12-1 Capital Budgeting and Financial Planning LECTURE 22 Course Instructor: M. Jibran Sheikh

12-2 What is a real option? Real options exist when managers can influence the size and riskiness of a project’s cash flows by taking different actions during the project’s life. Alert managers always look for real options in projects. Smarter managers try to create real options.

12-3 Real Options Many of the most important decisions that firms make concern real assets (factories, mines, office buildings, research and development, and other nonfinancial firm assets). In this topic we will see that it is possible to analyse investment and operating decisions for real assets using pricing models for financial options.

12-4 What are some types of real options? Investment timing options Growth options – Expansion of existing product line – New products – New geographic markets

12-5 Types of real options (Continued) Abandonment options – Cancelation – Temporary suspension Flexibility options – BMW Example

12-6 Real Options How it can be possible to evaluate an investment decision as an option? A call option is the right to pay a strike price to receive the present value of a stream of future cash flows (represented by the price of the underlying asset). An investment project is the right to pay an investment cost to receive the present value of a stream of future cash flows (represented by the present value of the project).

12-7 How are real options different from financial options? The payoffs for financial options are specified in the contract. Real options are “found” or created inside of projects. Their payoffs can be varied.

12-8 Valuing a real option Valuing a real option requires judgment, both to formulate the model and to estimate the inputs. Does this mean the answer won’t be useful? Definitely not. For example, the models used by NASA only approximate the centers of gravity for the moon, the earth, and other heavenly bodies, yet even with these “errors” in their models, NASA has been able to put astronauts on the moon. As one professor said, “All models are wrong, but some are still quite useful.” This is especially true for real options. We might not be able to find the exact value of a real option, but the value we find can be helpful in deciding whether or not to accept the project. Equally important, the process of looking for and then valuing real options often identifies critical issues that might otherwise go unnoticed.

12-9 Real Options Analogies between real investment projects and financial options has come to be called real options, which we define as the application of derivatives theory to the operation and valuation of real investment projects. Example: Suppose we can invest in a machine, costing $ 10, that will produce one widget a year forever. In addition, each widget costs $0.90 to produce. The price of widgets will be $0.55 next year and will increase at 4% per year. The effective annual risk-free rate is 5 % per year. We can invest, at any time, in one such machine. There is no uncertainty.

12-10 Example Solution PV of Revenue = 0.55/ = 55 PV of Costs = 0.9/0.05 = 18 Initial Investment = 10 NPV = 55 – (18+10) = 27 Suppose we wait for 5 years before making the investment. Price in 5 years would be = 0.55 (1.04) 5 = 0.67 PV of Revenues = (0.67/ )/ = 52.5 PV of costs = (0.9/0.05)/ = 14 PV of Initial Investment = 10/ = 7.84 NPV = 52.5 – ( ) = Increase in NPV due to waiting for 5 years = – 27 = is the Passive or Static NPV of the Project (i.e. without considering the value of the option) is the Dynamic or Option Adjusted NPV of the project.

12-11 Types of Real Options Above example highlights an important fact i.e. most investment projects involve options. These options can add considerable value to the project and are often either ignored or valued incorrectly. Examples of the options embedded in Real Project: 1) Abandonment Option: This is an option to sell or close down a project. It is an American put option on the project's value. The strike price of the option is the liquidation (or resale) value of the project less any closing-down costs. When the liquidation value is low, the strike price can be negative. Abandonment options mitigate the impact of very poor investment outcomes and increase the initial valuation of a project.

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12-13 Types of Real Options 2) Expansion Option. This is the option to make further investments and increase the output if conditions are favourable. It is an American call option on the value of additional capacity. The strike price of the call option is the cost of creating this additional capacity discounted to the time of option exercise. The strike price often depends on the initial investment. If management initially chooses to build capacity in excess of the expected level of output, the strike price can be relatively small. 3) Contraction Option. This is the option to reduce the scale of a project's operation. It is an American put option on the value of the lost capacity. The strike price is the present value of the future expenditures saved as seen at the time of exercise of the option.

12-14 Types of Real Options 4) Option to defer. One of the most important options open to a manager is the option to defer a project. This is an American call option on the value of the project. As seen in the example above 5) Option to extend. Sometimes it is possible to extend the life of an asset by paying a fixed amount. This is a European call option on the asset's future value.

12-15 Valuation of Real Options Different methods can be employed to value Real Options. We can value Real Options same way we value Financial Options i.e.  By using Black-Scholes Option Valuation Formula  By using Binomial Option Pricing Method (Binomial Tree or Lattice)  By using Decision Trees