = Time of expiry of the project Variance 2003 High Wait Average Low 0.25 0.50 0.25 = ln(0.472 + 1)/t = 0.20 = 20 percent 2005 3.3 2.5 0.5 2006 3.3 2.5 0.5 2007 3.3 2.5 0.5 PV in 2004 in this Scenario 7.661 5.804 1.161 Prob 0.25 0.50 0.25 1.00 Expected Value of PV (2004) = (1.915 + 2.902 + 0.290) = 5.108 Standard Deviation of PV (2004) = 2.402 Co-eff of Variation of PV (2004) = 0.47 Type 4: Calculation of the Value of the Investment Timing Option using a Standard Financial Option KRF = T X P 2 d1 d2 = = = = = = = Risk-free rate Time (in years) until the option expires Cost of project implementation Current projects value [as calculated in (i)] Rs.4.48 crore Annualized standard deviation of returns on the underlying asset, i.e. volatility measures Variance of the projects return {l (P/X) + [KRF + (2/2)] + T}/( d1 N (d1) N (d2) V T = = = 0.54 0.37 P [N(d1)] N(d2) = 0.704 20 percent T ) = 0.112 =0.33 6 percent 1 Rs.5 crore Prob x NPV 1.915 2.902 0.290 Calculation for Co-efficient of Variation (CV) 2004 -

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As it is seen from the above calculations, the value of the option to defer investment in the project is 0.704 crore. This is significantly higher than 0.108 crore under immediate implementation, as the option should be forfeited. If the company implements it immediately, one can conclude that the company should defer the final decision until more information is gathered. Type 5: Financial Engineering Technique It might sometimes happen that the decision analysis in valuing a real option may not always give satisfactory results, as it becomes difficult to find a standard financial option that corresponds to a real option. In such a situation the only other way is to develop a unique model that corresponds to the specific real option being analyzed, which in other words, is called financial engineering. Here we use the technique of risk-neutral valuation. Risk-Neutral Valuation of Real Options: As we discussed in the chapter, decision trees will always give an inaccurate estimate of a real options value because it is impossible to estimate the appropriate discount rate. In many cases, there is an existing model for a financial option that corresponds to the real option in question. Sometimes, however, there is no such model, and financial engineering techniques must be used. Many financial engineering methods are extremely complicated and are best left for an advanced finance course. However, one method is reasonably easy to implement with simulation analysis. This method is risk-neutral valuation. It is similar to the certainty equivalent method in that a risky variable is replaced with one that can be discounted at the risk-free rate. We show how to apply this method to the investment timing option that we discussed earlier in the chapter. Murphy software is considering a project with uncertain future cash flows. Discounting these cash flows at a 14 percent cost of capital gives a present value of $51.08 million. The cost of the project is $50 million. So it has an expected NPV of $1.08 million. Given the uncertain market demand for the software, the resulting NPV could be much higher or much lower. However, Murphy has certain software licenses that allow it to defer the project for a year. If it waits, it will learn more about the demand for the software and will implement the project only if the value of those future cash flows is greater than the cost of $50 million. As the text shows, the present value of the projects future cash flows is $44.80 million, excluding the $50 million cost of implementing the project. We expect this value to grow at a rate of 14 percent, which is the cost of capital for this type of project. However, we know that the rate of growth is very uncertain and could either be much higher or lower than 14 percent. In fact, the text shows that the variance of the growth rate is 20 percent. Given a starting value ($44.80), a growth rate (14 percent), and a variance of the growth rate (20 percent), option pricing techniques assume that the resulting value at a future date comes from a lognormal distribution. Because we know the distribution of future values, we could use simulation to repeatedly draw a random variable that has this distribution.1 For example, suppose we simulate a future value at Year 1 for the project and it is $75 million. Since this is above the $50 million cost, we would implement the project in this random draw of the simulation. The payoff is $25 million, and we could find the present value of the payoff if we knew the appropriate discount rate. We could then draw a new random variable and simulate a new value at Year 1. Suppose the new value is $44 million. In this draw of the simulation, we would not implement the project, and the payoff is $0. We could repeat this process many thousands of times and then take the average of all the resulting present values, which is our estimate of the value of the option to implement the project in one year.
1

This means that the log of the stock price comes from a normal distribution. For a very clear explanation of how to implement this in an Excel spreadsheet, see Wayne Winston, Financial Models Using Simulation and Optimization (Newfield, NY: Palisade Corporation, 1998).

