Real Options Modeling Options Prof. Luiz Brandão 2009

Discrete Models Modeling Simple Options

IAG PUC – Rio Brandão 3 Modeling Simple Options  A stochastic process allows us to adopt a probability distribution for forecasted prices, instead of estimating each individual forecasted price directly on the decision tree.  For assets that follow a GBM, we can use the CCR model.  To do this we need only the initial value (S), an estimate of the volatility (  ) and the risk free rate (r).  After the binomial model is completed, we apply the corresponding option exercises and roll back the tree using the risk neutral probabilities and discounting at the risk free rate.

IAG PUC – Rio Brandão 4 Example  MMZ Corp. is analyzing the feasibility of a MiniMall construction project in a suburban area. Preliminary studies and required licenses will take two years.  Project Information If operating today, the value of the project would be $10 million. Volatility is estimated to be 25% The risk free rate is 6%. The investment cost is $11 million.  If the market picks up in the next two years, MMZ has an option to expand the mall to a neighboring area at an additional cost of $ 3 million. This expansion would increase the value of the mall by 50% two years from now.  What is your recommendation to the firm?

IAG PUC – Rio Brandão 5 Binomial Model  Model Parameters:

IAG PUC – Rio Brandão 6 Modeling the Underlying Asset 10 10u 10d 10ud 10u 2 10d 2  The parameters for the binomial approximation are:  With these parameters we can model the evolution of the value of the project in time.

IAG PUC – Rio Brandão 7  The parameters for the binomial approximation are:  With these parameters we can model the evolution of the value of the project in time.  The last column shows the value of the project in each state with the expansion. With Expansion 10 Modeling the Underlying Asset 12,84 7,79 10,0 6,07 16,49 12,0 6,11 21,73

IAG PUC – Rio Brandão 8  The parameters for the binomial approximation are:  With these parameters we can model the evolution of the value of the project in time.  The last column shows the value of the project in each state with the expansion. With Expansion Modeling the Underlying Asset 12,84 7,79 10,0 6,07 16,49 12,0 6,11 21,73

IAG PUC – Rio Brandão 9 Solving by Risk Neutral Probability  Risk neutral probabilities allow is to determine the correct project value when options are present.  In this case, we determine a probability p that incorporates the project risk in each node.  This allows us to discount the cash flows/values at the risk free rate.  One advantage of this method is that in most cases, the probability p is the same for the whole tree. p 1-p p p

IAG PUC – Rio Brandão 10 Solving by Risk Neutral Probability 12,33 16,43 8,86 p 1-p 12,0 6,11 21,73 p p 1-p  Risk neutral probabilities allow is to determine the correct project value when options are present.  In this case, we determine a probability p that incorporates the project risk in each node.  This allows us to discount the cash flows/values at the risk free rate.  One advantage of this method is that in most cases, the probability p is the same for the whole tree.  The value of the project with the option to expand increases to $ million

IAG PUC – Rio Brandão 11 Solving with DPL  Notation:  Decision nodes, uncertainty and value  Inserting nodes in a tree  “Detach Tree” command  “Perform Subtree” command Objective Function Cash Flows (Get/Pay) Expected Value of this node Probability

IAG PUC – Rio Brandão 12 12,84 7,79 21,17 4,72 MMZ: Three Periods  In the same example as before, additional periods can be modeled as follows: 10 12,84 7,79 10,0 6,07 16,49 With Expansion 15,26 7,69 28,55 3,08

Aplication

IAG PUC – Rio Brandão 14  Step 1: Determine the Parameters for the underlying asset The underlying asset is the project without options We use the binomial lattice to model the stochastic process of a GBM  Step 2: Build the binomial model We use DPL to model the undelying asset with risk neutral probabilities. The resulting lattice shows the evolution of project value with time  Step 3: Model the project options. Options are modeled by inserting decision nodes in the binomial lattice, transforming it in a decision tree.  Step 4: Solve the decision tree Steps to solve Real Option Problems

