9.

Topic 9 – Valuation II: Real Options

Many financial managers recognize that the classic NPV approach to capital budgeting is
inadequate in that it ignores, or cannot properly capture, management’s flexibility to adapt and
revise later decisions in response to unexpected market developments.

In the actual marketplace, the realization of cash flows will probably differ from what managers
expected initially. As market conditions changed, managers may have valuable flexibility to
alter their operating strategy in order to capitalize on favorable future opportunities or mitigate
losses. For example, managers may be able to defer, expand, contract or abandon a project at
different stages during its useful operating life. The real option approach to capital budgeting
provides a new tool to quantify the value of flexibility from active management.

1. Comparing NPV with Real Options

At Year 0, a firm is deciding to invest in a machine that costs $1,600. Once pre-committed,
one unit of good is produced at the end of Year 1 and the capital cost will be paid immediately.
Each year, the machine will produce one unit of good which is assumed to be operated forever.
The price of the good is uncertain at Year 1. It will be worth either $300 or $100 with a 50/50
probability. But once the price level becomes known at Year 1, it stays there forever. The
discount rate is 10%.

Should the firm invest?

1. Static NPV Approach

The NPV of this investment is:

PV (t = 0) = 0.5*300/0.1 + 0.5*100/0.1 = 2000

PV (t =1) = 0.5*(300 + 300/0.1) + 0.5*(100 + 100/0.1) = 2200
NPV (t = 0) = 2000 – 1600 = 400

According to the NPV criterion, the firm should invest as the NPV is positive.

Examples of these uncertainty could be election (Trump vs Biden)

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Knowing that the price is only uncertain at Year 1, what if the firm has an option to decide at
the end of Year 1 instead of pre-committing now?

9.1.2. Expanded NPV Approach

Suppose the cost of investment goes up to $1,800 if the firm waits to decide. The firm will
invest when the price is $300. If the price becomes $100, the firm will choose not to invest.
Then the NPV with this right to defer becomes:

PV (t = 2) = 0.5(300 + 300/0.1) = 1650

NPV (t = 0) = 1650/1.1^2 - 0.5*1800/1.1 = 545.45

Obviously, it is better for the firm to wait since the NPV is higher. The value of the right to
do so is worth 145.45 (545.45 – 400).

9.1.3. NPV and Managerial Flexibility

In the example, the managerial flexibility to decide later in response to altered future market
conditions expands the investment value by improving its upside potential while limiting
downside losses relative to the firm’s initial expectations under passive management.

The expanded NPV approach can reflect the traditional (static) NPV of cash flows and a
premium for the flexibility inherent in the real options.

That is,
545.45 400 145.45
Expanded NPV = Static NPV + Option Premium

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2. Valuing Real Options

1. One-step Binomial Model

Consider a very simple illustration. A stock price is currently $20, and it is known that at the
end of 3 months it will be either $22 or $18.Given a European call option with an exercise
price of $21, at maturity, this option will have one of two values.

If the stock price turns out to be $22, the call option will be worth $1. If the stock price turns
out to be $18, the call will become worthless.

p
S1  $22
C1  $1 (22 - 21 = 1)
PV (t = 0) = [ p*1 + (p-1)*0 ] / (1+r)
S0  $20
But we do not know discount rate r for option
- Solution 1) Make risk adjustment to discount rate
- Solution 2) Make risk adjustment to cash flow and use risk-free rate for discount rate
P-1
S1  $18
C1  $0 (18 - 21 = -3)

The logic to price this option in the illustration rests on the assumption that arbitrage
opportunities do not exist. If we can set up a portfolio of the stock and option in such a way
that there is no uncertainty about the value of the portfolio at the end of the 3 months, this
portfolio must earn a return equal to the risk-free interest rate.
Hedging

Now consider a portfolio consisting of Δ shares of stock and a short position in one call
option. Our objective is to find the value of Δ that makes the portfolio riskless. That is, no
matter the stock price moves up to $22 or moves down to $18, the final value of the portfolio
is the same for both alternatives.

Mathematically,

22 1  18  0
   0.25

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Thus, this riskless portfolio is to:

Longing call option: Buying call option at fixed price

 Long 0.25 shares. Shorting call option: Selling call option at fixed price
 Short 1 call option.

