INTRODUCTION TO REAL OPTIONS

Lee Macdonald Wakeman, PhD

July, 2017
These lectures will first discuss the impact that Options Theory has
had on Corporate Finance generally and then demonstrate how to
improve on traditional Net Present Value analysis by considering
options such as the right to delay, abandon or expand a project,
which can add significant value when uncertainty about a project is
high.
 Stocks and Bonds as Options

Imagine a firm with a simple financing structure

A zero coupon bond, with a face value of B and market value of D, payable at time T

Common stock, with a market value of E

Then the market value of the firm is given by: V=E+D

If at maturity the assets of the firm are greater in value than the debt, the shareholders
have an in-the-money call. They will pay the bondholders and call in the assets.

If at the maturity of the debt the shareholders have an out-of-the-money call, they will
declare bankruptcy and let the call expire.
 The Value of a Corporate Bond
Value of an Unlevered
Firm, V

Bond &
Firm Values Risk-free bond

B
Corporate Bond
(Risk-free bond minus
a put on V)

Firm Value
Face Value
of Bond, B
 The Value of Common Stock
Value of an Unlevered
Firm, V

Stock &
Firm Values Common stock

Firm Value
Face Value
of Bond, B
 Using Put-Call Parity

E
C0 = S0 + P0
(1+ R)T

Value of a Value of a Value of a

Value of
call on the = the firm + put on the risk-free
firm firm bond

Stockholders position in Stockholders position in terms of

terms of call options put options
 Application to valuation: A simple example

Assume that you have a firm whose assets are currently valued at
$100 million and that the standard deviation in this asset value is 40%.
Further, assume that the face value of debt is $80 million (It is zero
coupon debt with 10 years left to maturity).
If the ten-year treasury bond rate is 10%,
how much is the equity worth?
What should the interest rate on debt be?

Aswath Damodaran, NYU

 Model Parameters

Value of the underlying asset = S = Value of the firm = $ 100 million

Exercise price = K = Face Value of outstanding debt = $ 80 million

Life of the option = t = Life of zero-coupon debt = 10 years

Variance in the value of the underlying asset = 2 = Variance in firm value

= 0.16

Riskless rate = r = Treasury bond rate corresponding to option life = 10%

Aswath Damodaran, NYU

 Valuing Equity as a Call Option

The Black-Scholes model provides the following value for the call:
d1 = {ln(100/80) + (0.1 + 0.16/2)*10} / {10 * 0.16}0.5 = 1.5994 N(d1) = 0.9451
d2 = 1.5994 1.2649 = 0.3345 N(d2) = 0.6310
Probability of default = 1 N(d2) = 37%

Value of the call = 100 (0.9451) - 80 e(-0.10)(10) (0.6310) = $75.94 million

Value of the outstanding debt = $100 - $75.94 = $24.06 million
Interest rate on debt = ($ 80 / $24.06)1/10 -1 = 12.77%
Aswath Damodaran, NYU
 Value of a troubled firm

Assume now that the value of the firm were suddenly reduced to $50
million while keeping the face value of the debt at $80 million

This firm could be viewed as troubled, since it owes (at least in face
value terms) more than it owns

The equity in the firm will still have value, however. This value is an
increasing function of the time remaining until the debt matures.

Aswath Damodaran, NYU

 The Value of Equity as an Option

Based upon the decrease in firm value to $50 million, the Black-
Scholes model provides the following value for the call:
d1 = 1.0515 N(d1) = 0.8534
d2 = -0.2135 N(d2) = 0.4155
Value of the call = 50 (0.8534) - 80 e(-0.10)(10) (0.4155) = $30.44 million
Value of the bond= $50 - $30.44 = $19.56 million
The equity in this firm drops, but is not valueless
This might explain why stock in firms, which are in Chapter 11 and
essentially bankrupt, still has value.

Aswath Damodaran, NYU

 Equity value persists ..

Value of Equity as Firm Value Changes

80

70

60

50
Value of Equity

40

30

20

10

0
100 90 80 70 60 50 40 30 20 10
Value of Firm ($ 80 Face Value of Debt)

Aswath Damodaran, NYU

 Valuing equity in a troubled firm

Although the firm will be viewed as troubled by investors, accountants and

analysts, that does not mean that its equity is worthless.
Just as deep out-of-the-money traded options command value because of the
possibility that the value of the underlying asset may increase above the strike
price in the remaining lifetime of the option, equity will command value because
of the time premium on the option (the time until the bonds mature and come
due) and the possibility that the value of the assets may increase above the face
value of the bonds before they come due.

