Agenda

Real Options: Overview

James Alleman
University of Colorado & PHB Hagler Bailly, Inc.

Investment Theory Real Options Approach Uncertainties Implications for Economics Conclusions

Copyright 1998 & 1999, James Alleman. All Rights Reserved. James Alleman University of Colorado

Overview

Agenda

"The new view of investment opportunities as options . has shown that the traditional "net present value" rule can give very wrong answers."
Dixit & Pindyck Investment under Uncertainty, page ix
James Alleman University of Colorado

Investment Theory
Olde Tyme View Decision Tree Analysis

James Alleman

University of Colorado

Investment Theory: Olde Tyme View

Investment Theory: Olde Tyme View

Investment Valuation:
Net Discounted Present Value Jorgenson's User cost of capital Tobin's q

Traditional DCF
Management's flexibility not captured
Adapt Revise decisions

Dixit & Pindyck Investment under Uncertainty, Chapters 1 & 2

James Alleman University of Colorado James Alleman University of Colorado

1-6

Investment Theory: Olde Tyme View

Investment Theory

Traditional DCF
Management's flexibility not captured
adapt revise decisions

Traditional DCF Real world

Change Uncertainty Competitive interactions

DCF
Static operating strategy Cash flows are projected with certainty Discount rate accounts for uncertainty
James Alleman University of Colorado

James Alleman

University of Colorado

Investment Theory

Investment Theory: Olde Tyme View

Traditional DCF Real world New information

Flexibility to alter strategy Flexibility similar to financial options Modelled with financial option tools

Traditional Discounted Present Value

DPV > 0, invest Also called NDPV or DPV or PV
DPV =

CF /(1 + r)
t=0
i

James Alleman

University of Colorado

James Alleman

University of Colorado

Olde Tyme: Discounted Value

Investment Theory: DCF

Discounted Present Value

DPV = CFi /(1 + r)t , summed over t = 0, T

What is the appropriate risk-adjusted discount rate? One based on a comparable security.

"r" Constant
Constant discount rate over time Opportunity cost of capital

James Alleman

University of Colorado

James Alleman

University of Colorado

7-12

Investment Theory: DTA

Investment Theory: DTA

q2 q1 1 - q2 q3 1 - q1 1 - q3

Investment Theory
Olde Tyme View Decision-tree Analysis (DTA)

James Alleman

University of Colorado

James Alleman

University of Colorado

Investment Theory: DTA

Investment Theory: DTA

<I0>

q1

(CFi )/(1 + ra)t

t=1 t=1

Ex Ante Decision Expected Value of DTA Risk-adjusted Rate?

1 - q1

(CFj )/(1+ra)t
University of Colorado James Alleman University of Colorado

James Alleman

Investment Theory: DTA

q2

Investment Theory: DTA, example

go q1

q1 1 - q2 stop q3

1 - q1

1 - q1

I0 = $ 104 rf = 8% ra = 20% q1= .5

1 - q3
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13-18

Investment Theory: DTA

q1 = .5
1

Investment Theory: DTA, example

T=1

<$104>

q1

($180)/(1+.2)1
t=1

1 - q1

t=1

($60)/(1+.2)1
University of Colorado

DCF = - $ 104 + .5($240)/(1+.2)1 = = $100 - $104 =<$4>

James Alleman

James Alleman

University of Colorado

Investment Theory: DTA, example

Opportunity Cost of Capital

Wait one period: max[$180 - $ 104(1.08)] = $ 67.68 max[$ 60 - $ 104(1.08)] = $ 0.00

James Alleman University of Colorado

Divine Discount Rate!? Options Pricing Model

Security of equivalent risk Calculate implied rate

James Alleman

University of Colorado

Real Options Approach

Real Options Approach

Investment Theory Real Options Approach

Definition Characteristics Investment characteristics

Option definition
The "right" to purchase an asset in the future but not the obligation
Uncertainty of future Asymmetry of returns

James Alleman

University of Colorado

James Alleman

University of Colorado

19-24

Real Options Approach

Value of Option
Value of Options $14 $12 $10 $8 $6 $4 $2 $0 $50 $70 $90 Stock price $110 $130

