1. Chapter Twelve Capital Allocation: Real Options

2. Copyright © Houghton Mifflin Company.All rights reserved. 12–2 Intertemporal Decision Making Winners of a $1 million lottery (net after taxes) in Florida wanted to sell their tickets. The lottery paid $50,000 per year for 20 years. What would you pay for the ticket?

3. Copyright © Houghton Mifflin Company.All rights reserved. 12–3 Intertemporal Decision Making Present value Future value

4. Copyright © Houghton Mifflin Company.All rights reserved. 12–4 Intertemporal Decision Making Net present value is the present value of cash flow less the cost of the investment. NPV = $50 + $50 - $60 (1+r) (1+r)2

5. Copyright © Houghton Mifflin Company.All rights reserved. 12–5 Intertemporal Decision Making Suppose the cost of capital, r, is 10%. Then: NPV = $50 + $50 - $60 (1+.1) (1+.1)2 = $50(.909) + $50(.826) - $60 = $45.45 + $41.3 - $60 = $26.75

6. Copyright © Houghton Mifflin Company.All rights reserved. 12–6 Capital Allocation Microsoft is moving into further development of windows, the internet, and other areas. The manager of software development for residential users has requested $500 million for new facilities. The manager of software development for commercial users has requested $1 billion for facilities and research. The manager for software production has requested $5 billion over two years for additional facilities.

7. Copyright © Houghton Mifflin Company.All rights reserved. 12–7 Intertemporal Decision Making So the NPV of each project would be calculated, and then what? The highest NPV is chosen? All NPV above zero are chosen? Focusing on economic profit means focusing on those investments returning more than all costs, including capital costs.

8. Copyright © Houghton Mifflin Company.All rights reserved. 12–8 Options The NPV approach is a NOW or NEVER. But, it is possible that an investment would look different a year or two from now. Perhaps the allocation of resources should be considered in terms of an option -- having the choice of making the allocation now, later, or never.

9. Copyright © Houghton Mifflin Company.All rights reserved. 12–9 Options A stock option enables the owner to “exercise” the option -- buy or sell the stock -- at a specific price, the “strike price.” A call option allows the owner to buy the stock. A put option allows the owner to sell the stock.

10. Copyright © Houghton Mifflin Company.All rights reserved. 12–10 Options Executive pay is often put in terms of stock options. The executive is given the option of purchasing several shares of stock at a specified price. If the stock price rises above the specified price, the executive may exercise the option, thereby purchasing the stock at the exercise price and selling it at the current stock price.

11. Copyright © Houghton Mifflin Company.All rights reserved. 12–11 Options Many business opportunities have the same features as options. 1.Rubbermaid’s entrance into China is an example. 2.Lincoln Electric’s expansion into other countries is also an example.

12. Copyright © Houghton Mifflin Company.All rights reserved. 12–12 Options (cont’d) 3.Ben and Jerry’s expansion. 4.Hollywood Entertainment’s introduction of three new movies. 5.Brand name expenditure, product line extension, price changes, relocation, facility changes, new markets, and so on, are others.

13. Copyright © Houghton Mifflin Company.All rights reserved. 12–13 Real Options When resources are considered rather than just stock, the opportunity is referred to as a real option. A real options approach may be useful: a)When uncertainty is large enough that more information could be valuable. b)When the value seems to be more in future possibilities than current cash flow. c)When there will be project updates and midcourse changes.

14. Copyright © Houghton Mifflin Company.All rights reserved. 12–14 Valuing Options To know if considering an opportunity as an option is useful, we must determine a value for the option. Suppose a NPV is negative, but it is possible to delay making a decision for a couple of years. This option has a value if there is any chance the NPV could change during those two years.

15. Economic Value (NPV) + interest 0 1 increasing Volatility Probably never neverInvest now Maybe now Probably later Maybe later

16. Copyright © Houghton Mifflin Company.All rights reserved. 12–16 Valuing Options Consider the following two projects: Project 1Project 2 Asset value100m Capital cost90m110m NPV10m-$10m TimeNow2 yrs Value1.11.02 VolatilityO4 RegionnowProbably later

17. 0 1 Probably never neverInvest now Maybe now Probably later Maybe later Economic Value (NPV) + interest increasing Volatility

18. Copyright © Houghton Mifflin Company.All rights reserved. 12–18 Valuing Options The Black-Scholes option pricing formula gives the value of each call option as: Project 1 Project 2 $10 $23.24

19. Copyright © Houghton Mifflin Company.All rights reserved. 12–19 Managing the Value of Options Having defined an option and determined its value is really the first step. The most important step is managing the value of options. Uncertainty -- volatility -- increases the range of potential outcomes. This is good if a decision can be deferred.

20. Copyright © Houghton Mifflin Company.All rights reserved. 12–20 Managing the Value of Options As time passes, that is, as it gets closer to the now or never time, the value of the option declines. The position on the pricing diagram moves upward and to the left. The value of an option will rise if: a)The value of a project can be increased. b)The capital costs can be decreased. c)The likelihood that the project’s value will change increases.