1. Risk Management & Real Options VIII. The Value of Flexibility Stefan Scholtes Judge Institute of Management University of Cambridge MPhil Course 2004-05

2. 2 September 2004 © Scholtes 2004Page 2 Course content I. Introduction II. The forecast is always wrong I. The industry valuation standard: Net Present Value II. Sensitivity analysis III. The system value is a shape I. Value profiles and value-at-risk charts II. SKILL: Using a shape calculator III. CASE: Overbooking at EasyBeds IV. Developing valuation models I. Easybeds revisited V. Designing a system means sculpting its value shape I. CASE: Designing a Parking Garage I II. The flaw of averages: Effects of system constraints VI. Coping with uncertainty I: Diversification I. The central limit theorem II. The effect of statistical dependence III. Optimising a portfolio VII. Coping with uncertainty II: The value of information I. SKILL: Decision Tree Analysis II. CASE: Market Research at E-Phone VIII. Coping with uncertainty III: The value of flexibility I. Investors vs. CEOs II. CASE: Designing a Parking Garage II

3. 2 September 2004 © Scholtes 2004Page 3 Project design Designing a project means sculpting its risk profile

4. 2 September 2004 © Scholtes 2004Page 4 Design parameters Where? When? How big? With whom? Etc.

5. 2 September 2004 © Scholtes 2004Page 5 Timing A key issue is the timing / phasing of investments When is the right time for which decision? What is a decision in the first place? A DECISION IS A COMMITMENT OF RESOURCES NPV analysis leads us into one-off thinking Take one decision (invest, yes/no), then the project evolves on a fixed plan NPV does not capture value of staging the investment Many decisions enable you to make further decisions downstream Commit money to “buy an option” vs. “buy cash flows” Option: “Right but not obligation to an action in the future”

6. 2 September 2004 © Scholtes 2004Page 6 Pros and cons of waiting Waiting with a decision allows you to learn / gain information Reduce risk Waiting can lead to loss of revenues during waiting period Waiting can lead to loss of competitive advantage First mover advantage, pre-emption Need to trade-off “costs of waiting” against “value of waiting” No obvious solution Needs case-by-case analysis

7. 2 September 2004 © Scholtes 2004Page 7 Options Postponing a decision is about keeping your option open An option is a “right but not an obligation to a certain future action” R&D activity buys you the option to launch a product in the future if and when R&D is successful and the market is right VC portfolios are portfolios of options Foreign direct investment offers you the opportunity to learn about the foreign market and invest in the future in a big way, if and when you believe the time and circumstances are right

8. 2 September 2004 © Scholtes 2004Page 8 Examples of option values Typical pattern: Price of option is low relative to the possible gain If you buy an option you should realise that there is a good chance that you never exercise it  An option is a gamble “Compound option”: Series of increasingly more expensive stages, followed by a big “final” decision VC investment rounds, followed by IPO Phases of drug R&D Exploration in oil and gas Similar to “value of information” Additional information has only value if you have the option to act in the future in the light of this information

9. 2 September 2004 © Scholtes 2004Page 9 Options “on” systems vs. options “in” systems Options ON systems: Invest a relatively small amount of money for the possibility to invest a large amount later Example: R&D is an option to invest in launch, venture capital investments Options IN systems: You are already committed to a large expenditure and can now improve its risk and opportunity profile by adding design features Many design features can be seen as options, i.e., giving you the right but not the obligation to use them in the future Examples: Y-junction in an underwater pipeline, extra strong footings for parking garage expansion, etc.

10. 2 September 2004 © Scholtes 2004Page 10 Diversification vs. Flexibility Three main risk management approaches Diversify: passive risk / opportunity management Remain flexible: active risk / opportunity management Diversification is important if you don’t have control over the fate of your investment Owner of a fleet of ships, investor in shares Dealt with in finance class Flexibility is important if you are in control Captain of the ship, CEO of company Flexibility can increase the value of each individual project and therefore the value of the portfolio of such projects That’s why VC’s are interested

11. 2 September 2004 © Scholtes 2004Page 11 Flexibility Flexibility is more important for managers than for investors Managers are more likely to be held responsible for the fate of one / few big projects then for the fate of a portfolio of many investments Flexibility is only helpful if it is used skilfully in the future That’s why VC’s are so interested in the quality of the management team Flexibility is only valuable if there is uncertainty about the future The more uncertainty there is the better for the skilful manager Avoid downsides, amplify upsides, beat the competition A good captain likes a stormy sea…