Options characteristic
Time limited "Killed" or exercised terminates

Value: max(V - Ix,0)

James Alleman

University of Colorado

James Alleman

University of Colorado

Non-linear

Call Option v. Real Options

PV of E(CF) Investment costs Opportunity goes Project value uncertainty Riskless interest
Trigeorgis (1996), p.125
James Alleman University of Colorado

Uncertainty Contingent Decision

Value of stock Exercise price Expiration Uncertainty of value Riskless interest

Call Options v. Investment

PV of assets Expenditure Deferral Riskiness Time value of money
Amram and Kubtibka, (1996)
James Alleman University of Colorado

Financial v. Real Options

Search for Tailored solutions Way of thinking

Stock price Exercise price Expiration Variance of return Risk-free RoR

Specified in contract Off the shelf ` software Output: $'s

Amram and Kubtibka, (1996)

James Alleman University of Colorado

25-30

Types of Real Options

Investment Theory: DTA

Natural
Option to defer a capital investment Option to abandon

What is the appropriate risk-adjusted discount rate?

Planned for and created

Research & development
New services/products

Alter investment levels

As state of nature revealed
James Alleman University of Colorado James Alleman University of Colorado

Investment Theory: DTA

Investment Theory: RO

What is the appropriate risk-adjusted discount rate?

<$104>

$180

Enter Real Options!

q1 =.5 $60

1 - q1 =.5

James Alleman

University of Colorado

James Alleman

University of Colorado

Investment Theory: RO
Comparable Security

Investment Theory: RO

uS = 1.8 ($20) = $36 q1 =.5 S = $20 q1 =.5 dS = 0.6 ($20) = $12 1 - q1 =.5 1 - q1 =.5 S = $20

uS = 1.8 ($20) = $36 $20 = [.5 ($36) + .5($12)]/(1+r)

dS = 0.6 ($20) = $12

University of Colorado

James Alleman

University of Colorado

James Alleman

31-36

Investment Theory: RO

$180 <$104> $60 DCF = [(qit)CFit/]/(1+ r) t = {[.5($180) + .5($60)]/(1+.20)} - $104

James Alleman University of Colorado James Alleman

$180 <$104> $60

DCF = [(qit)CFit/]/(1+ r) t = - $104 + {[.5($180) + .5($60)]/(1+.20)}

University of Colorado

Investment Theory: RO

Investment Theory: RO

defer

$180 max [V,0] = $180 - $104(1.08) = $67.68 q1 =.5 max [V,0] = [$60 - $104(1.08),0] =0

$180 go start $60 stop defer

DCF = <$4> DCF = 0 DCF = ?

James Alleman

University of Colorado

James Alleman

University of Colorado

Twin Portfolio

Twin Portfolio

m(uS) - (1+ rf)B = $67.68 m(dS) - (1+ rf)B = $ 0.00

m(uS) - (1+ rf)B = $67.68 m(dS) - (1+ rf)B = $ 0.00 uS = $36, dS =$12, & rf = 8% B = $31.33 and m = 2.82 shares

James Alleman

University of Colorado

James Alleman

University of Colorado

37-42

Twin Portfolio

Investment Theory: DTA, example

m(uS) - (1+ rf)B = $67.68 m(uS) - (1+ rf)B = $ 0.00 uS = $36, dS =$12, & rf = 8% B = $31.33 and m = 2.82 shares mS - B = $25.07
James Alleman University of Colorado

Value of Option to Delay = Expanded - static DCF

James Alleman

University of Colorado

Twin Portfolio

Investment Theory: RO

m(uS) - (1+ rf)B = $67.68 m(uS) - (1+ rf)B = $ 0.00 B = $31.33 and m = 2.82 shares Option Value = mS - B - DCF = $25.07 - (-$ 4) = $29.07 > $28.20
James Alleman University of Colorado James Alleman

defer

max [V,0] = $180 - $104(1.08) = $67.68 q1 =.5 max [V,0] = [$60 - $104(1.08),0] =0 DCF = [(qit)CFit/]/(1+ r)t = [.5($67.68) + .5($0)]/(1 .20) = $28.20
University of Colorado