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Unfortunately, we do not know the appropriate discount rate. This is where we turn to risk-neutral valuation. Instead of assuming that the projects value grows at an expected rate of 14 percent, we would assume that it grows at the risk-free rate of 6 percent. This will reduce the resulting project value at Year 1, the time we must exercise the option. Suppose we did this, and our first simulation run has a value of $55, based on the $44.8 starting value, a 20 percent variance of the growth rate, and a 6 percent growth rate instead of the true 14 percent growth rate. The payoff is only $5 ($55 $50 = $5). However, we now discount this at the riskfree rate to find the present value. Note that this is analogous to the certainty equivalent approach in which we reduce the value of the risky future cash flow but then discount at the risk-free rate. We can repeat the simulation many times, finding the present value of the payoff when discounted at the risk-free rate. The average present value of all the outcomes from the simulation is the estimate of the real options value. We used the risk-neutral approach to simulate the value of the real option. With 5,000 simulations, our average present value was $7.19 million. With 200,000 simulations, the average value was $6.97 million. As the text shows, the true value of the real option in this example is $7.03 million. One disadvantage of the risk-neutral approach is that it may require several hundred thousand simulations to get a result that is close to the true value. Also, risk-neutral valuation requires that you know the current value and variance of the growth rate of the underlying asset. For some real options, the underlying source of risk is not an asset, and so you cannot apply risk-neutral valuation. However, risk-neutral valuation offers many advantages as a tool for finding the value of real options. The example we showed had only one embedded option. Many actual projects have combinations of embedded real options, and simulation can easily incorporate multiple options into the analysis. Personal computers are now so powerful and simulation software so readily available, we believe that within ten years, risk-neutral valuation techniques will be very widely used in business to value real options. Let us now try to understand more about the growth option and the abandonment option. Similar to the framework of investment timing option, these two can also be categorized under the five different approaches. Let us here try to understand each of this with the help of an illustrative example.

The Growth Option: An Illustration

Grow well Corporation designs and produces products aimed at the rural market. Most of its products have a very short life, given the rapidly changing tastes of the rural population. Grow well is now considering a project that will cost Rs.3.0 crore. The companys management believes there is a 25 percent chance that the project will take off and generate operating cash flows of Rs.3.4 crore in each of the next two years, after which rural tastes will change and the project will be terminated. There is a 50 percent chance of average demand, in which case cash flows will be Rs.2 crore annually for two years. Finally, there is a 25 percent chance that the rural population will not like the product at all, and it will generate cash flows of only Rs.2 crore per year. The estimated cost of capital for the project is 14 percent. Based on its experience with other projects, the company believes it will be able to launch a second-generation product if demand for the original product is average or above. This second-generation product will cost the same as the first product, Rs.3.0 crore, and the cost will be incurred in 2005. However, given the success of the first-generation product, it believes the second-generation product will be just as successful as the first-generation product. THE MODEL The growth option for the project resembles a call option on a stock, since it gives Grow well corporation the opportunity to purchase a successful follow-on 65

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project at a fixed cost if the value of the project is greater than the cost. Otherwise, it will let the option expire by not implementing the second-generation product. The following sections apply the first four valuation approaches: (1) DCF, (2) DCF and qualitative assessment, (3) decision-tree analysis, and (4) analysis with a standard financial option. Approach 1 DCF Analysis Ignoring the Growth Option Based on probabilities for the different levels of demand, the expected annual operating cash flows for the project are Rs.1.875 crore per year: 0.25 (Rs.3.4) + 0.50 (Rs.2.0) + 0.25 (Rs.0.2) = Rs.1.900 crore Ignoring the investment timing option, the traditional NPV is Rs.0.129 crore: NPV = Rs. 0.3 + Rs.1.970 (1+0.14)
1