Aswath Damodaran, NYU

 Mergers and Diversification
Diversification is a frequently mentioned reason for mergers.
Diversification reduces risk and, therefore, volatility.
Decreasing volatility decreases the value of an option.
Assume diversification is the only benefit to a merger:
Since equity can be viewed as a call option, should the merger increase or decrease
the value of the equity?
Since risky debt can be viewed as risk-free debt minus a put option, what happens to
the value of the risky debt?
Overall, what has happened with the merger and is it a good decision in view of the
goal of stockholder wealth maximization?
 Example
Consider the following two merger candidates, whose returns are uncorrelated
The merger is for diversification purposes only with no synergies involved
Risk-free rate is 4%
Company A Company B
Market value of assets $40 million $15 million
Face value of zero coupon $18 million $7 million
debt
Debt maturity 4 years 4 years
Asset return standard 40% 50%
deviation
 Using the Black Scholes Model

Company A Company B

Market Value of Equity 25.72 9.88

Market Value of Debt 14.28 5.12

 The asset return standard deviation for the combined firm is 30.5%
{(40/55)2*(0.4)2 + (15/55)2*(0.5)2} 0.5
Market value assets (combined) = 40 + 15 = 55
Face value debt (combined) = 18 + 7 = 25

Combined Firm

Market value of equity 34.18

Market value of debt 20.82

Total MV of equity decrease by 1.42 = increase in Total MV of debt

 M&A Conclusions

Mergers for diversification only transfer wealth from the stockholders

to the bondholders.

The standard deviation of returns on the assets is reduced, thereby

reducing the option value of the equity.

If managements goal is to maximize stockholder wealth, then mergers

for reasons of diversification should not occur.
 Options and Capital Budgeting

Stockholders may prefer low NPV projects to high NPV projects if the
firm is highly leveraged and the low NPV project increases volatility.
Consider a company with the following characteristics:
MV assets = 40 million
Face Value debt = 25 million
Debt maturity = 5 years
Asset return standard deviation = 40%
Risk-free rate = 4%
 Example: Low NPV
Current market value of equity = $22.7 million
Current market value of debt = $17.3 million

Project I Project II
NPV $3 $1
MV of assets $43 $41
Asset return standard 30% 50%
deviation
MV of equity $23.8 $25.4
MV of debt $19.2 $15.6
 Example: Low NPV

Even though project B has a lower NPV, it is better for stockholders

The firm has a relatively high amount of leverage:

With project A, the bondholders NPV increases because the project reduces
the risk of bankruptcy as well as increasing the firms value

With project B, the stockholders actually appropriate additional wealth from

the bondholders for a larger gain in value.
 Example: Negative NPV

We have seen that stockholders might prefer a low NPV to a high one, but
would they ever prefer a negative NPV?
Under certain circumstances, they might
If the firm is highly leveraged, stockholders have nothing to lose if a project
fails, and everything to gain if it succeeds
Consequently, they may prefer a very risky project with a negative NPV but
high potential rewards.
 Example: Negative NPV

Consider the previous firm. They have one additional project they are
considering with the following characteristics
Project NPV = -$2 million
MV of assets = $38 million
Asset return standard deviation = 65%

Estimate the value of the debt and equity

MV equity = $25.453 million
MV debt = $12.547 million
 Example: Negative NPV

In this case, stockholders would actually prefer the negative NPV

project to either of the positive NPV projects.

The stockholders benefit from the increased volatility associated with

the project even if the expected NPV is negative.

This happens because of the large levels of leverage.

 Options and Capital Budgeting

As a general rule, managers should not accept low or negative NPV

projects and pass up high NPV projects.

