and Cross-Border Investment Strategy Chapter 16 Real Options and Cross-Border Investment Strategy Learning objectives  Real options and corporate investment – Definitions, terminology, concepts…  The value of flexibility in an uncertain world – Market entry as a simple real option – Market entry as a compound real option  Real options and NPV as complements

The blunders are all there on the board, waiting to be made. 16.1 Real Options and the Theory and Practice of Investment The blunders are all there on the board, waiting to be made. Savielly Tartakower (Chess grandmaster)

and the Theory and Practice of Investment 16.1 Real Options and the Theory and Practice of Investment The conventional theory of investment Discount expected future cash flows at an appropriate risk-adjusted discount rate: NPV = St [E[CFt] / (1+i)t] Include only incremental cash flows. Include all opportunity costs. Oft-neglected opportunity costs include the option to invest (or disinvest) at a different time or in a different form.

and the Theory and Practice of Investment 16.1 Real Options and the Theory and Practice of Investment Options on real assets A real option is an option on a real asset. Real options derive their value from managerial flexibility in a changing and uncertain world: Options to invest or abandon Options to expand or contract Options to speed up or defer Pursuing one investment option necessarily involves forgoing other investment options.

and the Theory and Practice of Investment 16.1 Real Options and the Theory and Practice of Investment Option terminology Simple options Call versus put options European versus American options Compound option A compound option is an option on an option. Special case: An alternating sequence of calls and puts is called a switching option. Rainbow option Multiple sources of uncertainty

16.2 Market Entry as a Simple Real Option Market entry and the option to invest Investing today means forgoing the opportunity to invest at some future date, so that projects must be compared against similar future projects. A puzzle: Firms often use inflated hurdle rates: Because of the value of waiting for more information, hurdle rates on investments in uncertain environments are often set above investors’ required returns.

16.2 Market Entry as a Simple Real Option An example of the option to invest Investment I0 = PV(I1) = $20 million The present value of investment is $20 million regardless of when investment is made Price of oil P = $70 or $90 with equal probability Þ E[P] = $80 Variable production cost V = $68 per barrel E[production] = Q = 200,000 barrels/year Discount rate i = 10%

16.2 Market Entry as a Simple Real Option The option to invest as a now-or-never decision NPV(invest today) = [ ($80-$68) (200,000) / 0.1 ] – $20 million = $4 million > $0 Þ invest today (?)

16.2 Market Entry as a Simple Real Option Invest today or wait for more information

16.2 Market Entry as a Simple Real Option The option to wait one year before deciding NPV = [ (E[P]-V) Q / i ] / (1+i) - I0 In this example, waiting one year reveals the future price of oil.

16.2 Market Entry as a Simple Real Option The investment timing option NPV(wait 1 year½P = $90) = (($90 – $68)(200,000) / 0.1) / (1.1) – $20,000,000 = $20,000,000 > $0 Þ invest if P = $90 NPV(wait 1 year½P = $70) = (($70 – $68)(200,000) / 0.1) / (1.1) – $20,000,000 = –$16,363,636 < $0 Þ do not invest if P = $70 Þ NPV(wait 1 year½P = $70) = $0

16.2 Market Entry as a Simple Real Option The investment timing option NPV(wait 1 year) = Probability(P = $70) (NPV$70) + Probability(P = $90) (NPV$90) = ½ ($0) + ½ ($20,000,000) = $10,000,000 > $0 Þ wait one year before deciding whether to invest

When you see a good move, look for a better one. 16.2 Market Entry as a Simple Real Option When you see a good move, look for a better one. Emanuel Lasker (Chess grandmaster)

16.2 Market Entry as a Simple Real Option Option value = Intrinsic value + Time value Intrinsic value = value if exercised immediately Time value = additional value if left unexercised

16.2 Market Entry as a Simple Real Option The opportunity cost of investing today Option Value = Intrinsic Value + Time Value NPV (wait 1 year) = Value if exercised + Additional value immediately from waiting $10,000,000 = $4,000,000 + $6,000,000

16.2 Market Entry as a Simple Real Option The value of BP’s option to invest 15 Option value prior to expiration 10 Time value 5 Intrinsic value at expiration 5 10 15 20 25 30 Value of an oil well

16.2 Market Entry as a Simple Real Option A resolution of a puzzle: Inflated hurdle rates Managers facing this type of uncertainty have four choices: Ignore the timing option (?!). Estimate the value of the timing option using option pricing methods. Adjust the cash flows with a decision tree that captures possible future states of the world. Inflate the hurdle rate (apply a “fudge factor”) to compensate for high uncertainty.