Rs.1.970 (1+0.14)2

= Rs.0.129

Based upon this DCF analysis, the company should accept the project. Approach 2 DCF Analysis with a Qualitative Consideration of the Growth Option Although the DCF analysis indicates that the project should be accepted, it ignores a potentially valuable real option. The options time to maturity and the volatility of the underlying project provide qualitative insights into the options value. Grow wells growth option has two years until maturity, which is a relatively long time, and NPV (calculated on case 2). The cash flows of the project are quite volatile. Taken together, this qualitative assessment indicates that the growth option should be quite valuable. Approach 3 Decision Tree Analysis of the Growth Option Table 5.1 shows a scenario analysis for Grow wells project. The coefficient of variation of the project is 14.54, indicating that the project is very risky. Table 5.2 shows a decision tree analysis in which Grow well undertakes the secondgeneration product only if demand is average or high. In these scenarios, shown on the top two branches of the decision tree, the company will incur a cost of Rs.3.0 crore in 2005 and receive operating cash flows of either Rs.3.4 crore or Rs.2.0 crore for the next two years, depending on the level of demand. If the demand is low, shown on the bottom branch, it has no cost in 2005 and receives no additional cash flows in subsequent years. All operating cash flows, which do not include the cost of implementing the second-generation project in 2005, are discounted at the WACC of 14 percent. Because the Rs.3.0 crore implementation cost is known, it is discounted at the risk-free rate of 6 percent. As shown in Table 5.2, the expected NPV is Rs.0.470 crore, indicating that the growth option is quite valuable. Table 5.1 Scenario Analysis and Decision Tree Analysis for the Grow well Project Scenario Analysis of First-Generation Project (Rs. in crore) Future Cash NPV of this Probability Probability x Flows Scenario NPV 2003 2004 2005 3.4 3.4 2.599 0.25 0.650 High 0.25 3.0 Average 0.5 2.0 2.0 0.293 0.50 0.147 Low 0.25 0.2 0.2 2.671 0.25 0.668 66

Strategic Financial Management

1.00 Expected value of NPVs = Standard deviation Coefficient of variation Table 5.2: Decision Tree Analysis of the Growth Option Future Cash Flows 2006 2007 3.4 3.4 2.0 0 2.0 0 NPV of this Scenario 4.237 0.157 2.671 =

0.129 1.870

= 1.454

(Rs. in crore) Probability Probability x NPV 0.25 0.50 1.059 0.079

3.0

2003 2004 3.4 High 0.25 Average 0.50 2.0 Low 0.25 0.2

2005 0.4 1.0 0.2

0.25 0.668 1.00 Expected value of NPVs = 0.470 Standard deviation = 2.462 Coefficient of variation = 0.524

Approach 4 Valuing the Growth Option with Black-Scholes Option Pricing Model The fourth approach is to use a standard model for a corresponding financial option. As we noted earlier, Grow well corporations growth option is similar to a call option on a stock, and so we will use the Black-Scholes model to find the value of the growth option. The time until the growth option expires is two years. The rate on 91-day Treasury bill is 6 percent, and this provides a good estimate of the risk-free rate. It will cost Rs.3.0 crore to implement the project, which is the exercise price. The input for stock price in the Black-Scholes model is the current value of the underlying asset. For the growth option, the underlying asset is the secondgeneration project, and its current value is the present value of its cash flows. The calculations in Table 5.3 show that this is Rs.2.407 crore. Because the exercise cost of Rs.3.0 crore is greater than the current price of Rs.2.407 crore, the growth option is presently out of the money. Table 5.4 shows the estimates for the variance of the projects rate of return. We use an initial estimate of 15.3 percent in our initial application of the BlackScholes model, shown in Table 5.5.

USING THE BLACK-SCHOLES MODEL FOR A CALL OPTION

Table 5.5 shows a Rs.0.434 crore value for the growth option. The total NPV is the sum of the first-generation projects NPV and the value of the growth option: Total NPV = Rs.0.129 + Rs.0.434 = 0.563 crore, which is much higher than the NPV of only the first-generation project. As this analysis shows, the growth option adds considerable value to the original project. Table 5.3: Estimating the Input for Stock Price in the Growth Option Analysis of the Investment Timing Option (Rs. in crore) Future Cash NPV of this Probability Probability x Flows Scenario NPV 2003 2004 2005 2006 2007 3.4 3.4 4.308 0.25 1.077 High 0.25 67

Real Options

Average 0.50 Low 0.25

2.0 0.2

2.0 0.2

0.50 1.267 0.25 0.063 1.00 Expected value of NPVs = 2.407 Standard deviation = 1.439 Coefficient of variation = 0.060