Under certain circumstances, however, this may benefit stockholders:

The firm is highly leveraged

The low or negative NPV project causes a substantial increase in the standard
deviation of asset returns.
 The Result? Bond Covenants

A bond covenant is a legally binding term of agreement between a

bond issuer and a bond holder:
Affirmative covenants stipulate what the bond issuer must do, such as perform
according to the basic terms of the issue, pledge certain property or maintain
certain financial levels
Negative covenants stipulate what the bond issuer is prohibited from doing,
such as carry more than a stated amount of debt, sell assets or do business in a
certain country
Bond covenants benefit shareholders by decreasing the cost of a given
level of debt and increasing the amount of debt that can be raised.
 Executive Stock Options

Executive Stock Options exist to align the interests of shareholders and managers
Executive Stock Options are warrants on the employers shares:
Inalienable
Typical maturity is 10 years
Typical vesting period is 3 years
Most include an implicit reset provision to preserve incentive compatibility
Executive Stock Options give executives an important tax break: grants of at-the-
money options are not considered taxable income. (Taxes are due if the option is
exercised.)
 Valuing Executive Stock Options

FASB has historically allowed firms to record zero expense for grants of at-the-
money executive stock options

However, the economic value of a long-lived call option is enormous, and

therefore many firms report the value of these options on their annual reports

Most companies use the Black Scholes model, which under-reports the value if a
firm resets the exercise price after drops in the price of the stock. The Binomial
model provides a more accurate, higher value.
 Three Period Binomial Process

$25.00 (1.15)3
38.02
$25.00 (1.15) 2
2/3

$25.00 (1.15) 33.06 $25.00 (1.15) 2 (1 .15)

2/3
1/3
28.75
$25.00 (1.15)(1 .15) 28.10

2/3 2/3
1/3
$25 24.44 $25.00 (1.15) (1 .15) 2
2/3
1/3 1/3
21.25 $25.00 (1. 15) 2 20.77
2/3
1/3
$25.00 (1 .15) 18.06
$25.00 (1 .15)3
1/3
15.35
 C 3 (U , U , U ) max[$ 38 .02 $ 25,0 ]
38.02
2 3 $13.02 (1 3) $3.10
C 2 (U , U ) 2/3 13.02
(1.05)
C1 (U ) C3 ( D , U , U )
33.06
2 3 $9.25 (1 3) $1.97 C3 (U , D, U ) C3 (U , U , D )
2/3 9.25
(1.05) 1/3 max[$ 28.10 $25,0]
C 2 (U , D ) C 2 ( D, U )
28.75 28.10
2/3 6.50
2 3 $3.10 (1 3) $0 3.10
2/3
C1 ( D ) 1/3 (1.05) C3 (U , D, D )
$25
2 3 $1.97 (1 3) $0 24.44
C3 ( D , U , D ) C3 ( D , D , U )
4.52 2/3 1.97
(1.05)
1/3 max[$ 20.77 $25,0]
C 2 ( D, D ) 1/3
21.25 20.77
2 3 $0 (1 3) $0
1.25 2/3 0
1/3 (1.05)
C3 ( D , D , D )
18.06
2 3 $6.50 (1 3) $1.25 max[$ 15.35 $25,0]
C0 0
1/3
(1.05) 15.35
0
 Valuation of a Lookback Option

When the stock price falls due to the stock market as a whole falling, the board
of directors tends to reset the exercise price of executive stock options

To see how this reset provision adds value, lets price that same three-period
call option (exercise price initially $25) with a reset provision

Notice that the exercise price of the call will be the smallest value of the stock
price depending upon the path followed by the stock price to get there.
Three Period Binomial with Lookback
38.02

33.06

28.10

28.75
28.10
24.44

20.77

$25

28.10

24.44

20.77
21.25

20.77

18.06

15.35
 C 3 (U , U , U ) max[$ 38 .02 $ 25,0 ]
38.02 13.02

C 3 (U , U , D ) max[$ 28 .10 $ 25,0 ] 3 .10 33.06

28.10 $3.10

28.75 C 3 (U , D , U ) max[$ 28 .10 $ 24 .44,0 ] 3 .66

28.10 $3.66
24.44

20.77 0
C 3 (U , D , D ) max[$ 20 .77 $ 24 .44,0 ] 0
$25
C 3 ( D , U , U ) max[$ 28 .10 $ 21 .25,0 ] 6 .85 28.10 $6.85