16.2 Market Exit as a Simple Real Option Market exit and the option to abandon Abandoning today means forgoing the opportunity to abandon at some future date, so that abandonment today must be compared to future abandonment. Another puzzle: Failure to abandon losing ventures Because of the value of waiting for additional information, hurdle rates on corporate abandonment decisions are often set above investors’ required return.

16.2 Market Exit as a Simple Real Option An example of the option to abandon Cost of disinvestment I0 = PV(I1) = $2 million The present value of abandonment is $2 million regardless of when abandonment is made. Price of oil P = $65 or $75 with equal probability Þ E[P] = $70 Variable production cost V = $72 per barrel E[production] = Q = 200,000 barrels/year Discount rate i = 10%

16.2 Market Exit as a Simple Real Option Abandon today or wait for more information

16.2 Market Exit as a Simple Real Option The abandonment option as a now-or-never decision. NPV(abandon today) = –($70 – $72) (200,000) / 0.1 – $2 million = $2 million > $0 Þ abandon today (?)

16.2 Market Exit as a Simple Real Option The abandonment timing option NPV(wait 1 year½P = $65) = –(($65-$72)(200,000) / 0.1) / (1.1) – $2 million = $10,727,273 > $0 Þ abandon if P = $65 NPV(wait 1 year½P = $75) = –(($75 – $72)(200,000) / 0.1) / (1.1) – $2 million = –$7,454,545 < $0 Þ do not abandon if P = $75

16.2 Market Exit as a Simple Real Option The abandonment timing option NPV(wait 1 year) = Probability(P=$65) (NPV$65) + Probability(P=$75) (NPV$75) = ½ ($10,727,273) + ½ ($0) = $5,363,636 > $0 Þ wait one year before deciding to abandon

16.2 Market Exit as a Simple Real Option Opportunity cost of abandoning today Option Value = Intrinsic value + Time value NPV(wait 1 year) = NPV(abandon today) + Additional value from waiting 1 year $5,363,636 = $2,000,000 + $3,363,636

16.3 Uncertainty and the Value of Real Options The determinants of call option values Relation to call option BP Option value determinant value example Value of the underlying asset P + $24 million Exercise price of the option K – $20 million Risk-free rate of interest rF + 10% Time to expiration of the option T + 1 year Volatility of the underlying asset sP + ($3.6m or $40m) Time value = f ( P, K, T, rF, sP )

16.3 Uncertainty and the Value of Real Options Volatility and option value Option value Exercise price Value of the underlying asset

16.3 Uncertainty and the Value of Real Options Exogenous price uncertainty Exogenous uncertainty is outside the influence or control of the firm. Oil price example P1 = $65 or $95 with equal probability Þ E[P1] = $80/bbl NPV(invest today) = (($80 – $68)(200,000) / 0.1) – $20 million = $4,000,000 > $0 Þ invest today?

16.3 Uncertainty and the Value of Real Options Exogenous price uncertainty NPV(wait 1 year½P1=$95) = (($95 – $68)200,000 / 0.1) / 1.1 – $20 million = $29,090,909 > $0 Þ invest if P1 = $95 NPV(wait 1 year½P1 = $65) = (($65-$68)(200,000) / 0.1) / 1.1 – $20 million = –$25,454,545 < $0 Þ do not invest if P1 = $65

16.3 Uncertainty and the Value of Real Options Exogenous price uncertainty NPV(wait one year) = (½)($0) + (½)($29,090,909) = $14,545,455 > $0 Þ wait one year before deciding to invest

16.3 Uncertainty and the Value of Real Options Time value & exogenous uncertainty Option value = Intrinsic value + Time value ±$70 $10,000,000 = $4,000,000 + $6,000,000 ±$15 $14,545,455 = $4,000,000 + $10,545,455 The time value of a real option increases with exogenous price uncertainty.

16.3 Uncertainty and the Value of Real Options Compound real options Real options are compound rainbow options: A compound option is an option on an option. A rainbow option has multiple sources of uncertainty. Project valuation and investment strategy is difficult because most investment alternatives are compound rainbow options.

16.4 Market Entry as a Compound Real Option Another puzzle: Negative-NPV entry into emerging markets Firms often make investments into emerging markets even though investment does not seem warranted according to the NPV decision rule. An exploratory (perhaps negative-NPV) investment can reveal information about the value of subsequent investments.

