Presentation on theme: "Real Options Traditional capital budgeting analysis:"— Presentation transcript:
1 Real Options Traditional capital budgeting analysis: estimates cashflows each perioddiscounts to get NPVfirm decides to invest/not investBIG PROBLEM: Traditional analysis assumes that a firm’sonly choice is accept/reject the project.THIS IS NOT TRUE!!
2 In a real business situation, firms face many choices with respect to how to operate a project, both before it startsand after it is underway.Eg.Flexibility:use a production technology that is adaptablecan produce more than one productif market for one product goes down, can switch productionto the otherthe option to change production if the firm wantsto (the flexibility) is valuablemakes the project worth moretraditional NPV analysis assumes cashflows fixed,will not change with future business conditions – ignoresthe value of this option
3 Eg.Abandonmentfirm invests in projectafter a time the firm may be able to shut down productionif things are not going welloption to abandontraditional analysis assumes that the firm either takesthe project and runs it for its life, or rejects itBut…the ability to start a project and shut it down(perhaps temporarily) if conditions warrant is valuable
4 Eg.Option to Delaytraditional analysis assumes firm accepts project nowor never investsBut…what if firm has choice to delay making decision?Wait and see how things develop and then decide to investor notThe choice to delay if the firm wants is valuableOther examples of valuable options (choices) a firm may have include:option to expand/shrink productionoption to move into new marketR&D gives the option to develop new products ifthey become viabledevelopment options on natural resourceset cetera
5 Real OptionsAny time a firm has the ability to make choices, there is avalue added to the project in questiontraditional NPV analysis ignores this valuethe study of real options attempts to put a dollar value on theability to make choices
6 How are real options valued? Three major ways: Use methods developed for pricing financial optionsWe look at financial options later in the courseBlack-Scholes ModelMay be problems2) Decision treeslook at this method here3) Stochastic optimization problemslike (2) but using far more complicated(and realistic) models for the probabilityof different events occurring
7 Option to Delaysimple example from “Irreversibility, Uncertainty and Investment”,Robert Pindyck [Journal of Economic Literature, 1991]for $800 a firm can build widget factorymakes 1 widget per yearfactory is built instantlyinvestment is irreversibleif factory built, first widget produced immediatelyno costs of manufacturingno taxesappropriate discount rate is 10%
8 Option to Delay the price of widgets is currently $100 next year the price will be either $150 (50% probability) or$50 (50% probability)whatever price holds next year will hold forever after
9 year 2 year 0 year 1 Price = $150 Price = $150 Price = $100 prob. = 0.5Price = $100prob. = 0.5Price = $50Price = $50
10 Traditional NPV Analysis Expected year 1 price = E[price]= 0.5($150) + 0.5($50) = $100Standard analysis says NPV > 0, so start project.
11 Option to DelayBUT… firm has another option. Delay the choice of whetherto invest or not.Wait until next year to decide.Can see what price turns out to be before making decision.If you delay, you lose on the year 0 sales ($100).The bad part of delaying – lost sales.But, you get to see what price will be before makingirreversible investment.The good part of delaying, reduced uncertainty.
12 CASE 1:If delay and price turns out to be $50:NPV < 0 , so firm will not invest.From today’s perspective, NPV = 0 if price turns out to be $50.
13 CASE 2:If delay and price turns out to be $150:Firm will invest if the price goes to $150.
14 the essence of the option to delay is that it allows the firm to avoid the “bad” outcomedelay deciding until you see what the state of the world is:you lose some sales on delayif the market turns out to be bad, you do not investand do not take the lossdoes the avoided loss make the foregone salesworthwhile?Price = $150NPV =NPV = ??Price = $50NPV = 0
15 NPV in year 0 of delaying project = (0.5)(772.73) + (0.5)(0)= $386.36the NPV of delaying ($386.36) is more than the NPV ofstarting immediately ($300)therefore, firm should delay start of projectthe flexibility of being able to wait another year to decidewhether to invest or not is worth an additional $86.36Does this mean that firms should always delay projects?No, if probability of high price in this example was90% it would be best to start immediately
16 Option to Abandonability to abandon a project if things are not going well is valuableallows firm to avoid bad outcomesvalue of the option to abandon can be calculated in similarway to option to delaysee example handout