IAG PUC – Rio Brandão 15  Parameters: Underlying Asset Price: $100 Volatility: 30% Distribution: GBM (Lognormal) Time to Expiration: 3 anos Exercise Price: $140 r = 5%  Solution with DPL  Solution with B&S  Solution with Simulation European Option (with DPL)

IAG PUC – Rio Brandão 16 Weston Inc. (Option to Expand)  Weston Inc. is analyzing the purchase of a concession project valued at $30M which it plans to sell in two years. The volatility of the project value is assumed to be 25% and the corporate cost of capital is 15%.  The initial investment required for the concession is 25M, and at the end two years there is an option to expand the project by 30% at a cost of $5M. The risk free rate is 5%.  What is the NPV of this project?  Step 1: Parameters u, d, and risk neutral probability p:

IAG PUC – Rio Brandão 17  Step 2: Binomial Lattice Weston Inc.

IAG PUC – Rio Brandão 18 Weston Inc.  Step 3: Model the options  Step 4: Solve the decision tree.  The project value is $ and the NPV is $ 9.465

IAG PUC – Rio Brandão 19 BetaLog (Option to Abandon)  Data: A project has a life of three years and a value of $100M. The initial investment will be $110M and the volatility is 30%. The firm can abandon the project at any moment in exchange for a residual value of $90M. The WACC is 15% and the risk free rate is 7%.  Questions: Should Betalog invest in this project? What is the optimal investment strategy? 4.2

IAG PUC – Rio Brandão 20 Rio Verde Mining (Option to Abandon)  Rio Verde Mining (RVM) has been invited to participate in a project. The expected value of its share in this project is valued at $1.000M.  Given large uncertainties about this project, RVM is negotiating to include an exit clause in its contract, which would allow it to abandon the project by selling it to its partners for $800M at any time over the next two years.  All project cash flows will be reinvested in the project, which will be sold at market price in two years.  It is estimated that the volatility of the project is 30%, and that the risk free rate is 6%.  The partners of RVM agree to include this clause in the contract in exchange for the payment of $50 million. What is your recommendation for the firm? 5.6

IAG PUC – Rio Brandão 21 Solution

IAG PUC – Rio Brandão 22 Rio Verde Mining: Additional Options  Option to Expand Suppose the investors now decided to extend the life of this project to three years, after which there will be an opportunity to expand the project by 25% at a cost of $200M. What is the impact of this opportunity on the value of the project?  Option to Contract In case the market price of the project turns out to be less than expected, there is an option to contract operations of the mine by 50% at any time through the sale of assets worth $470M. In this case, the amount received by RVM in case of abandon is also halved. Assume that once the project has been contracted, this decision is irreversible and can be exercised only once. On the other hand, the project may still be expanded after being contracted.

IAG PUC – Rio Brandão 23 MegaCorp Inc.  MegaCorp is analyzing a new project which will be sold at the end of three years. The expected value of this project is $ , its volatility is 35%, and the risk free rate is 5% per year.  The firm has contracted an insurance that allows it to abandon the project at the end of the three years and receive $  MegaCorp can also expand this project by 40% at a cost of $ at the end of the second year.  Consider that the project does not generate cash flows for MegaCorp during this period.  What is the value of the project with these options? 5.6

IAG PUC – Rio Brandão 24 Ecotech Ltd  A Ecotech Ltd. has an opportunity to invest in a project of sustainable exploration of forestry products in the Amazon rain forest. The project has na expected value of $30 milion, a volatilty of 25%, a WACC of 15% and a risk free rate of 6% a.a.  If the investment is sucessfully undertaken, by the end of the third year there is the probability of adding a processing plant which will double the sales of the project. This plant will have a cost of $20 million.  Assume the project will be sold to international investors at its market price at the end of five years. If the additional investment is made, the project may also be abandoned for $50 million  Questions: If the required initial investment is $35 milhões, should the project be undertaken? What is the probability that the processing plant will be implemented? Perform a sensitivity analysis on the cost of volatility and the abandon value

Real Options Modeling Options Prof. Luiz Brandão 2009