REAL OPTIONS

The value of managerial flexibility: Chapter 16

The Real Options approach to
corporate investments
Naïve NPV is based on expected cash flows, assuming
no dynamic decisions.
In reality, managers make decisions over time as
information becomes available.
The ‘value of managerial flexibility’ reflects the value of
being able to learn and decide dynamically.
Decision Tree Binomial tree

Good news Cash flow

L O
Decision Node
E P invest
Bad news Cash flow
S T
S I
Cash flow
Information Node
O Good news
V N Don’t
A invest
L Bad news Cash flow

Invest Cash flow

M O
O P Good news
Don’t Invest Cash flow
R T
E I
O Invest Cash flow
V N Bad News
A
L Don’t Invest Cash flow
Real Option Financial Option

•Expenditure required K • Exercise Price

to acquire asset
•Current value of S •Stock Price
operating asset that will be
acquired
•Length of time before •Time to maturity
opportunity disappears. T
•Riskiness of  •Variance of return
underlying asset
•Time value of money rf •Risk free rate
•Cash flow from operations Div •Dividends
The option to delay:Black
Scholes
Electric Car Dealership costs $5
million to open
FCF = $600,000, g=.02, r=.12,
rf=.05
You can pay for the right to open
now or in one year.
How much is delay worth?
If you opened today
Valuing the option to wait
Waiting lets you decide later but
you lose a year’s FCF=600,000
Black Scholes approach
S Current value of the dealership 6, 000, 000
K Cost of building dealership 5, 000, 000
T Decision time (years) 1
rf Default free rate .05
 volatility of dealership value .4
Div cash flow that would be generated 600, 000
600, 000
S x S  PV ( Div ) 6, 000, 000  5, 464, 286
1.12
Valuing the option to wait
C = [N(d1) x Sx ] + [N(d2) xPV( K )

So 6
rf 0.0512711
K 5.00
PV(K) 4.76
SoX 5.46
sigma 0.4
t 1
So/PV(K) 1.14888913
sqrtt 1
sigma t 0.4
d1 0.54698875 Value of Waiting (i.e. C) 1.21
N(d1) 0.70780677 PV Invest Today 1.00
d2 0.14698875
N(d2) 0.55842955
Factors Affecting
Investment Timing
Firm risk and Options
Think of the dealership as the
underlying asset
Recall from stock option value
S
 option  S
S  B
Recall C =  S + B
If the dealership has a deal of 2, the
option to wait has a wait of:
S .716 5.46
 wait   deal  2 3.19 2 6.46
C 1.21
Risk Neutral Equivalent:
one period
One period binomial tree
Cu  Cd 2.64  0
  .71
Su  S d 7.64  3.9
Cd  S d  0  3.9(.71)
B   2.637
(1  rf ) 1.05
C .715.46  2.62 1.24
The option to expand and
abandon
An initial investment on its own may not
be profitable, but it might provide the
opportunity to decide to expand.
 Example:
 A franchise for {0,1,2} new restaurant locations
 Two marketing plans:
 Location A is small: marketing and startup cost =250
 Location B is large: marketing and startup cost =400
 One of the locations must be developed now or both
will be worthless.
  = 0, rf = 10%, =p
Payoffs from two marketing plans
Plan A: Hit 440
-250 Outcomes
Bomb 0
are equally
660 likely
Plan B: Hit
-400
Bomb 0

Buy franchise for location A only

.5(440)  .5(0)
NPV A  250   50
1.1

Buy franchise for location B only

.5(660)  .5(0)
NPVB  400   100
1.1
 buy franchises for both: B now, A if B is a hit
Hit 660
440
-400 -250

Bomb 0
Portfolio of B plus Call on A
Option payoff
Underlying
: 440/1.1=400 400-250=150
(400  0) / 2
181.82
1.1 0 0
Risk neutral pricing
S (1  rf )  D 181.82 (1.1)  0
  .5
U D 400  0
 CU .5 150
Call value   68.18
(1  rf ) 1.1