2.534 0.253

Table 5.4: The Value and Risk of Future Cash Flows at the Time the Option Expires Future Cash PV in 2003 for Probability Probability Flows this Scenario PV 2003 2003 2004 2005 2006 2007 3.4 3.4 5.599 0.25 1.400 High 0.25 Average 0.50 2.0 2.0 3.293 0.50 1.647 Low 0.25 0.2 0.2 0.329 0.25 0.082 1.00 Expected value of PV2005 = 3.129 Standard deviation PV2005 = 1.870 Coefficient of variation PV2005 = 0.060 Expected price at the time the option expires = Rs.31.29 Standard deviation of expected price at the time the option expires = 18.70 Coefficient of variation (CV) Time (in years) until the option expires (t) Real Option KRF t X P
2

= 0.60 =2

Table 5.5: Value of a Call Option Using The Black-Scholes Model = = = = = = = Risk-free interest rate Time until the option expires Cost to implement the project Current value of the project Variance of the projects rate of return {ln(P/X) + [KRF + (2/2)]t}/( t ) d1 t = = = = = = = = = = P[N(d1)] Xe KRFt[N(d2)] = 6 percent 2 Rs.3.000 crore Rs.2.407 crore 15.3 percent 0.096 0.46 0.54 0.32 Rs.4.34

d1 d2 N(d1) N(d2) V

Variance of the projects expected return = ln(CV2 + 1)/t = 15.3 percent

The Abandonment Option: An Illustration

Web World Systems produces a variety of switching devices for computer networks at large corporations. It is considering a proposal to develop and produce a wireless network targeted at homes and small businesses. The required manufacturing facility will cost Rs.2.6 crore. Web World can accurately predict the manufacturing costs, but the sales price is uncertain. There is a 25 percent probability that demand will be strong and the company can charge a high price. Table 1 shows a detailed projection of operating cash flows over the four-year life of the project. There is a 50 percent chance of moderate demand and average

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Strategic Financial Management

prices, and a 25 percent chance of weak demand and low prices. The cost of capital for this project is 12 percent. Web World can sell the equipment used in the manufacturing process for Rs.1.4 crore after taxes in 2004 if customer acceptance is low. In other words, the company can abandon the project in 2004 and avoid the negative cash flows in subsequent years.

The Model
This abandonment option resembles a put option on stock. It gives Web World the opportunity to sell the project at a fixed price of Rs.1.4 crore in 2004 if the cash flows beyond 2004 are worthless than Rs.1.4 crore. If the cash flows beyond 2004 are worth more than Rs.1.4 crore, it will let the put option expire and keep the project.

Expected Operating Cash Flows for Project at Web World

Table 5.6: Operating Cash Flow (Rs. in crore) Demand High Average Low Expected operating cash flow = 0.600 Approach 1 DCF Analysis Ignoring the Abandonment Option Using the expected cash flows from Table 1 and ignoring the abandonment option, the traditional NPV is Rs.0.174 crore. NPV = Rs.2.6 + 0.600 0.750 0.900 + + = Rs.0.174. 2 (1 + 0.12) (1 + 0.12) (1 + 0.12)3 Probability 25% 50% 25% 2004 1.8 0.77 0.8 0.750 2005 2006 2.3 2.8 0.8 0.9 0.9 1.0 0.900 1.025 2007 3.3 1.0 1.2

Based only on this DCF analysis, Web World should reject the project. Approach 2 DCF Analysis with a Qualitative Consideration of the Abandonment Option The DCF analysis ignores the potentially valuable abandonment option. Qualitatively, one would expect the abandonment option to be valuable because the project is quite risky, and risk increases the value of an option. The option has one year until it expires, which is relatively long for an option. Again, this suggests that the option might be valuable. Approach 3 Decision Tree Analysis of the Abandonment Option Table 5.6 shows a scenario analysis for this project. There is a 25 percent chance that customers will accept a high price for the product, with the cash flows shown on the top line. There is a 50 percent chance that it can charge a moderately high price, and the cash flows of this scenario are in the middle row. However, if customers are reluctant to buy this product, the company will have to cut prices, resulting in the negative cash flows on the bottom row. The sum in the last column in Table 5.2 shows the expected NPV of Rs.0.174 crore, which is the same as the traditional DCF analysis as calculated in Approach 1 above. Table 5.5 shows a decision tree analysis in which the company undertakes project in the low-price scenario. In particular, if the company has the Rs.0.8 crore 69