12. 2 September 2004 © Scholtes 2004Page 12 Option value: A stylised example You own an oil reservoir, what’s the value What’s the value if Volume 10 M bbl – no uncertainty If you pump oil out, it will cost you $39/bbl – no uncertainty Oil price projection is $40/bbl – no uncertainty What’s the value if there are two price scenarios with 50/50 chance: Oil price can go up to $45 or down to $35 Does the uncertainty increase or decrease the value? What’s the value if the uncertainty in oil prices increases? Upside scenario $50, downside scenario $30 Does additional uncertainty increase or decrease the value?

13. 2 September 2004 © Scholtes 2004Page 13 The options view of capacity Decide on capacity of new plant Cost of capacity: $500 / unit production capacity Operating margin: $600 / unit sold Projected demand 60,000 units What’s the optimal design?

14. 2 September 2004 © Scholtes 2004Page 14 The options view of capacity Decide on capacity of new plant Cost of capacity: $500 / unit production capacity Operating margin: $600 / unit sold Projected demand 60,000 units What’s the optimal design? Gain $100 for each unit capacity up to 60,000 units Build 60,000 units capacity Value = 60,000*$100= $6 M

15. 2 September 2004 © Scholtes 2004Page 15 The options view of capacity Decide on capacity of new plant Cost of capacity: $500 / unit production capacity Operating margin: $600 / unit sold Projected demand 40,000 units – 50% 80,000 units – 50% What’s the expected value of the chosen design?

16. 2 September 2004 © Scholtes 2004Page 16 The options view of capacity Decide on capacity of new plant Cost of capacity: $500 / unit production capacity Operating margin: $600 / unit sold Projected demand 40,000 units – 50% 80,000 units – 50% What’s the expected value of the chosen design? Upside 60,000*$100 = $6M Downside 40,000*$100 – 20,000*$500 = -$6M Average value = $0 Flaw of averages

17. 2 September 2004 © Scholtes 2004Page 17 The options view of capacity Decide on capacity of new plant Cost of capacity: $500 / unit production capacity Operating margin: $600 / unit sold Projected demand 40,000 units – 50% 80,000 units – 50% Can we improve on our design?

18. 2 September 2004 © Scholtes 2004Page 18 The options view of capacity Decide on capacity of new plant Cost of capacity: $500 / unit production capacity Operating margin: $600 / unit sold Projected demand 40,000 units – 50% 80,000 units – 50% Can we improve on our design? Gain $100 up for each unit of capacity up to downside demand of 40,000 Loose on average for each unit of capacity above 40,000 ̵ Expected loss per unit = 50%*$600-$500=-$200

19. 2 September 2004 © Scholtes 2004Page 19 The options view of capacity

20. 2 September 2004 © Scholtes 2004Page 20 The options view of capacity Plus: Building small avoids downside risk Minus: Building small reduces upside potential

21. 2 September 2004 © Scholtes 2004Page 21 The options view of capacity Smart solution: Build small but allow for later expansion Suppose after demand scenario has been observed, 50% of excess demand can still be captured through expansion How should we stage and what’s the value of the staged project?

22. 2 September 2004 © Scholtes 2004Page 22 The options view of capacity No uncertainty after demand scenario has been observed Build 50% of excess demand as expansion capacity Optimizing initial capacity:

23. 2 September 2004 © Scholtes 2004Page 23 The options view of capacity

24. 2 September 2004 © Scholtes 2004Page 24 The options view of capacity Expansion capability is an option on demand Value of the option: (=) value of the best two-stage design (-) value of the best one-stage design (=) $5,000,000 – $4,000,000 = $1,000,000 May have to invest some of the option value in advance to “buy” the option Trade-off between price and value of the option

25. 2 September 2004 © Scholtes 2004Page 25 The options view of capacity Options are the more valuable the more risky the environment Uncertainty level = Distance between the two demand scenarios

26. 2 September 2004 © Scholtes 2004Page 26 Summary Options allow you to exploit upsides and avoid suffering from downsides Option value increases with increasing uncertainty Options need to be thought of in the initial design phase Trade-off cost of the option with its value NOW TO A CASE: PARKING GARAGE, PART II