Benefits of Option

Real Options Approach: Flexibility

Total Risk Addressed Avoids Mis-valuation Market Disciple Compatible Evaluation

Defer Expand Abandon Start up (Shut down)

James Alleman

University of Colorado

James Alleman

University of Colorado

43-48

Real Options Approach: Defer

Real Options Approach

Investment Characteristics
Irreversibility Uncertainty Timing

Irreversibility
Investments become sunk cost (irreversible) when: Firm or Industry specific Regulations/laws Partially irreversible, "lemons"

Dixit & Pindyck Investment under Uncertainty, Chapters 1 & 2

James Alleman University of Colorado James Alleman University of Colorado

Real Options Approach

Real Options Approach

Irreversibility Waiting
Preempt investments preclude Cost of delay
Competitive entry Foregone revenues

Opportunity cost of option

Include in valuation i.e. if the DCF plus the Option Value > 0, invest

James Alleman

University of Colorado

James Alleman

University of Colorado

Agenda

Uncertainties

Investment Theory Real Options Approach Uncertainties

Regulation/Legislative Competition Technologies Costs Market

James Alleman

University of Colorado

James Alleman

University of Colorado

49-54

Uncertainties

Uncertainties

Regulation/Legislative
Courts: Suspension of FCC Orders Regulation: Decisions on RBOC LD Legislative: Re-regulation of Cable etc.

Regulation/Legislative Competition
Traditional: ATT/MFS/TPG Incumbent's reaction(s) Cable's Strategies
Entry into exchange market Broadband modems

James Alleman

University of Colorado

Uncertainties

Uncertainties

Regulation/Legislative Competition Technologies

Wireless impact
WinStar Wireless local loop

Regulation/Legislative Competition Technologies Costs

Spectrum costs Unbundled Network Elements Right of way Leases
James Alleman University of Colorado

ISP/Packet Network versus circuit

James Alleman University of Colorado

Uncertainties

Agenda

Regulation/Legislative ... Costs Market

Product acceptance Price and cross-elasticities Size Growth
James Alleman University of Colorado

Investment Theory Real Options Approach Uncertainties Implications for Estimation

James Alleman

University of Colorado

55-60

Implications for Estimation

Implications for Estimation

Investment Function
Most obvious impact Interest Rates
High hurdle rates (3- 4 times expectation) Limited stimulation effect

Specification Desirable Properties Economic Theory

Shutdown point invalid

Price below AVC, not exit Price substantially above LRAC, Invest
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Implications for Estimation

Implications for Estimation

Specification
Based on theory Available information

Specification Desirable Properties

Theoretically plausibility Compatible with economic theory Describes the phenomenon

James Alleman

University of Colorado

James Alleman

University of Colorado

Implications for Estimation

Implications for Estimation

Economic Theory
Basis for estimation Not data mining

Lagged Variables Stock Adjustment Models

Koyck Nerlove's Partial Adjustment Adaptive Expectations

James Alleman

University of Colorado

James Alleman

University of Colorado

61-66

Agenda

Conclusions

Investment Theory Real Options Approach Uncertainties Implications for Estimation Conclusions

DPV & DTA Inadequate Economic Models Redefined Implications for Estimation

James Alleman

University of Colorado

James Alleman

University of Colorado

Summary/Conclusions

Summary/Conclusions

DPV & DTA Inadequate

No dynamics Risk adjusted rate? No Uncertainties No Options Valuation

DPV & DTA Inadequate Economic Models Redefined

Inadequate Specifications Alternative view of dynamics Implications for models Rethink models

James Alleman

University of Colorado

James Alleman

University of Colorado

Conclusions

DPV & DTA Inadequate Economic Models Redefined Implications for Estimation
Inadequate Specifications Investment estimations Lagged models Others?
James Alleman University of Colorado

Real Options: Overview

James Alleman
University of Colorado & PHB Hagler Bailly, Inc.

Copyright 1998 & 1999, James Alleman. All Rights Reserved.

67-72