Real Options

operating cash flow in 2004 and the prospect of even bigger losses in subsequent years, it will abandon the project and sell the equipment for Rs.1.4 crore. Note that the company will not abandon the project in the average-demand scenario, even though it has a negative expected NPV as seen above. This is because the original investment of Rs.2.6 crore is a sunk cost. Only the future cash flows are relevant to the abandonment decision, and they are positive in the average-demand scenario. Therefore, the company will abandon the project only in the low-demand scenario. All operating cash flows, which do not include the salvage value in the lowdemand scenario of 2004, are discounted at the WACC of 12 percent. The salvage value is known with a high degree of certainty, so it is discounted at the risk-free rate of 6 percent. As shown in Table 5.3, the expected NPV is 0.704 crore, indicating that the abandonment option is quite valuable. In fact, the option to abandon is so valuable that it should accept the project. The option itself alters the risk of the project, which means that 12 percent may not probably be any longer the appropriate cost of capital. In addition, the estimated Rs.14 crore salvage value is relatively certain, but there is a slight chance that it might be either higher or lower. Table 5.6: Scenario Analysis of the Project (Ignoring the Option to Abandon) (Rs. in crore) Future Cash Flows 2003 High Rs.26 Average Low 0.25 0.50 0.25 0.8 0.9 1.0 1.2 5.506 0.25 1.00 Expected value of NPVs Standard deviation Coefficient of variation Table 5.7: Scenario Analysis of the Project (Ignoring the Option to Abandon) Future Cash Flows 2003 2004 1.8 0.1 0.50 0.7 0.25 0.6 2005 2006 2.8 3.3 0.8 0.0 1.0 0.0 2007 3.3 1.0 0.0 (Rs. in crore) NPV for this Probability Probability Scenario x NPV 4.931 0.061 1.994 0.25 0.50 1.233 0.031 = = = 0.174 3.692 2.117 1.377 0.7 0.8 0.9 1.0 0.061 0.50 0.031 2004 1.8 2005 2.3 2006 2007 2.8 3.3 4.031 0.25 1.233 NPV for Probability Probability this x NPV Scenario

Rs.2.6

High Average Low

0.25 0.498 1.00 Expected value of NPVs = 0.704 Standard deviation = 2.565 70

Strategic Financial Management

Coefficient of variation Approach 4 Valuing the Abandonment Option with a Financial Option

= 0.364

The fourth procedure for a real option valuation is to use a standard model for an existing financial option. As we have noted earlier, the companys abandonment option is similar to a put option on a stock. We can use the Black-Scholes model for the value of a call option, VCall, in order to determine the value of a put option, VPut: VPut = VCall P + Xe-kRFt where the symbols have usual meanings. Before we can apply the put formula to determine the value of Web Worlds project with an embedded abandonment option, we must break the original project into two separate projects plus an option to abandon the second project. Figure H shows Project A, which is a one-year project that includes the initial cost and firstyear operating cash flows of Web Worlds project. Table 5.9 shows Project B, which begins in 2005, the year after Project A ends. Project B has no cash flows in 2003 or 2004, but has the networking projects operating cash flows in the subsequent years. Note that combining Projects A and B gives the same cash flows as Web Worlds networking project. Project A has an NPV of Rs.2.064 crore (shown in the last column in Table 5.8) and Project B has an NPV of Rs.1.890 crore. The combination of the two projects has an NPV of Rs.2.064 + Rs.1.890 = Rs.0.174 crore, the same NPV shown for Web Worlds networking project. But the company also has an option to abandon Project B, which gives it the right to sell Project B for Rs.1.4 crore. In other words, it can invest in Project A by paying the initial cost of Rs.2.6 crore, which also gives it the ownership of Project B. But in addition to owning Projects A and B, it also has the right to sell Project B for Rs.1.4 crore. Table 5.8: DCF Analysis of Project A that Lasts One Year (Rs. in crore) Future Cash Flow 2003 2004 NPV of this Probability Probability Scenario x NPV 1.8 0.993 0.25 0.248 High 0.25 Rs.2.6 Average 0.50 0.7 1.975 0.50 0.988 Low 0.25 0.8 3.314 0.25 0.829 1.00 Expected value of PVs = 2.064 Standard Deviation = 0.826 Coefficient of variation = (0.40) Table 5.9: DCF Analysis of Project B that starts in 2005, in Project A is already in Place (Rs. in crore) Future Cash Flows 200 2004 2005 2006 2007 NPV for Probability Probability 3 this x NPV Scenario 2.3 2.8 3.3 5.924 0.25 1.481 0.25 (5.1)

