1. Chapter 22 Principles of Corporate Finance Eighth Edition Real Options Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

2. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 22- 2 McGraw-Hill/Irwin Topics Covered  The Value of Follow-On Investment Opportunities  The Timing Option  The Abandonment Option  Flexible Production  Vary Output or Production

3. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 22- 3 McGraw-Hill/Irwin Corporate Options 4 types of “Real Options” 1 - The opportunity to expand and make follow-up investments. 2 - The opportunity to “wait” and invest later. 3 - The opportunity to shrink or abandon a project. 4 - The opportunity to vary the mix of the firm’s output or production methods. Value “Real Option” = NPV with option - NPV w/o option

4. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 22- 4 McGraw-Hill/Irwin Microcomputer Forecasts Example – Mark I Microcomputer ($ millions)

5. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 22- 5 McGraw-Hill/Irwin Microcomputer Forecasts Example – Mark II Microcomputer

6. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 22- 6 McGraw-Hill/Irwin Microcomputer Forecasts Example – Mark II Microcomputer ($ millions) Forecasted cash flows from 1982 NPV(1982) =PV(inflows) -PV(investment) = 467 – 676 = - $209 million

7. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 22- 7 McGraw-Hill/Irwin Microcomputer Forecasts Example – Mark II Microcomputer (1985) Distribution of possible Present Values Expected value ($807) Required investment ($900) Present value in 1985 Probability

8. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 22- 8 McGraw-Hill/Irwin Intrinsic Value Option to Wait Option Price Stock Price

9. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 22- 9 McGraw-Hill/Irwin Intrinsic Value + Time Premium = Option Value Time Premium = Vale of being able to wait Option to Wait Option Price Stock Price

10. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 22- 10 McGraw-Hill/Irwin More time = More value Option to Wait Option Price Stock Price

11. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 22- 11 McGraw-Hill/Irwin Option to Wait Example – Development option Wait NPV<0 100 240 Hotel NPV>0 Cash flow from hotel Cash flow Office Bldg Office Bldg NPV>0 240 100

12. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 22- 12 McGraw-Hill/Irwin Example - Abandon Mrs. Mulla gives you a non-retractable offer to buy your company for $150 mil at anytime within the next year. Given the following decision tree of possible outcomes, what is the value of the offer (i.e. the put option) and what is the most Mrs. Mulla could charge for the option? Use a discount rate of 10% Option to Abandon

13. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 22- 13 McGraw-Hill/Irwin Example - Abandon Mrs. Mulla gives you a non-retractable offer to buy your company for $150 mil at anytime within the next year. Given the following decision tree of possible outcomes, what is the value of the offer (i.e. the put option) and what is the most Mrs. Mulla could charge for the option? Option to Abandon Year 0Year 1Year 2 120 (.6) 100 (.6) 90 (.4) NPV = 145 70 (.6) 50 (.4) 40 (.4)

14. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 22- 14 McGraw-Hill/Irwin Option to Abandon Year 0Year 1Year 2 120 (.6) 100 (.6) 90 (.4) NPV = 162 150 (.4) Option Value = 162 - 145 = $17 mil Example - Abandon Mrs. Mulla gives you a non-retractable offer to buy your company for $150 mil at anytime within the next year. Given the following decision tree of possible outcomes, what is the value of the offer (i.e. the put option) and what is the most Mrs. Mulla could charge for the option?

15. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 22- 15 McGraw-Hill/Irwin Option to Abandon Example – Ms. East - Revenues 2.50 3.05 2.05 3.73 2.50 1.68

16. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 22- 16 McGraw-Hill/Irwin Option to Abandon Example – Ms. East – Cash Flows 1.80 2.35 1.35 3.03 1.80.98

17. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 22- 17 McGraw-Hill/Irwin Option to Abandon Example – Ms. East – Value

18. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 22- 18 McGraw-Hill/Irwin Tanker Example Mothballing costs Value if mothballed Cost of reactivating Value in operation Tanker Rates Value of Tanker

19. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 22- 19 McGraw-Hill/Irwin Web Resources www.decisioneering.com Click to access web sites Internet connection required