Real Options Thinking IOM580 Hiroshi Ochiumi 1

Traditional NPV Analysis Discounts future cash flows to their present value. In 1970, 57% of large corporations were using NPV calculations to determine the profitability of major investment decisions. In 1980, 86% Today, NPV is the standard. It took corporate America 20+ years to replace payback with NPV. 2

Traditional NPV Analysis Sophisticated versions can handle –Uncertainties –Contingent decisions –Varying discount rate 3

Example: Regressive Insurance Co. Regressive has the opportunity to purchase a license to sell insurance in China. The cost of this license is $10 million. Need to pay an additional $50 million to develop the market. 20% chance of a huge success – profit of $100 million. 80% chance of failure – loss of $70 million NPV= - 96, reject the project. Really? 4

NPV undervalues investments when.. There are options embedded in the investments to –Delay or defer making the investment –Abandon a project (for a price) –Scale back a project –Expand a project into a new market or products –Extend the life of a project –Switch between two modes of operation Depending on the outcomes at early stages. 5

Real Options Flexibilities have values. We should be paying a premium on NPV estimates. A bad investment (according to NPV) can actually be a good one. 6

Bidding for a lease on Government- owned coal lands Estimated –Future price of coal –Quantity of coal in the ground –Extraction costs Consider the value of option to defer, and bid more aggressively. 7

Airbus told customers.. The value of being able to change the size of the aircraft within a family (and other configurations) up to 12 months before delivery Airbus can negotiate more effectively. 8

Real Options Analysis Oil Field Development Major R&D New Product Development under Uncertainty –Breakthrough type Pharmaceutical Research 9

Early Adopters Airbus – valuing delivery options Apple – exit decision for pc business Enron – new product development Exxon – oil exploration HP – production and distribution Smith & Nephew – funding research 10

When Managerial Flexibility is Valuable High Uncertainty about the Future –Likely to receive new information over time High Room for Managerial Flexibility –Allows management to respond appropriately to this new information NPV without flexibility is near zero The greater the volatility, the greater the value of the flexibility (option) 11

How to Compute the Value of Flexibility Fairly Complex –Stochastic Differential Equation –Black-Scholes 12