High 71

Real Options

Average 0.50 Low 0.25

0.8 0.9

0.9 1.0

1.0 1.2

1.914

0.50

0.957

2.192 0.25 0.548 1.00 Expected value of PVs = 1.890 Standard deviation = 2.869 Coefficient of variation = 0.152 We can use the standard Black-Scholes equation to determine the value of Web Worlds abandonment option. Note that we need the same five factors to price a put option using the Black-Scholes model as we do to price a call option: risk-free rate, time until the option expires, exercise price, current price of the underlying asset, and variance of the underlying assets rate of return. The rate on a 91-day Treasury bill is 6 percent, and this provides a good estimate of the risk-free rate. The time until the growth option expires is one year. Web World can sell the equipment for Rs.1.4 crore, which is the exercise price. The underlying asset in this application of the option-pricing model is Project B, since we have the option to abandon it. Project Bs current price is the present value of its future cash flows. As the last column in Table 5.9 shows, this is Rs.1.890 crore. Table 5.10 shows the estimates for the variance of Project Bs rate of return using the method previously described in the analysis of the option to delay. Table 5.10 shows an extremely high coefficient of variation, 0.518, reflecting the enormous range of potential outcomes. As in the previous examples, one can use the indirect method (refer to table 2) to convert the coefficient of variation at the time the option expires into an estimate of the variance of the projects rate of return: Table 5.10: Indirect Method: Use the Scenarios to Indirectly Estimate the Variance of the Projects Return Expected price at the time the option expires = Rs.21.17 Standard deviation of expected price at the time the = Rs.32.14 option expires Coefficient of variation (CV) = 1.518 Time (in years) until the option expires (t) = 1 Variance of the projects expected return = ln (CV2 + 1)/.t = 119.5 % ln (1.5182 + 1) = 1.195 = 119.5 % 1 Figure K shows the calculation of the abandonment options value. Using the BlackScholes model for a put option, the resulting value is Rs.0.528 crore. The total NPV of the project is the sum of the original projects NPV (which is also equal to the sum of NPVs of Projects A and B) and the value of the option to abandon: Total NPV 0.174 = 0.528 0.354 crore. Given the improvement in NPV caused by the abandonment option, Web World decided to undertake the project. Table 5.11: Find the Value and Risk of Future Cash Flows at the Time the Option Expires (Rs. in crore) Future Cash Flow 2004 200 200 2007 PV in Probability Probability 5 6 2004 for x PV2004 this Scenario 2.3 2.8 3.3 6.635 0.25 1.659 High 0.2 Average 0.50 0.8 0.9 1.0 2.144 0.50 1.072 72

Strategic Financial Management

Low

0.25 0.25 0.614 1.00 Expected value of PV2002 = 2.117 Standard deviation of PV2002 = 3.214 Coefficient of variation of PV2002 = 0.518 Table 5.12: Value of a Put Option Using the Black-Scholes Model Real Option (Rs. in crore) 0.9 1.0 1.2 2.455

kRFt t X P 2 d1 d2 N(d1) N(d2) V of Call V of Put V of Put V of Put

= = = = = = = = = = = = =

Risk-free interest rate Time until the option expires Salvage value if abandoned Current value of the Project B Variance of Project Bs rate of return {ln(P/X) [kRF + ( 2 /2)]t}/( t ) d1 t 0.82 0.35 P[N(d1)] Xe kRFt[N(d2)] Cal P + Xe (kRFt) 1.099 1.890 + 1.318 0.527

= = = = = = =

6 percent 1 1.400 1.890 175 0.934 0.39

1.099

Applications of Real Options

Exploring for Oil Reliance Petrochemicals has leased a large tract of land somewhere in the Southern India and was evaluating alternate exploration strategies. The Government of India were to provide additional information about the amount of oil in the ground, and the drilling would add information about the amount of oil reserves and could resolve whether the oil could be produced. Should Reliance begin the exploration? Which exploration investment strategy should they use? Following are the risk elements that Reliance was aware of Six to fifteen years time is required to get an unexplored tract into production. There is huge involvement of money in the project, that will amount to crores. There lies a very small chance, say about 10 percent, for the project to successfully lead to oil production.

