1. Chapter 23 Real Options Principles of Corporate Finance Ninth Edition
Slides by
Matthew Will
McGraw Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved

2. Topics Covered The Value of Follow-On Investment Opportunities
The Timing Option
The Abandonment Option
Flexible Production
Aircraft Purchase Options
A Conceptual Problem

3. Corporate Options
4 types of “Real Options” 1 - The opportunity to expand and make follow-up investments. 2 - The opportunity to “wait” and invest later. 3 - The opportunity to shrink or abandon a project. 4 - The opportunity to vary the mix of the firm’s output or production methods. Value “Real Option” = NPV with option - NPV w/o option 37

4. Microcomputer Forecasts
Example – Mark I Microcomputer ($ millions)

5. Microcomputer Forecasts
Example – Mark II Microcomputer Option

6. Microcomputer Forecasts
Example – Mark II Microcomputer ($ millions)
Forecasted cash flows from 1982
NPV(1982) =PV(inflows) -PV(investment)
= 467 – 676
= - $209 million

7. Microcomputer Forecasts
Example – Mark II Microcomputer (1985)
Distribution of possible Present Values
Probability
Present value in 1985
Expected value
($807)
Required investment
($900)

8. Option to Wait
Intrinsic Value
Option Price
Stock Price

9. Option to Wait
Intrinsic Value + Time Premium = Option Value Time Premium = Vale of being able to wait
Option Price
Stock Price

10. Option to Wait
More time = More value
Option Price
Stock Price

11. Timing Option Example
Possible cash flows and end-of-period values for the malted herring project are shown. The project costs $180 million, either now or later. The figures in parentheses show payoffs from the option to wait and to invest later if the project is positive-NPV at year 1. Waiting means loss of the first year’s cash flows. The problem is to figure out the current value of the option.

12. Timing Option Example
High demand generates $25 million and a value of $250 million at the end of the year. Low demand generates $16 million and no value.
High Demand
Low Demand
Risk neutral return = 5%

13. Timing Option Example
The next step requires the calculation of the probability of there being a high demand for the malted herring project.
The option value is now determined as follows.

14. Option to Wait Example – Development option Cash flow Office Bldg
NPV>0
240
100
Wait
Cash flow from hotel
240
Hotel NPV>0
NPV<0

15. Option to Abandon
Example - Abandon Mrs. Mulla gives you a non-retractable offer to buy your company for $150 mil at anytime within the next year. Given the following decision tree of possible outcomes, what is the value of the offer (i.e. the put option) and what is the most Mrs. Mulla could charge for the option? Use a discount rate of 10% 38

16. Option to Abandon Example - Abandon Year 0 Year 1 Year 2 120 (.6)
Mrs. Mulla gives you a non-retractable offer to buy your company for $150 mil at anytime within the next year. Given the following decision tree of possible outcomes, what is the value of the offer (i.e. the put option) and what is the most Mrs. Mulla could charge for the option?
Year 0 Year 1 Year 2
120 (.6)
100 (.6)
90 (.4)
NPV = 145
70 (.6)
50 (.4)
40 (.4) 39

17. Option to Abandon Option Value = 162 - 145 = $17 mil Example - Abandon
Mrs. Mulla gives you a non-retractable offer to buy your company for $150 mil at anytime within the next year. Given the following decision tree of possible outcomes, what is the value of the offer (i.e. the put option) and what is the most Mrs. Mulla could charge for the option?
Year 0 Year 1 Year 2
120 (.6)
100 (.6)
90 (.4)
NPV = 162
150 (.4)
Option Value = =
$17 mil 40

18. Option to Abandon Example – Ms. East - Revenues 3.73 3.05 2.50 2.50
2.05
1.68

19. Option to Abandon Example – Ms. East – Cash Flows 3.03 2.35 1.80 1.80
1.35
.98

20. Option to Abandon
Example – Ms. East – Value

21. Tanker Example Value of Tanker Tanker Rates Value in operation
Cost of reactivating
Value if mothballed
Mothballing costs
Tanker Rates

22. Aircraft Purchase Option
The option to purchase an aircraft provides the holder both the ability to obtain a lower price as well as receive the aircraft sooner. Both have value to the aircraft buyer, thus the option has value.

23. Aircraft Purchase Option
Value of aircraft purchase option—the extra value of the option versus waiting and possibly negotiating a purchase later. The purchase option is worth most when NPV of purchase now is about zero and the forecasted wait for delivery is long.

24. Real Option Barriers
Practical reasons exist why real options are not always feasible to use.
Valuation of real options can be complex and sometimes it is impossible to arrive at the “perfect” answer.
Real options do not always have a clear structure their path and cash flows.
Competitors also have real options, which an alter the value of your options by altering the underlying assumptions and environment that serves as the basis of your valuation.
Given these limitations, real options are not always the best approach when valuing projects.

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