Real Options

Dr. P.K. Gupta

 Peculiar Features of RO

Real options investments are characterized by

sequential, irreversible investments made under
conditions of uncertainty.
Purchasing a real option on a strategically
important opportunity allows firms to postpone
commitment until a substantial portion of the
uncertainty about the opportunity has been
resolved.
 Peculiar Features of RO

The value of the option (and the underlying asset)

is exogenous to the investor’s activity—the
investor cannot take steps to make the intrinsic
characteristics of the asset more attractive.
 Peculiar Features of RO

The market signal of option value is readily

observable and is independent of the investor’s
behavior. If these properties carry over to an
investment of a non financial sort (such as in plant
and equipment, or in technology licenses), then
the logic of options can directly carry over.
 Peculiar Features of RO

The greater the extent to which these properties

are violated, the more problematic the application
of an options framework is.
 Peculiar Features of RO

The underlying logic of the real options

framework is based on the realization that future
investment opportunities are contingent on prior
investment commitments. Thus, in contrast to net
present value analysis, real options analysis
accounts for the sequential nature of choice
processes.
 Value of RO

Value “Real Option” = NPV with option

- NPV w/o option
Boundaries of RO
Boundaries of RO
Structure of Real Options
 Types of Real Options

• Follow Up Investments
• Abandon
• Wait
• Vary Output or Production
Criteria NPV/DCF DTA RO

Valuation Expected Cash Expected Cash Synthetically

Flows discounted at Flows recreate cash
WACC discounted at flows with a
arbitrary portfolio of
rate(WACC/risk traded assets
free rate) with change in
cost of capital at
every node.
Decision Year 0 Deferred until Deferred until
Year 1 Year 1

Flexibility Not Valued Valued with Valued correctly

error
Abandonment or Termination
Options
Whereas traditional capital budgeting analysis
assumes that a project will operate in each year of its
lifetime, the firm may have the option to cease a
project during its life. This option is known as an
abandonment or termination option.
Abandonment options, which are the right to sell the
cash flows over the remainder of the project's life for
some salvage value, are like American put options.
When the present value of the remaining cash flows
falls below the liquidation value, the asset may be sold.
 Abandonment or Termination
Options
• Examples
– These options are particularly important for large
capital intensive projects such as nuclear plants,
airlines, and railroads.
– They are also important for projects involving new
products where their acceptance in the market is
uncertain.
 NPV and Real Options
• Abandonment or Termination Options
 Abandonment Illustration

Super Projects Ltd. has undertaken a project a few years ago. The project is
still running and has a remaining useful life of 6 years. The company now feels
that the project does not fit into its overall strategy and is considering whether
it should be abandoned. The following information is available:
Year Cash flow (Rs.Crore) Value if sold (Rs.Crore)
1 175 510
2 200 475
3 235 400
4 350 300
5 400 200
6 100 50
The cost of capital of the company is 22%. Decide whether the project should
be abandoned, and if yes, in which year.
 Option to Wait

Intrinsic Value
Option
Price

Stock Price
 Option to Wait
Intrinsic Value + Time Premium = Option Value

Time Premium = Value of being able to wait

Option
Price

Stock Price
 Option to Wait
More time = More value

Option
Price

Stock Price
Temporary-Stop or Shutdown
Options
For projects with production facilities, it may not
be optimal to operate a plant for a given period if
revenues will not cover variable costs.
In a oil extraction plant, if the price of oil falls
below the cost of extraction, it may be optimal to
temporarily shut down the oil well until the oil
price recovers.
 NPV and Real Options
Farming: May be exercised if the cost of fertilizing,
watering and harvesting exceeds the sale price of the
product.
Real-estate development: May be exercised if the cost
of construction exceeds rent revenues.
 Intensity or Operating Scale
Options

Intensity or operating scale options involve the

flexibility to expand or contract the scale of the
project. Management may have the option to
change the output rate per unit of time or to
change the total length of production run time.
 Intensity or Operating Scale
Options
– In order to obtain the option to expand production
if demand increases suddenly, a firm may build
production capacity in excess of the expected
level of output.
– In this case, management has the right, but not the
obligation to expand, and will exercise the option
only if project conditions turn out to be favorable.
 Intensity or Operating Scale
Options

Whereas the excess capacity will have an initial cost,

the project with the option to expand is worth more
than the project without the possibility of expansion,
in which case the extra cost may be justified.
Also, a firm may build a plant whose physical life
exceeds the expected duration of use, thereby
providing the firm with the option of producing more
by extending the life of the project.
 Option to Expand
It is like a American call. Build production capacity or
the infrastructure for the capacity in excess of
expected level of output (so it can produce at higher
rate if needed).
Management has the right (not the obligation to
expand). If project conditions turn out to be favorable,
management will exercise this option.
Option to Expand
 Option to Contract

This is the equivalent to a American put option.

