FIN 614: Financial Management Larry Schrenk, Instructor

1.Real Option Example 2.Analysis of Real Options 3.How Real Option Analysis is Used

The SuperCom Project: A large telecommunications company faces an opportunity to invest in an R&D project that will revolutionize the way consumers use telephones, internet, and TV. I 1 : Required investment in the R&D project. I 2 : Required investment in the commercial-scale plant, marketing, and distribution - if the R&D effort is successful, and if market conditions are favorable.. I 3 : Final investment in the project; can be decreased by I c if the market is weak. I E: Flexibility in the design of the production process allows for output expansion with an outlay of I E. V: Gross present value of the completed project’s expected operating cash flows.

Option to Defer Investment Congress is currently debating the viability and the process by which to allocate or auction the airwaves that are crucial to the commercial success of SuperCom. Our lobbyist in Washington advises us that the debate would be resolved within a year. We could initiate the R&D project immediately, or wait a year to see what Congress does. Option to Expand Given an initial design choice, management may deliberately favor a more expensive technology for the built-in flexibility to expand production/sales if and when it becomes desirable. If the market’s response to SuperCom is better than expected, management can accelerate the rate or expand the scale of production by x% by incurring a follow-on cost I E. The option to expand also applies to complementary markets: Investing in SuperCom in a new geographical area allows for the possibility to expand to other similar markets; for example besides local and long-distance tele-communication, the market for telephone-via-internet could be explored in the new geographical area.

Option to Default during Staged Construction (Time-to-Build-Option) Investing in the R&D project, or investing I 1, provides the opportunity to invest in the commercial stage by investing I 2 or to abandon the project if the R&D and initial test-marketing is unsatisfactory. Option to Contract If the market does not respond to SuperCom as expected, management can reduce the scale of operations by c%, thereby saving I c of the planned investment outlays. Option to Abandon for Salvage Value If SuperCom does significantly worse than expected in the market, management may choose to abandon the project permanently in exchange for its salvage value: the resale value of the capital equipment, license, etc. for A.

The underlying for a financial option is a security such as a share of common stock or a bond (or interest rates), while the underlying for a real option is a tangible asset, for example, a business unit or a project. Both types of option are the right, but not the obligation, to take an action. The fact that financial options are written on traded securities makes it much easier to estimate their parameters.

With real options, the underlying risky asset is usually not a traded security They are not issued by the company on whose shares they are contingent, but rather by independent agents who write them and buy those that are written. Consequently, the agent that issues a call option has no influence over the actions of the company and no control over the company’s share price.

Real options are different because management controls the underlying real assets on which they are written. The act of enhancing the value of the underlying real asset also enhances the value of the option. Finally, with both financial and real options, risk – the uncertainty of the underlying – is assumed to be exogenous. The actions of a company that owns a real option may affect the actions of competitors, and consequently the nature of uncertainty that the company faces.

Advantages: Successfully explains valuation of multiple companies believed to have substantial real options Explain some of the difference in markets not accounted by traditional techniques The real options method applies financial options theory to quantify the value of management flexibility in a world of uncertainty. Real options capture the value of managerial flexibility to adapt decisions in response to unexpected market developments. The real option method enables corporate decision-makers to leverage uncertainty and limit downside risk. Companies create shareholder value by identifying, managing and exercising real options associated with their investment portfolio. Disadvantage: Real Options can be miscalculated/misused and may incorrectly value a company

A survey of 39 managers at 34 companies conducted in Spring 2001 revealed ways in which real option analysis is currently used in practice: Real Options as a ‘Way of Thinking’ Real Options as an Analytical Tool See “Real Options: State of the Practice” by Alex Triantis and Adam Borison, Journal of Applied Corporate Finance, Summer 2001 (pp. 8-24).

Mindset of thinking about uncertainty in positive light Heightened awareness of creating or extinguishing options Increased appreciation for learning/information acquisition Framing exercise to map out future scenarios and decisions Contractual arrangements as bundles of options

There are four approaches used in practice to value options: Black-Scholes Formula Binomial Option Pricing Model Risk-Adjusted Decision Trees Monte-Carlo Simulation

FIN 614: Financial Management Larry Schrenk, Instructor