Value of Portfolio of B plus Call on A = -100+68.18

= -31.82
 buy franchises for both: B now, A if B is a hit
Hit 440
600
-250 -400

Bomb 0
Portfolio of A plus Call on B
Option payoff
Underlying
: 660/1.1=600 600-400=200
(600  0) / 2
272.72
1.1 0 0
Risk neutral pricing
S (1  rf )  D 272.72 (1.1)  0
  .5
U D 600  0
 CU .5 200
Call value   90.91
(1  rf ) 1.1

Value of Portfolio of B plus Call on A = -50+90.91

= 40.91
More on staging
Problem 23: Geneco New Drug
 2 preliminary improvements needed:
Potency and toxicity
r 0.06
Cost Years Prob of success
Potency 10 2 0.05
Toxicity 30 4 0.2

 If successful on both, sell patent for $2billion.

 Decision: Simultaneous or Sequential? Order?
1. Simultaneous
2, 000
NPVsim  10  30  (.05 .2) 4
 24.16
1.06
Sequencing
Potency first, then toxicity
 NPV of Toxicity if potency successful
2, 000
NPVtox  30  (.2) 4
286.84
1.06

 NPV of Potency then toxicity

 Potency is an option on toxicity
NPVtox
NPVPot then tox  10  (.05) 2.764
1.062
Sequencing
Toxicity First then Potency if successful
NPV of Potency if Toxicity successful

2, 000
NPV pot  10  (.05) 2
79
1.06

 NPV of Toxicity then Potency

 Toxicity is an option on Potency

NPV pot
NPVtoxc then pot  30  (.2) 4
 17.49
1.06
Abandonment Option
A put option: allows the sale of the asset for a fixed
amount.
Example:
 Gold mine costs: $4 million
 Gold reserves: Two years
 Production costs:$10 with certainty
 Production: 1 million oz/year
 Risk free rate: 10%
 
 Current price $12,
 expected price in one year, $12
 Price Tree
20

14

12 12
10

Today Next Year Final Year

Naïve NPV
Expected net cash flow = 12 – 10 = 2
2 2
NPV  4   2  .53
1 .1 1 . 1
But you can decide when to operate
20 – 10 = 10 Operate
14 – 10 = 4
-4 12 – 10 = 2
10 – 10 = 0 Abandon

4 – 10 = -6
 4  10 2   2 
NPV  4  .5   .5  2  2   0  .5  0  2   .71
 1.1  1.1 1.1   1.1  
The Option to Abandon as a
Put
A put option allows you to sell at a fixed
price.
 Suppose you have an option to sell gold for
$10.
 Payoff = max {10-price, 0}
 Exercised only when price =4, payoff = 6
 Value of put = (.5 x .5 x 6)/1.12
= 1.24
 Operation plus Put has
NPV = -.53 + 1.25 = .71
The ability to switch and
asset life
You can buy a machine that will last
5 years and cost $10
You can buy a machine that will last
10 years and cost $16
Either machine will produce $3 per
year
The discount rate is 10%
The five year machine gives you the
option to continue or abandon.
 option on technological
progress
Year Year
Toda 5 10
y

ong term machine NPV = -16 +PV(3, 10 years, 10%) =2.43

Machine cost rises 2 million to
12 million - shut down
Short Term Machine
NPV First 5 years Machine cost stays same, Continue
=1.37 NPV = 1.37 in 5 years

Machine cost drops 3 million, Contin

NPV = 4.37 in 5 years
Valuing the replacement
option
Assuming all three outcomes are
equally likely
1 1 1
0  1.37  4.37
NPV 1.37  3 3
5
3 2.56
1.1

This is greater than the long term

investment.
Rules of thumb
Profitability index: PV cash
flows/investment
 When > 1 is an approximation of an
option rule.
Hurdle rate
 When > cost of capital is an
approximation of an option rule.
Real Options: Concluding
Comments

Option pricing has solid structure in

security market setting.
Applying the same tools to make real
investments requires much more
judgment
 What are the options?
 How do we estimate underlying parmeters?
Expectations
You should be able to
 Spot various options in the context of
an investment opportunity.
 Understand how to value the option
using basic option pricing techniques