Many projects can be engineered in such a way
that output can be contracted in future. Forgoing
future expenditures is equivalent to exercising the
put option.
• Example:
– Modularization of project.
 NPV and Real Options
• Option to Contract
Option to Expand or Contract
(Switching Option)
It is equivalent to the firm having a portfolio of
call and put options. Restarting operations when
project currently shut down is a call option.
Shutting down is a put option.
 Option to Expand or Contract
(Switching Option)
• Example:
– A project whose operation can be dynamically
turned on and off (or switched to two distinct
locations) is worth more than the same project
without the flexibility to switch.
Option to Expand or Contract
(Switching Option)
 Initiation or Deferment Option

– The option to choose when to start a project is an

initiation or deferment option.
• Examples:
– The purchaser of an off-shore lease can choose
when, if at all, to develop property.
Initiation or Deferment Option

– Initiation options are particularly valuable in natural

resource exploration where a firm can delay mining a
deposit until market conditions are favorable.
– If natural resource companies were committed to
producing all resources discovered, they would never
explore in areas where the estimated extraction cost
exceeded the expected future price at which the
resource could be sold.
Initiation or Deferment Options
 Intra-project vs. Inter-project
Options

– Inter-project options arise when the development of

one project creates value that attach to other projects.
Sequencing options, for example, are inter-project
options because the sequencing of projects creates
value for subsequent projects as the direct result of
undertaking the initial project.
– Traditional capital budgeting analysis will miss this
option because projects evaluated on stand-alone
basis.
 Growth Options
• The value of the firm can exceed the market value of
the projects currently in place because the firm may
have the opportunity to undertake positive NPV
projects in the future.
• Standard capital budgeting techniques involve
establishing the present value of these projects based
on anticipated implementation dates.
• However, this implicitly assumes that the firm is
committed to go ahead with the projects.
 Growth Options

Since management need not make such a

commitment, they retain the option to exercise
only those projects that appear to be profitable at
the time of initiation.
• Example:
– High-tech and software industries (where there
are significant first-mover advantages)
 Problems with DCF
Applies a single time and risk-adjusted discount
rate to derive and compare the NPVs of:
• Different projects with different risk characteristics
• Projects under different development design scenarios,
e.g. different capital-intensity, operating leverage
• Both the riskier revenue and less risky cost functions of
their financial models biasing decisions against
incurring expenditure now to save costs later
 Other Bias in DCF

• Revenues run price risk and are more risky than costs
• Capital and operating costs which are known with
greater certainty, can be controlled and are not subject
to price risk
• If costs are less risky than revenue then using a single,
high, risk-adjusted discount rate biases DCF/NPV
against incurring appropriate levels of expenditure now
to save costs later.
 Use of Real Options

Trade-offs between capital and operating

costs and by constructing models that
separate and discount more realistically the
inherently higher-risk revenue function of
projects as compared to discounting their
cost function using a risk-free rate
{Salahor (1998) and Samis (2002)}
Ander & Daniel A. Levinthal(2004)

We argue that the greater the extent to which choice

sets evolve as a consequence of firms’ exploration
activities, the less structured the firms’ abandonment
decisions become and, in turn, the less distinguishable a
real option is from more generic notions of path
dependence—a sequential stream of investment in and
of itself does not constitute a real option. While
organizational adaptations can extend the applicability
of real options, they impose tradeoffs that may lead to
the under utilization of discoveries made in the course
of exploration.
 Option Creation
The stock market supports “option creation” by
valuing some non-dividend-paying companies
holding sub-economic mineral deposits of
commodities with volatile prices. It does so on the
basis of their growth potential even though the
NPVs of their projects may be negative at current
prices This result in a “market premium” between
a company capitalisations and the the sum of the
“fundamental valuations” (NPVs) of all its
projects.
 Option Creation
Exploration, R & D and pilot studies have the
characteristics of real options, in that they create
opportunities but not obligations Yet many of
them continue to be penalised by DCF analysis
and are often unwisely rejected • This is due to
investors not recognising and valuing management
flexibility to keep their future options open to
progressively adjust their actions as a project
unfolds, depending on emerging circumstances
and information.
 Compound Options

R&D projects generally involve multiple

phases with or without overlapping. If the
investment is made in a phased manner,
with the commencement of subsequent
phase being dependent on the successful
completion of the preceding phase, it is
known as sequential investment.
 Compound Options

Each stage provides information for the

next thus creating an opportunity (option)
for subsequent investment in a new
technological area. Such projects can be
valued using the techniques of ‘Compound
Options’, also known as ‘Option on
Options’.
 Compound Options
By explicitly recognizing the ‘choice to invest’
aspect of earlier stage R&D projects, this
mechanism greatly enhances the ability of
decision-makers to justify long-term R&D
investments made by the public sector. For
example, an early R&D investment by the public
sector in an emerging technological area may be
considered the mechanism for enabling
(establishing the option for) the private sector to
undertake the follow-up investment required to
innovate in that area.
 Compound Options

Moreover, by differentiating among the

various stages in an R&D program, this
mechanism allows the use of more
appropriate discount rates that better reflect
the differential risks of technologies in
various stages of development.
 Compound Options
Models have tended to treat R&D investment as a
sequential compound option, where investments
take place in a phased manner. It is widely known
in the innovation systems literature, however, that
this assumed ‘linearity’ is false for two reasons:
- R&D phases very often take place in parallel or,
at least, overlap significantly;
- Binomial method can be applied but continuous
time real options are difficult to value.
 Illustration

• A project is costing 2000 million with a

with a life of 25 years and its present value
is 1850 million. The company has an option
to sell the plant after the end of 10 years at
1800 million. Volatility of cash flows is
30% and risk free rate is 8% Value the
abandon option.
 Illustration
Super Products Ltd. Plans proposes to come out with a new product
with the help of R&D activities. The marketing cost of the product
would be Rs. 15 crores equally divided over the next two years.
Expected cash inflows for the year 3 to 8 are: -
Year 3 4 5 6 7 8
Cash Flow (Rs. Cr) 1 2 4 4 3 1
If the project is successful the company has option to expand at the end
of year 5 and invest additional 10 Crores. The probability of success is
0.60 and if successful, the company would be earning 6 crores every
year from year 6 to 10 with probability of 0.50 or Rs. 4 crores with
probability of 0.50. The opportunity cost is 14%. Decide the option to
expand.