If the stock price goes up to $22, the value of the portfolio is:

220.25 1  4.5

If the stock price drops to $18, the value of the portfolio is:

180.25  0  4.5

Regardless of whether the stock price moves up or down, the value of the portfolio is always
4.5. Therefore, this portfolio must earn a risk-free interest; otherwise, there will be arbitrage
opportunities. Suppose that the risk-free rate is 12% p.a. The present value of this portfolio:

4.5
 4.3743
1.120.25

And the value of the option is:

20 0.25  C0  4.3743
 C0  0.6257

9.2.2. A Generalization

S0u
Cu
S0
C
S0 d
Cd

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We can generalize the illustration. Let:

S0  the stock price

C  the option value
u  the multiplicative upward movement in the stock price u  1
d  the multiplicative downward movement in the stock price d  1

As before, we can form a portfolio with a long position in Δ shares of stock and a short position
in one call option so that this portfolio is riskless.

The value of Δ that makes the portfolio riskless when:

Up Down
S0u  Cu  S0d  Cd
C  Cd
 u
S0u  S0d

The cost of setting up the portfolio is:

S 0 u Cu
S0  C 
1 rf
S01 rf  S0u  Cu
C
1 rf
 u  Cu
 S0  1 
 1 r f  1 r f

Substitute Δ into above equation and simplify the expression6, we get:

1
C  pCu  1 pC d 
1 rf 
where: 1) Risky CF / (1+r) where r is risk
adjusted
1 rf  d 2) Risk neutral cash flow / (1+r)
p
ud where r is risk free

Risk-neutral probability: Turns risky cash flow into certainty equivalent (riskless) value

6 See appendix. This is what we use here

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9.3. Elements in a Real Option

The options models used to value real options are borrowed from financial options pricing
models. The characteristics of the real options resemble those of the financial options. The
table below summarizes the inputs for the valuation of the real options.

Financial Option Real Option

Price of the underlying asset = PV of expected cash flows
Exercise price = Future capital investment
Time to expiration = Time until opportunity
Stock value volatility = Project value uncertainty

9.4. Static NPV Analysis

Consider an opportunity to invest $104 to build a plant that a year later will have a value of
either $180 or $60 with equal probability. Assume the discount rate k is 20% and the risk-
free interest rate is 8%.

 0.5
V1  $180
so 104x 80
V0

1 0.5 V1  $60

等古 104xct40
NPV ⼆
The traditional NPV approach would discount the expected cash flows using the discount rate:

NPV = 180/1.2*0.5 + 60/1.2*0.5 – 104 = - 4

Reject the project

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Using the NPV rule, we should reject the investment.

Should we only rely on standard NPV rule? With uncertainty and irreversibility, NPV rule is
not correct. Real option gives better answer.

9.5. The Option to Defer Essentially call option

Suppose the firm has a one-year license granting it the exclusive right to construct a new plant.
What is the value of the investment opportunity provided by the license, given that undertaking
the project immediately was shown to have a negative NPV?

This license is like giving the firm a call option with an exercise price equal to the investment
outlay. The firm has the right to invest when the market condition is good; at the same time,
it has no obligation to invest in unfavorable market circumstances.

Assume the investment cost grows at the risk-free rate, 8%. The investment outlay next year
will be:

I1  104 1 0.08

Future investment outlay (exercise price)
 112.32

The intrinsic value of this call option if the market turns out to be:

Good  Cu  max V0u  I1 ,0

 max 180 112.32,0
 67.68

Bad  Cd  max V0d  I1 ,0

 max 60 112.32,0
0

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The payoff structure:

p0.4
V0u  $180 = V(0) X u | u = 1.8
Cu  $67.68

V0
p (risk neutral probability) = (1+0.08-0.6) / (1.8 – 0.6) = 0.4
C

V0d  $60 = V(0) X d | d = 0.6

1 p0.6
Cd  $0

Applying the risk neutral probability formula:

1 rf  d
p
ud
1.08  0.6

1.8  0.6
 0.4

The total value of the investment opportunity, that is, the expanded NPV that incorporates the
value of the option to defer:

1
C  pCu  1 p Cd 
1 rf  1. Make cashflow risk-free by multiplying
risk neutral probability
1
 0.4 67.68  0.6 0 2. Use risk free rate to discount the project
1.08
 25.07

With managerial flexibility, the investment criterion is similar to the standard NPV analysis.
This flexibility calls for an expanded NPV criterion that reflects both sources of a project’s
static NPV and a premium for the flexibility embedded in its operating options.