24.44

20.77 0
21.25 C 3 ( D , U , D ) max[$ 20 .77 $ 21 .25,0 ] 0
20.77 2.71

C 3 ( D , D , U ) max[$ 20 .77 $ 18 .06,0 ] 2 .71 18.06

15.35 0
C 3 ( D , D , D ) max[$ 15 .36 18 .06,0 ]
 38.02 13.02
2 3 $13.02 (1 3) $3.10
C 2 (U , U ) 33.06
(1.05) 9.25 28.10 $3.10
2 3 $3.66 (1 3) $0
28.75
C 2 (U , D )
(1.05) 28.10 $3.66
24.44

2.33 20.77 0

$25
2 3 $6.85 (1 3) $0
C 2 ( D,U ) 28.10 $6.85
(1.05)
24.44

4.35 20.77 0
21.25

20.77 2.71

2 3 $2.71 (1 3) $0 18.06
C 2 ( D, D ) 1.72 15.35 0
(1.05)
 38.02 13.02

C1 (U ) 33.06
2 3 $9.25 (1 3) $2.33 9.25 28.10 $3.10
(1.05) 28.75
6.61 28.10 $3.66
24.44

2.33 20.77 0

$25 C1 ( D )
5.25 2 3 $4.35 (1 3) $1.72 28.10 $6.85
(1.05)
24.44

4.35 20.77 0
21.25
3.31 20.77 2.71

2 3 $6.50 (1 3) $1.25 18.06

C0 1.72
(1.05) 15.35 0
 Real Options

Discounted cash flow is going to look at an average scenario,"

comments Triantis. "But if you talk to any manager, that's not how
they think. They think about contingencies what's going to happen,
how would we react. And even if they don't think that way, once it's
presented to them that way, they say, 'Yeah, that's the way we should
be thinking.'"

CFO Magazine Will Real Options take roots?, July 2003

 NPV and Real Options

Many Types of Real Options

The key is to identify them

Often they are difficult to value. However, one can often tell if they add value
to the project.
 Input Mix Options or Process Flexibility

The option to use different inputs to produce the same output is

known as an input mix option or process flexibility
Examples:
Agriculture: A beef producer will value the option to switch between various
feed sources, preferring to use the cheapest acceptable alternative
Utility industry. An electric utility may have the option to switch between
various fuel sources to produce electricity. In particular, consider an electric
utility that has the choice of building a coal-fired plant or a plant that burns
either coal or gas.
 Output Mix Options or Product Flexibility

The option to produce different outputs from the same facility is

known as an output mix option or product flexibility
Example:
Toy industry. A manufacturer's ability to cease producing a style of toy that has
become unfashionable and quickly begin producing a popular new style of toy.
 Options in Projects/Investments/Acquisitions

Traditional investment analysis is static and does not do a good

job of capturing the options embedded in investment
The first of these options is the option to delay taking a investment,
when a firm has exclusive rights to it, until a later date
The second of these options is taking one investment may allow us
to take advantage of other opportunities (investments) in the
future (ex. growth options)
The last option that is embedded in projects is the option to
abandon a investment, if the cash flows do not measure up.

Aswath Damodaran, NYU

 The Initiation or Deferment Option
The option to choose when to start a project is an initiation or deferment option

A traditional investment analysis just answers the question of whether the project
is a good one if taken today

Thus, the fact that a project does not pass muster today (because its NPV is
negative, or its IRR is less than its hurdle rate) does not mean that the rights to
this project are not valuable

Initiation options are particularly valuable in natural resource exploration where a

firm can delay mining a deposit until market conditions are favorable.
 Deferment Option Example

A company has the opportunity to build a new power project in a foreign

country. Cost is $1,100 mm and cost of capital is 10%
Net cash flows are $100mm in the first year of operation
Net cash flows in the second year of operation depend upon whether the
government sponsors a link to bypass a transmission bottleneck
There is a 50% probability the government will intervene
This is an example of political risk.
 Build Now?
156 ...
0.5

125
0.5
0.5
100 100 ...
0.5
0.5
80
0.5
64 ...
Expected Net
Cash Flow 100 103 105 ...

NPV = -1,100 + 100/1.1 + 103/1.12 + 105/1.13 + = -56

..
 Delay One year?

During this one-year delay, the company learns whether or not the
new entrepreneurial link will proceed

Based on this additional information, a smarter decision can be

made

Cost to build in one years time is 1,150.

 156 ...
0.5

up state 125
0.5
100 ...
0.5

down state 80
0.5
64 ...

