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Real Options

We will maintain our highly disciplined approach to capital spending. Our objective remains to maximize return on every dollar we invest - and to invest where we find the very best growth opportunities.

- Richard C. Notebaert, ex-Chairman and CEO, Ameritech

Finance theory properly applied, is critical to managing in an increasingly complex and risky business climate... Option analysis provides a more flexible approach to valuing our investments... To me all kinds of business decisions are options.

- Judy Lewent, CFO, Merck -

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What is a Real Option?

Traditional discounted cashflow approaches (such as the NPV rule) cannot properly capture management’s flexibility to adapt and revise later decisions in response to unexpected market developments. Traditional approaches assume an expected scenario of cashflows and presume management’s passive commitment to a certain static operating strategy.

The real world is characterized by change, uncertainty and competitive interactions =>

As new information arrives and uncertainty about market conditions is resolved, management may have valuable flexibility to alter its initial operating strategy in order to capitalize on favorable future opportunities or to react so as to mitigate losses.

This managerial operating flexibility is like financial options, and is known as Strategic Options, or Real Options.

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Source of value in an option

Financial Options:

A call option gives the owner the right, with no obligation, to acquire the underlying asset by paying a prespecified amount (the exercise price, X) on or before the maturity date.

Value of a Call Option

on the

Maturity Date

Stock Price on the Maturity Date

Source of value in an option: The asymmetry from having the right but not the obligation to exercise the option.

X

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Different types of real options

Occurring naturally.

Example: Option to defer a capital investment.

Planned for and created.

Example: Option to invest in a new technology-based service/product, as the result of a successful R&D effort.

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Traditional Approaches To Dealing with Uncertainty and Complexity in Capital Budgeting - 1

Sensitivity Analysis

Considers effect on the NPV of varying one variable at a time.

Useful in identifying key drivers in a project.

Indicates how large the forecast error on a key driver can be tolerated, before the project becomes unacceptable.

Pro: Easy to implement and understand.

Con: Ignores interdependencies among variables (at a point in time), and over time.

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Traditional Approaches To Dealing with Uncertainty and Complexity in Capital Budgeting - 2

Simulation

Steps:

1. Equations specify relationships among variables.

2. Specify probability distribution of underlying variables.

3. Random draws from distributions; compute NPV.

4. Repeat steps 1, 2, and 3 many times.

Pro: Takes into account interdependencies among variables.

Cons:

A. Difficult to interpret a distribution of NPVs. Traditional view of NPV as "increase in shareholder wealth from accepting the project" not applicable.

Solution: Use simulation to assess the distribution of the net cashflows.

B. Problems in specifying interdependencies in step 1.

C. Cannot handle well asymmetries in the distributions introduced by management's flexibility to revise its prior operating strategy as more information about project cashflows becomes available over time: Real Options.

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Traditional Approaches To Dealing with Uncertainty and Complexity in Capital Budgeting - 3

Decision tree analysis

Helps structure the managerial decision problem by mapping out feasible managerial alternatives in response to future events.

Pro: Forces management to recognize its implied operating strategy and the interdependencies between the initial and subsequent decisions.

Cons:

A. Number of different paths on the tree increases geometrically.

B. Choice of discount rate: Risk of project may change over time. (Options based approach circumvents the discount rate problem by constructing a riskfree hedge.)

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Traditional Approaches To Dealing with Uncertainty and Complexity in Capital Budgeting - 4

Traditional capital budgeting procedures cannot properly capture management’s flexibility to adapt and revise later decisions in response to unexpected regulatory/technological/market developments.

The real option techniques can conceptualize and value managerial flexibility to alter its initial operating strategy in order to capitalize on favorable future opportunities or to react so as to mitigate losses.

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Example of Real Options The SuperCom Project:

A large telecommunications company faces an opportunity to invest in an R&D project that will revolutionize the way consumers use telephones, internet, and TV.

Real Options in the SuperCom Project

R&D Stage Commercialization Stage

0 (Years) 3 5 7 T = 15

I1

Ic

Defer( up to 1 year)

IE

I3

ExpandSwitch Use

(Abandon for salvage) Contract( save Ic )

I2

Abandon(forgo I2)

I1: Required investment in the R&D project.

I2: Required investment in the commercial-scale plant, marketing, and distribution - if the R&D effort is successful, and if market conditions are favorable..

I3: Final investment in the project; can be decreased by Ic if the market is weak.