Recall that, Project value goes up because of deferring for one year

Expanded NPV  Static NPV  Option Premium

25.07  4  29.07

Incorporating flexibility to the traditional NPV rule

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Since the option premium is worth 29.07, although the project per se has a negative (static)
NPV of $4 if taken immediately, the investment proposal should not be rejected because the
opportunity to invest in the project within a year is worth a positive $25.07.

9.6. The Option to Expand Call option

Once a project is undertaken, the manager may find it desirable to invest more as the product
is more enthusiastically received in the market than originally expected.

Suppose that in the example, the firm has the option to invest an additional I1  $80 one year
after the initial investment which would double the scale and value of the plant.

The payoff structure: Value

Max (180-80, 0) = 100

0.4

0.6
Max (60-80, 0) = 0
Payoff
80

The firm will only exercise its option to expand if market turns out to be good, but will leave
it unexercised otherwise.

The value of the option to expand:

1
C0   pCu  1 pC d 
1 rf 
1
 0.4100  0.6 0
1.08
 37.04

Expanded NPV  Static NPV  Option Premium

33.04  4  37.04

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 Put option
9.7. The Option to Contract

Sometimes, if the product is not as well received in the market as initially expected, it is worth
to contract the scale of a project’s operation by cutting down future expenditures.

The option to contract is like a put option on part of the project with an exercise price equal to
the value of the planned expenditures that can be forgone.

Suppose that in the example part of the investment cost having a $104 present value necessary
to initiate and maintain the given scale of the plant’s operation is to be spent next year.
Assume $50 has to pay immediately and I1 $58.32 (the future value of $54) is the planned
investment in next year.

Suppose also that in one year, as an alternative to making the full $58.32 investment necessary
to maintain the current scale of operations, management has the option to halve the scale and
value of the project by not making the $58.32 outlay.

Clearly, if market condition next year turns out unfavorably, the firm may find it valuable to
exercise its option to contract the scale of the project’s operation.
Giving up half of the project
The payoff structure:
Value
Amount saved
Max (58.32– 90, 0)

Max (58.32 – 30, 0) Payoff

58.32 = Amount that can be saved

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The option to contract is worth:

1
P  pP  1 p  Pd 
1 rf  u
1
 0.4 0  0.6 28.32
1.08
 15.73

Expanded NPV  Static NPV  Option Premium

11.73  4 15.73

9.8. Implications for Capital Budgeting

The real option approach offers new insights in decision making by expanding the traditional
NPV analysis such that it incorporates an option premium that reflects the value of managerial
flexibility.

Recognizing the option value in real investments,

1. The conventional, static NPV may indeed undervalue projects by suppressing the “option
premium” component.

2. It may be correct to accept projects with negative NPVs if the option premium associated
with the value of managerial flexibility exceeds the negative NPV of the project’s
measurable expected cash flows.

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9.9. Appendix

The cost of setting up the portfolio is:

 u  Cu
C  S 0  1 
 1 r f  1 rf

Cu  Cd
Substituting   into the cost of portfolio:
S0u  S0d

 C  Cd   u  Cu
C  S0  u  1 
 S0u  S0 d   1 r f  1 rf
C  Cd Cu  Cd u C
 u    u
ud u  d 1 rf 1 rf
Cu C u C C C u
  u   u  d  d 
u  d u  d 1 rf 1 rf u  d u  d 1 rf
 1 u 1   u 1 
 Cu      C d   
u  d u  d 1 r f 1 r f  u  d 1 r f u  d 
1  1 rf u   u 1 rf 
 Cu   1   Cd  u  d  u  d 
1 rf   u  d u  d   
1  1 rf u ud  u 1 rf 
 Cu      Cd  u  d  u  d 
1 r f   u  d u  d u  d   
1  1 rf  d   u  1 rf 
 Cu    Cd  
1 r f   u  d   u  d 

1 rf  d u  1 rf  , the value of the call can be simplified

By setting p  and 1 p 
ud ud
into:

1
C  pCu  1 pC d 
1 rf 

187