Expected Net Cash Flow ...

125 128
in up state
Expected Net Cash Flow ...
80 82
in down state
PV(UP)1 = 125/1.1 + 128/1.12 + . = 1,877

PV(Down)1 = 80/1.1 + 82/1.12 + = 818

NPV = -1,150 + {0.5 * 1,677 + 0.5 * 818}/1.1 = 75

 Remarks
The option to delay can be valuable, even if the project has positive NPV if
started immediately, if relevant information can be obtained by waiting. As new
information arrives and uncertainty about market conditions is resolved,
management may have valuable flexibility to alter its initial operating strategy
to capitalize on favorable future opportunities or mitigate losses.

In this examples we used decision trees, rather than option pricing, to answer
the delay question. The next example uses option pricing.
 Valuing an Oil Reserve

Consider an offshore oil property with an estimated oil reserve of 50 million barrels
of oil, where the current development cost is $12 per barrel, growing at 4 % per
annum and the development lag is two years.
The firm has the rights to exploit this reserve for twenty years and the marginal
value per barrel of oil is currently $20 per barrel
Once developed, the net production revenue each year will be 5% of the value of
the reserves
The riskless rate is 8% and the variance in ln(oil prices) is 0.03.
 Develop Now

Annual revenue = $20 * 50 mm * 0.05 = $50 mm

PV = 50/0.08 * { 1 - 1/(1.08)20} / 1.082 = $421 mm

(because production begins in 2 years time)

NPV = 421 ( 12 * 50) = ($179 mm)

 Inputs to Option Pricing Model

Assume that the option is a European option exercisable in 20 years (an

American option will be at least as valuable)
Current Value of the asset = Value of the developed reserve discounted back
the length of the development lag
Annual revenue for 20 years = $20 * 50 mm * 0.05 =$ 50 mm
PV = 40/0.08 * { 1 - 1/(1.08)20} / 1.082 = $ 421 mm
Exercise Price = 600 * 1.0420 = $1,315 mm
 http://www2.stat.duke.edu/~banks/111-FAQ.dir/z-table.pdf

1. Cumulative probabilities
for negative z-values

2. Cumulative probabilities
for positive z-values
 Valuing the Option
Based upon these inputs, the Black-Scholes model provides the following
value for the call:
d1 = 1.0359 N(d1) = 0.8498
d2 = 0.2613 N(d2) = 0.6030
Call Value = 421 * 0.8498 1,315 e(-0.08)(20) (0.6030) = $198 mm

This oil reserve, though not viable at current prices, is still a valuable
property because of its potential to create value if oil prices go up:
NPV + Call Value = ($179) + $198 = $19 mm
 Valuing a Patent

Obtaining a patent gives the owner the right to receive royalties for a given
number of years (ex. 15 years). A delay in implementing the patent (ex. delaying
marketing a new drug) reduces the number of years of revenue, and therefore
decreases the value of the deferral option
For example, in the case of the offshore lease, if the right to draw oil ceases after
20 years, each year of delay causes a reduction of revenues of $50mm
This problem is handled using the Merton Continuous Dividend Model, with the
continuous dividend yield acting as a proxy for expected annual cost of delay.
Options on Stocks Paying Known Dividend Yields
(Merton's Continuous Dividend Model)
If a stock pays a continuous dividend yield at an average annualized rate of
, the value of the stock is diminished by a factor of:
e (T t)
Thus, in the Black-Scholes formulae, if we replace stock price S by Se -(T t)

and r by (r )
we get the pricing formula derived by Merton.

In the case of the oil well, we would set equal to 5% (1/20 years)
 Growth Options
The value of a 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

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.

Stephen Gray and Campbell Harvey

 Option to Expand

Imagine a start-up firm, Campusteria, Inc., which plans to open private

dining clubs on college campuses
The test market will be your campus, and if the concept proves
successful, expansion will follow nationwide
Nationwide expansion will occur in year four
The start-up cost of the test dining club is only $20,000 (this covers
leaseholder improvements and other expenses for a vacant restaurant
near campus)
We anticipate a useful life of 10 years.
 Campusteria Pro Forma Income Statement
Investment Year 0 Years 1-4 We plan to sell 25 meal plans at
$200 per month with a 12-month
Revenues $60,000 contract

Variable Costs ($42,000) Variable costs are projected

to be $3,500 per month
Fixed Costs ($18,000)
Depreciation ($7,500) Fixed costs (lease payment)
are projected to be $1,500
Pretax profit ($7,500) per month
Tax shield 34% $2,550 We can depreciate our
Net Profit ($4,950) capitalized leaseholder
improvements.
Cash Flow -$20,000 $2,550
4
$2,550
NPV $30,000 t
$21,916.84
t 1 (1.10)
 Invest in the Test Dining Club?