Several earlier attempts to carry out similar projects were futile because the estimated development costs were supposed to exceed the production profit or because the oil price fell too low so as to justify more expenditures. The decision regarding the exploration of oil is made by valuing the tract under each initial exploration strategy, as well as the other contingent follow on strategies. The strategy that is able to deliver the highest valued tract is chosen. The tract value is dependent on three sources of uncertainty. 73 Oil Prices Reserve Size Chance Of Success (COS)

Real Options

The current spot price of the oil is observed daily and the volatility of the oil prices is estimated as the volatility that is implied by the option contract on the oil. The initial level and the standard deviation of the companies are based on historical experiences in the region and also the experience with specific geological features. The market priced risk is easily tracked and the private risks are uncorrelated with any traded asset. This ratio can be defined as the (Standard deviation after the exploration)/(Standard deviation before the exploration investment). This ratio is always less than one, differs by the type of investments, and its value decreases with the stage of investment. The featuring ratios for the companies with drilling equals zero, because drilling fully resolves the companies uncertainty. At the end of the lease, the tract is either developed or abandoned.

The Findings
The first finding of the problem is the value of the tract that is under each first stage strategy. When the optional strategy is to delay the project, the same analysis is repeated after one years time with the changed oil prices and a shorter time to the expiration of the lease. The optimal strategy will be immediate implementation in case the payoff resulting from producing oil is so high that the managers are willing to risk abandoning the tract after a sizeable development expenditure. The following figure shows the optimal first stage exploration investment strategy as a function of the current estimate of reserve size and of current oil prices, keeping the other inputs constant. The figure reveals two types of waiting the lower left of the grid power of the optimal strategy calls for the condition of wait to explore. This is because the oil prices and the estimate of reserve size is low. The upper right of the grid suggests an optimal strategy to wait to develop as the estimated reserve size is high but the price of oil is a bit too low to justify the development. The figure 5.1 actually reflects a very interesting feature of the oil industry, an increase in the oil price brings tracts out of delay mode and into exploration, thus creating demand for oil services. This in turn enhances the cost of further exploration development, thereby reducing the value of the exploration option. The final deals with the value of the information that is proportionate to the extent of how much the oil company would be willing to pay to further resolve reserve size or companys uncertainty. The real option approach of valuing the project shows that the value of resolving uncertainty depends on the following factors. Future decision involving exploration Current value of oil prices Uncertainty type.

Say for example, when the development costs are high, the value of resolving the companys uncertainty is high and the seismic investments are not very valuable as they are unable to supply the important piece of information. The use of the real option aligns the value of the information with financial market valuation. Figure 5.1: Strategy Space for Oil Exploration Investment
High

Seismic Drill
Seismic Drill W ait to explore W ait to develop Strategy space for oil exploration i nvestment

Current oil price

Low High Estimate Reserve Low Size

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Strategic Financial Management

APPLICATIONS OF THE REAL OPTIONS IN THE DRUG INDUSTRY

The process of developing and marketing a drug is a very costly as well as a lengthy process. These characteristics make it a very good case for the real option approach in investment decision making. The development of a drug can be viewed as a learning investment in which the R&D investment reduces the uncertainty regarding the remaining costs to complete the development of the drug, and the initial marketing efforts resolve the uncertainties about the size of the drugs market. During the first year of drug development there is the birth of the market priced risk. The level of uncertainty is relatively small as compared to the private risk uncertainty. The real option based approach to drug development relies more on the evaluation of the consequences of private risk. Market priced risk is relatively more important in case of oil exploration strategies and transacted values of reserves. In case of drug development the private risk is relatively important. While valuing a drug development project with the help of real options, certain questions need to be answered. What are the roles that private and market priced risks play in the development of decisions and valuations? What are the possible implications of the large amount of the private risk?

The drug development process and the marketing process can be modeled as a sequence of fearing investment and abandonment options. In each of the periods, the firm divides on whether to make expenditures at a predetermined amount for further development and marketing or to abandon the development process, the reward that the firm gets by continuing the next option. Each of the options contain the opportunity to make a similar decision in future periods and later garner possible profits in the life cycle of the project. The application of the real option associates the following sources of uncertainties. Remaining life cycle costs of drug The size of the market for the drug that completes development Industry wide evidence of value Probability of passing regulatory tests.