16.4 Market Entry as a Compound Real Option Growth options and project value VAsset = VAsset-in-place + VGrowth options Real options derive their value from flexibility in responding to an uncertain world, so this equation can alternatively be stated as: VAsset = VAsset-in-place with no flexibility + VFlexibility

16.4 Market Entry as a Compound Real Option Consider a negative-NPV investment Initial investment I0 = PV(I1) = $20 million The present value of investment is $20 million regardless of when investment is made. Price of Oil P = $70 or $90 with equal probability Þ E[P] = $80 Variable production cost V = $72 per barrel E[production] = Q = 200,000 barrels/year Discount rate i = 10%

16.4 Market Entry as a Compound Real Option The option to invest as a now-or-never decision NPV(invest today) = ($80 – $72) (200,000) / 0.1 – $20,000,000 = –$4 million < $0 Þ do not invest today (?)

16.4 Market Entry as a Compound Real Option Endogenous price uncertainty Uncertainty is endogenous when the act of investing reveals information about the value of an investment. Suppose this oil well is the first of 10 identical wells that BP might drill and that the quality and hence price of oil from these wells cannot be revealed without drilling a well.

16.4 Market Entry as a Compound Real Option Invest today in order to reveal information about future investments. Investing today E[P] = $80/bbl P = $90/bbl reveals information P = $70/bbl

16.4 Market Entry as a Compound Real Option The investment timing option NPV(wait 1 year½P = $90) = (($90 – $72)(200,000) / 0.1) / (1.1) – $20,000,000 = $12,727,273 > $0 Þ invest if P = $90 NPV(wait 1 year½P = $70) = (($70 – $72)(200,000) / 0.1) / (1.1) – $20,000,000 = –$23,636,363 < $0 Þ do not invest if P = $70

16.4 Market Entry as a Compound Real Option A compound option in the presence of endogenous uncertainty. NPV(invest in an exploratory well) = NPV(one now-or-never well today) + Prob($90) (NPV of 9 more wells$90) = –$4,000,000 + ½ (9) ($12,727,273) = $53,272,727 > $0 Þ invest in an exploratory oil well and then reconsider further investment in one year.

16.4 Market Entry as a Compound Real Option Market entry and the value of growth options Negative-NPV investments into emerging markets are often out-of-the-money call options entitling the firm to make further investments should conditions prove to be favorable: If conditions are unfavorable, the firm can forego further investment. If conditions are good, the firm can expand its investment.

16.4 Market Entry as a Compound Real Option Competitors’ actions influence investment decisions, and vice versa When exit costs are zero, the effect of a shared investment opportunity is spread across all firms in an industry and results in a lower value to each firm. When there are exit costs, competitive response to uncertainty is asymmetric and firms must be more cautious in their investment decisions. As with hysteresis, firms might stay invested in unprofitable situations in the hope that other less-profitable firms will exit first.

16.5 Real Options as a Complement to NPV Why DCF fails Option value Exercise price -3s -2s -1s +1s +2s +3s Value of the underlying asset

16.5 Real Options as a Complement to NPV Why DCF fails Nonnormality Returns on options are not normally distributed even if returns to the underlying asset are normal. Option volatility Options are inherently more volatile than the underlying asset on which they are based. Changing option volatility Option volatility changes with changes in the value of the underlying asset.

16.5 Real Options as a Complement to NPV The option pricing alternative Option pricing methods construct a replicating portfolio that mimics the payoffs on the option. Costless arbitrage then ensures that the value of the option equals the value of the replicating portfolio.

16.5 Real Options as a Complement to NPV Pricing financial options Underlying asset values are observable An example is the price of a share of stock. Low transactions costs allow arbitrage Most financial assets are liquid. A single source of uncertainty Contractual exercise prices and expiration dates result in a single source of uncertainty. Exogenous uncertain Most financial options are side bets that don’t directly involve the firm, so uncertainty is exogenous.

16.5 Real Options as a Complement to NPV Pricing real options Underlying asset values are unobservable What is the value a manufacturing plant? High transactions costs impede arbitrage Real assets are illiquid. Multiple sources of uncertainty e.g., exercise prices can vary over time. e.g., exercise dates are seldom known. Endogenous uncertain Investing reveals information.

To get anywhere, or even to live a long time, 16.6 Summary To get anywhere, or even to live a long time, a man has to guess, and guess right, over and over again, without enough data for a logical answer. Robert Heinlein Time Enough for Love