IE: Flexibility in the design of the production process allows for output expansion with an outlay of IE.

V: Gross present value of the completed project’s expected operating cashflows.

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Example of Real Options in the Supercom Project - 1

Option to Defer Investment

Congress is currently debating the viability and the process by which to allocate or auction the airwaves that are crucial to the commercial success of SuperCom. Our lobbyist in Washington advises us that the debate would be resolved within a year. We could initiate the R&D project immediately, or wait a year to see what Congress does. The option to defer investing in the R&D project is similar to a call option whose value is max (V - I1, 0).

Option to Expand

Given an initial design choice, management may deliberately favor a more expensive technology for the built-in flexibility to expand production/sales if and when it becomes desirable. If the market’s response to SuperCom is better than expected, management can accelerate the rate or expand the scale of production by x% by incurring a follow-on cost IE. The option to expand has value max (xV - IE, 0).

The option to expand also applies to complementary markets: Investing in SuperCom in a new geographical area allows for the possibility to expand to other similar markets; for example besides local and long-distance tele-communication, the market for telephone-via-internet could be explored in the new geographical area.

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Example of Strategic Options in the Supercom Project - 2

Option to Default during Staged Construction ( Time-to-Build-Option) Investing in the R&D project, or investing I1, provides the opportunity to invest in the commercial stage by investing I2 or to abandon the project if the R&D and initial test-marketing is unsatisfactory.

Option to Contract

If the market does not respond to SuperCom as expected, management can reduce the scale of operations by c%, thereby saving Ic of the planned investment outlays. This option to mitigate loss has value max (Ic - cV, 0).

Option to Abandon for Salvage Value

If SuperCom does significantly worse than expected in the market, management may choose to abandon the project permanently in exchange for its salvage value: the resale value of the capital equipment, license, etc. for A. This flexibility to abandon the project has value max (V, A).

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Defer

Expand or contract

Abandon

Switch inputs or outputs

Grow

To wait before taking an action until more is known or timing is expected to be more favorable

To increase or decrease the scale of an operation in response to demand

To discontinue an operation and liquidate the assets

To commit investment in stages giving rise to a series of valuations and abandonment options

To alter the mix of inputs or outputs of a production process in response to market prices

Stage investment

To expand the scope of activities to capitalize on new perceived opportunities

ExamplesDescriptionOption

Adding or subtracting to a service offering, or adding memory to a computer

When to introduce a new product, or replace an existing piece of equipment

Discontinuation of a research project, or product/service line

Staging of research and development projects or financial commitments to a new venture

The output mix of telephony/internet/cellular services

Extension of brand names to new products or marketing through existing distribution channels

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Quantifying Strategic Options using the Binomial approach

The SuperCom project requires an initial investment of I0 = $104. Each year, the gross value of this project can move up by 80% or down by 40%, depending on market penetration and intensity of use of SuperCom. There is an equal probability (q = 0.5) that market penetration and intensity of use of SuperCom will increase or decrease each year. Hence, if SuperCom is successful, the gross value next year is $180, and $60 if it is not successful.

Let W be the price of a “twin security” that is traded in the financial markets and has the same risk characteristics (that is, is perfectly correlated) with SuperCom’s cashflows. The expected rate of return on W is 20%. The riskfree rate is 8%.

SuperCom’s gross cashflows, St , and the value of the twin security,Wt, move through time as:

(324, 64.88)

(180, 36)

(100, 20) (108, 21.6)

(60, 12)

(36, 7.2)

Year 0 Year 1 Year 2

Traditional (or, Passive) NPV Analysis

St = = 100.

SuperCom’s NPV = 100 - 104 = - 4.In the absence of real options, traditional NPV analysis would have rejected the SuperCom project.

1.20

60) * 0.5 ( + 180) * 0.5 (

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Option to Defer Investment - 1

Management could wait for a year and invest only if the regulatory uncertainty is resolved in a favorable manner, while it has no obligation to invest under unfavorable developments. The option to wait is analogous to a call option on the project value, V, with an exercise price equal to the required outlay next year,

I1 = (104 * 1.08) = $112.32

Value of SuperCom under favorable circumstances (in year 1): S+ = max (V+ - I1, 0)

= max (180 - 112.32 , 0) = 67.68

Value of SuperCom under unfavorable circumstances (in year 1) : S- = max (V- - I1, 0)

= max (60 - 112.32 , 0) = 0.