PV(Revenue) = {$2,550/0.1} * {1 1/1.110} = $15,669

NPV = -20,000 + 15,669 = ($4,331)

 Valuing a Start-Up

The Campusteria test site has a negative NPV

If we expand, we project opening 20 Campusterias in year four

The value of the project is in the option to expand

We will use the Black-Scholes option pricing model to value this

option.
 Valuing a Start-Up with Black-Scholes

We need to find the value of a four-year call option with an

exercise price of $400,000 = $20,00020.

The interest rate available is R = 10%.

The option maturity is four years.

The volatility of the underlying asset is 30% per annum.

The current value of the underlying assets is: $15,669 * 20

 d1 = {ln(313,380/400,000) + (0.1+0.5*0.32)*4}/0.3*40.5 = 0.560

d2 = 0.560 0.3 *40.5 = -0.040

N(d1) = 0.7123 N(d2) = 0.4840

C = 313,380 * 0.7123 - 400,000 * e (0.1 * 4) * 0.4840 = $93,447

Value = NPV + Option = ($4,331) + 93,447 = $89,116

 The Impact of Volatility
If the volatility is estimated to be 20%, rather than 30%

d1 = {ln(313,380/400,000) + (0.1+0.5*0.22)*4}/0.*40.5 = 0.236

d2 = 0.236 0.2 * 40.5 = -0.164

N(d1) = 0.5930 N(d2) = 0.4345

C = 313,380 * 0.5930 - 400,000 * e (0.1 * 4) * 0.4345 = $69,332

Value = NPV + Option = ($4,331) + 69,332 = $65,001

 The Determinants of the Expansion Value

Does taking on the first investment/expenditure provide the firm

with an exclusive advantage on taking on the second investment?
If yes, the firm is entitled to consider 100% of the value of the real option
If no, the firm is entitled to only a portion of the value of the real option,
with the proportion determined by the degree of exclusivity provided by
the first investment
Is there a possibility of earning significant and sustainable excess
returns on the second investment?
If yes, the real option will have significant value
If no, the real option has no value.

Aswath Damodaran, NYU

 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.
Stephen Gray and Campbell Harvey
 Abandonment or Termination Options

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.

Stephen Gray and Campbell Harvey

 Abandonment Option Example
Abbeytown Copper has a 2-yr lease over a known deposit
Deposit contains eight million pounds of copper

Mining involves a one-year development phase, at a cost of $1.25 million

immediately

Extraction costs (outsourced) at $0.85 / pound at beginning of extraction

phase (one year after development phase is initiated)
 Sale of copper would be at spot price of copper as of beginning of
extraction phase

Current spot price of copper is $0.95 / pound

Log change in copper prices are normally distributed with mean 7%

and standard deviation 20% (p.a.)

Abbeytown's required rate of return for this project is 10%, and the
riskless rate is 5%
 Traditional NPV analysis

Expected NPV = -1.25 + 8 * (E[S1] - 0.85) / 1.1

where E[S1] = Expected price of Copper in one year's time
Current price of Copper, S0 = 0.95
Expected rate of return on copper, r = 7%
Expected price of copper in one year, S1 = 0.95e0.07 = 1.0189
Hence E[NPV] = -1.25 + 8 * (1.0189 - 0.85)/1.1 = ($0.022 mm)
 Option Analysis
S = 0.95 * 8 = 7.6 K = 0.85 * 8 = 6.8 T = 1 year (abandon after 1 year)

d1 = 0.9061 N(d1) = 0.8176

d2 = 0.7061 N(d2) = 0.7599 P(Abandon) = 0.2401

Put = 0.166

Project Value = - 0.022 + 0.166 = $142,000

Why does the option to abandon have value? Abbeytown can choose to
abandon the project if the price of copper is low after one year.
 Airbus Lear Aircraft Project
Airbus is considering a joint venture with Lear Aircraft to produce a small
commercial airplane (capable of carrying 40-50 passengers on short haul
flights)
Airbus will have to invest $500 million for a 50% share of the venture
Its share of the present value of expected cash flows is $480 million
Lear Aircraft, which is eager to enter into the deal, offers to buy Airbuss
50% share of the investment anytime over the next five years for $400
million, if Airbus decides to get out of the venture
A simulation of the cash flows on this time share investment yields a
variance in the present value of the cash flows from being in the
partnership is 0.16
The project has a life of 30 years.