The Findings
The following figure 5.2 (a) shows that as the managers opt for using the option to abandon the project, the number of drugs that are in the development stage falls by phase of investments. Figure (b) reveals that the value of a surviving drug increases as it paves the regulatory hurdles along with uncertainty about the remaining costs and size of the market is resolved. Figure 5.2 (c) shows, how the level of uncertainty about surviving drug projects decreases by phases until a time comes when all the private risk is eliminated and the uncertainty of the project is equal to the volatility of the market priced risk. Figure 5.2
( a )
( b )
R e a l o p t i o n v a l u e p e r d r u g

( c )

u m

b e

L u n o

e c f

v e

l i n i t y

e r t a

V m

o l a t i l i t y o f a r k e t p r i c e r i s k

E
N

a r l y
u m in

a t e

b e r o f s u r v i v in N g d e v e lo p m e n t

E u d mr u b g e s r o f s u r v i v i n g U i n d e v e l o p m e n t

r l y

t e

r l y
c e

r u g

r t a

L
i n i t y

t e
a b o u t d r u g v a l u e

75

Real Options

Though the use of a discounted cash flow analysis might show that developing a drug is a zero NPCE investment, if one considers all the options during the drugs life cycle it reveals that the correct valuation might be much higher. Using the real option approach, to manage a portfolio of drugs results in more drugs in the development process to more drugs to be abandoned.

76

Strategic Financial Management

Drawbacks of using Real Option Analysis

Though the use of real options had brought in considerable advantages in creating a project, still there exists some pitfalls in their usage. These pitfalls can broadly be categorized under the following: Using the real option analysis when one should not use them Framing a wrong model for the purpose of valuation Using incorrect data and biased judgments in the model Miscalculation in the process of valuation. Let us now try to discuss each of the drawbacks in brief. a. Using real option analysis when one should not Real option analysis takes into account a number of assumptions. One basic assumption of real option is that the relevant uncertainities are random walks and as a result are unforeseeable. Coupled with this, it also states that the consumer is the price taker, and decision taken by the consumer can change the future course of the random walk. Such assumptions are in fact violated if there exists a small number of leading competitors. In this case the decisions may not be random. Each players action can influence the price of all the players who will take decisions with full knowledge of what the possible counter moves will be for every other player. The other assumption the option theory makes is that the risks of an option can be hedged away. If hedging is feasible the option will be priced as if it had been hedged, in which case the risk is risk-free. If it is given that hedging is indeed possible it does not matter whether any one option is actually hedged or not. b. Using the wrong real option model It is easy to wrongly assume that the actual decisions pertaining to the project is Like a given real option model while in reality it is Unlike so. Thus picking up a wrong model can be disastrous. Say for example, if one has assumed that the interest rates are fixed, should it change the decisions to a large extent if the interest rates were truly variable. If one bases his assumption that the prices of oil and gas are independent of each other, how can it, in any way, influence the decision if they were linked by some economic mechanism. c. Miscalculation in the data inputs It is important to understand the drivers of the option value in any specific real option model. One needs to check the model for sensitivity to the associated variables, try to understand how the errors in the variables could result in based results. Say for example, the value of the call option is increased in the time to expiry and the volatility of the underlying asset is increased. As far as this is concerned it is important to note that one has overestimated the length of the available time, or what could be the smallest possible estimate one could use for volatility? d. Getting both the models of the data right, but making mistakes in the solution It may sometimes happen, that while using the complete mathematical algorithm, one can easily miss an important variable. While calculating the option value, one may notice that the calculated option values are exploding towards plus or minus infinity, or are oscillating between the two. The results of option valuation are sometimes in conflict with common sense approach. Nevertheless, it is important to make as many logical checks as possible to ensure that these results are commensurate with the economic rationality.

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Real Options

SUMMARY
Opportunities to respond to changing circumstances are called managerial option as they give managers a chance to influence the outcome of the project. Such projects are also called as real options as they deal with real rather than financial assets. Many projects include a variety of embedded options that can dramatically influence its NPV. These can be a. b. c. d. a. b. c. d. e. Investment timing option that allows the firm to delay the project. Growth option that enable a firm to manage its capacity in response to changing market conditions. Abandonment option, and Flexibility options which give flexibility to a firm over its operations. DCF only, ignoring the real option. DCF analysis and qualitative assessment of the real option value Decision tree analysis Analysis with a standard model for an existing financial option. Financial engineering technique. Using it where it is not applicable Framing a wrong model for valuation Using incorrect data and biased judgment, and Miscalculation.

There are five possible procedures for valuing real options.

The various drawbacks of real option analysis includes

78