Value of SuperCom now (in year 0) : S0 = pS+ + (1-p)S-

(1+r)

where p is the risk neutral-probability obtained from the price dynamics of the twin security:

p = (1 + r) W - W-

(W+ - W-)

p = (1.08 * 20) - 12 = 0.4

36 - 12

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Option to Defer Investment - 2

Hence, S0 = = 25.07

Hence, Option to Defer = Expanded NPV - Passive NPV = 25.07 - (-4) = 29.07.

Using the NPV/Decision Tree Analysis, the value of SuperCom would have been:

S0 = 0.5 * 67.68 + 0.5 * 0 = 28.20.

1.20

Please note the probabilities and the discount rate used in the option analysis, and the decision tree analysis.

081

060686740

.

*..*.

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Option to Expand (Growth Option)

Original investment opportunity: Initial-scale project + Call option on a future opportunity

S = V + max (xV - IE , 0) = max (V, (1+x)V - IE). Or,

S+ = max (V+, 1.5V+ - IE) = max (180, 270 - 40) = 230.

S- = max (V-, 1.5V- - IE) = max (60, 90 - 40) = 60.

S0 = pS+ + (1-p)S- - I0

(1+r)

S0 = 0.4*230 + 0.6*60 - 104 = 14.5.

1.08

Hence, value of the option to expand = 14.5 - (-4) = 18.5.

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Option to Default on Planned Staged Cost Installments

During the R&D and construction phase, management may abandon a project if the coming required investment exceeds the value from continuing the project (including any future options).

Suppose the investment of $104 can be staged as a series of installments: I0 = $44 to be paid out immediately. The remaining $60 will be placed in an account (earning the riskfree rate) to be paid out as I1 = $64.8 next year. Management will pay the installment of $64.8 next year only if the R&D results and the regulatory climate looks favorable, else it will forego the investment and receive nothing. Such an option to default translates into

S = max(V - I1 , 0).

S+ = max (V+ - I1, 0) = max (180 - 64.8, 0) = 115.2; hence, continue.

S- = max (V- - I1, 0) = max (60 - 64.8, 0) = 0; hence, default.

The value of the investment opportunity with the option to default on future outlays is:

S0 = pS+ + (1-p)S- - I0

(1+r)

S0 = 0.4 * 115.2 + 0.6*0 - 44 = -1.33

1.08

Hence, Option to abandon = -1.33 - (-4) = 2.67.

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Strategic Interactions Among Sets of Projects - 1

Consider the base-case of a mature business unit: (in $ millions)

Sales (S) 100

Operating costs (C) (80)

Net cashflow (V) (ignoring depreciation, taxes, changes in working capital) 20

Now consider two new investment opportunities:

A. A marketing campaign of IE = $11 million that would expand sales by e = 50%.

B. A cost-reduction investment of Ic = $10 million that would cut costs by c = 10% regardless of the scale of the project.

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Strategic Interactions Among Sets of Projects - 2

Present values for market-expansion and cost-reduction projects taken separately and in combination

Market expansion Cost reduction Both

Sales (S) 150 100 150

Operating costs (C) (120) (72) (108)

Investment (IE, Ic, or IE + Ic) (11) (10) (21)

Net cashflow (V) 19 18 21

The market expansion project can be viewed as a call option:

max (eV - IE, 0) = max (0.50*20 - 11, 0) = max (-1, 0).

Hence, if exercised alone, the market expansion project would lower firm value by $1 million.

The cost reduction project can also be viewed as a call option:

max (cC - Ic, 0) = max (0.10*80 - 10, 0) = max (-2, 0).

Hence, if exercised alone, the cost reduction project would lower firm value by $2 million.

The two projects undertaken jointly can also be viewed as an option:

max [(eV - Ie) + c(1 + e)C - Ic, 0]

= max [(0.50*20 - 11) + 0.10(1 + 0.50)*80 - 10, 0] = max [+1, 0].

The strategic source of value of $1 million comes from the synergy or complementarity of the two projects undertaken jointly.

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Strategic Interactions Among Sets of Projects - 3

Strategic interaction among a set of projects may make the set worth significantly more than any of the individual projects or their sum.

The “LaserTalk” CaseFavorable resolution of a regulatory uncertainty could make expansion

into a new market worth an additional, say, $100 million.

Favorable resolution of a technological uncertainty (for example, internet’s ability to provide telephone services) could make expansion into a new market worth an additional, say, $250 million.