Aswath Damodaran, NYU

 Project with Option to Abandon

Asset Value (S) = PV of Cash Flows from Project = $480 million

Strike Price (K) = Salvage Value from Abandonment = $400 million
Variance in Underlying Assets Value = 0.16
Time to expiration = Life of the Project =5 years
Dividend Yield = 1/Life of the Project = 1/30 = 0.033 (We are assuming
that the projects present value will drop by roughly 1/n each year into
the project)
Assume that the five-year riskless rate is 6%. The value of the put
option can be estimated as follows:

Aswath Damodaran, NYU

 Should Airbus enter into the joint venture?

Value of Put = Ke-rt * (1 - N(d2)) - Se-yt * (1 - N(d1))

=400 * e(-0.06)(5) * (1 - 0.4624) - 480 * e(-0.033)(5) * (1 - 0.7882)
= $73.23 million
The value of this abandonment option has to be added on to the net
present value of the project of -$20 million, yielding a total net
present value with the abandonment option of $53.23 million
This analysis assumes that Lear will be in a position to honor its
commitment to buy back Airbuss share for $400 million.

Aswath Damodaran, NYU

 Implications for Investment Analysis
Having a option to abandon a project can make otherwise unacceptable
projects acceptable
Actions that increase the value of the abandonment option include
More cost flexibility, that is, making more of the costs of the projects into
variable costs as opposed to fixed costs
Fewer long-term contracts/obligations with employees and customers, since
these add to the cost of abandoning a project
Finding partners in the investment, who are willing to acquire your investment
in the future
These actions will undoubtedly cost the firm some value, but this has to
be weighed off against the increase in the value of the abandonment
option.

Aswath Damodaran, NYU

 Temporary 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

Examples:

If the price of oil falls below the cost of extraction, for example, it may be
optimal to temporarily shut down the oil well until the oil price recovers

Farming: May be exercised if the cost of fertilizing, watering and harvesting

exceeds the sale price of the product.

Stephen Gray and Campbell Harvey

 Electricity Generation Using Gas Turbines
Since they produce electricity at a cost at least 50 percent higher than the most
efficient state-of-the-art facility, they are expected to sit idle most of the year

The typical price of electricity is around $40 per megawatt-hour, but occasionally
the price spikes, to more than several thousand dollars

In these cases, the gas turbine engines supplement the regular electricity-
producing plant at prices that create a positive NPV investment when the
engines are operating only a limited number of hours per year

By installing these engines, electric utilities are buying a series of out-of-the

money put options on electricity.
 Calculating the Volatility of a Real Asset

How do you estimate the volatility of a chemical plants value? The answer is
to look at the plants value drivers. For a commodity chemical company like
Copano, plant value is often driven by changes in a single key variable, such as
the spread between the price of the output commodity chemical
(polyethylene terephthalic acid, or PTA, for example) and the cost of a key
input commodity chemical (p-xylene, say). The volatility of such a spread can
be easily estimated. By looking at how this volatility feeds into the plant value,
which you can do by performing sensitivity analyses on the original
discounted-cash-flow model of the plant value today, you can estimate the
volatility of the plants value.
Tom Copeland and Peter Tufano: A Real-World Way to Manage Real Options, HBR
 Problems with Real Option Pricing Models

1. The underlying asset may not be traded, which makes it difficult to

estimate value and variance for the underlying asset
2. The price of the asset may not follow a continuous process, which
makes it difficult to apply option pricing models (like the Black
Scholes) that use this assumption.
3. The variance may not be known and may change over the life of the
option, which can make the option valuation more complex
4. Exercise may not be instantaneous, which will affect the value of the
option
5. Some real options are complex and their exercise creates other
options (compound) or involve learning (learning options).