Favorable resolution of both the regulatory and technological uncertainties could make expansion into the new market worth significantly more than $350 million.

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Investment Opportunities as Collections of Real Options

Justification of the options analogy.

Can the standard techniques of valuing options on the basis of a no-arbitrage equilibrium, using portfolios of traded securities to replicate the payoff to options, be justifiably applied to

capital budgeting where projects may not be traded?

Answer: Yes! The computation of NPV requires calculation (assumption) of a discount rate: The required return on an asset (that is traded in the capital markets) of similar risk as the project.

From a practical standpoint: Calculating real option values is non-trivial.

The Real Value in Real (Strategic) Options!

From option pricing theory we know that the value of a call option increases with Increase in variance of the underlying asset. Increase in the value of the underlying asset. Increase in the time to expiration. Increase in the riskfree rate. Decrease in the exercise price.

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Limitations of the options analogy

1. Exclusiveness of Ownership and Competitive Interaction:

Financial call option on a common stock is proprietary; only the owner can exercise it without worrying about competition for the underlying security. Some real options (patents, licenses) are also proprietary. Other real options are shared and can be exercised by any firm in the particular industry:

Examples:Opportunity to penetrate a new geographic market.

Opportunity to introduce a new product unprotected by possible introduction of close substitutes.

2. Nontradability and Preemption:

Financial call options are traded with minimal transaction costs. Real options are not generally traded. Non-tradability of real options may lead to its early exercise: A firm anticipating increase in industry demand - and hence subsequent competitive entry - may rush to expand its own production/sales capacity early to preempt competition. In the absence of such competition it might have preferred to wait for the uncertainty surrounding future demand to resolve itself.

3. Strategic Interdependencies and Option Compoundness:

Financial call options are simple: their value derives entirely from the received shares of the stock. Some real options (such as, maintenance or standard replacement projects) are simple. Other real options are compound: R&D investments, Expansion into a new geographic market. Compound real options may have a more strategic impact on firm value, than simple real options, and are more complicated to analyze. Compound real options must be looked at not as independent projects but rather as links in a chain of interrelated projects, the earlier of which may be prerequisites for those to follow.

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The Bottom Line

Options approach to capital budgeting has the potential to conceptualize (and in some circumstances, quantify) the value of options from active management and strategic market interactions.

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Sources

Baldwin, C., and L. Trigeorgis, 1995, “Real Options, Capabilities, TQM, and Competitiveness,” Harvard Business School Working Paper.

Capozza, D., and Y. Li, 1994, “The Intensity and Timing of Investment: The Case of Land,” American Economic Review.

Dixit, A., and R.S. Pindyck, 1994, Investment Under Uncertainty, Princeton University Press.

Kogut, B., and N. Kulatilaka, 1994, “Operating Flexibility, Global Manufacturing, and the Option Value of a Multinational Network,” Management Science.

Kulatilaka, N., 1995, “The Value of Flexibility: A general model of Real Options,” Real Options in Capital Investments, Praeger.

Trigeorgis, L., 1996, Real Options, MIT Press.

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Real Options and LaserTalk - 1

A large telecommunications company, TCOM Inc., is considering the real/strategic options associated with investing in a new geographical territory: The LaserTalk Investment Opportunity (LaserTalk).

What are the real options associated with LaserTalk?

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Real Options and LaserTalk - 2

Real options associated with LaserTalk: Business opportunities that will become available to TCOM

only if LaserTalk were to be invested in now. • What might be the nature of these business opportunities?

From an economic and strategic viewpoint, these business opportunities would be in TCOM’s areas of core competencies. If TCOM has a comparative advantage at doing something in their existing market, they probably have a comparative advantage at doing it elsewhere. Additionally, these business opportunities may arise as a result of TCOM’s R&D success here, or legal/regulatory changes.

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Real Options and Financial Options

Value of Call option = V e-yt N(d1) - X e -rt N(d2) . Where,

d1 = [ ln (V/X) + (r - y + (2)/2) t ] / (t) ½ .

d2 = d1 - (t) ½ .

Variable (Financial) Call Option Real Option

V: Underlying asset Stock Business projectValue of V Stock price Present value of project’s net cashflows

X Exercise price Present value of project’s cash outflows

t Time to maturity Time over which the project decision may be made

r Riskfree rate Riskfree rate

Variance of the stock price Variance of the present value of project’s net cashflows

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Real Options and LaserTalk - 3

We use a modification of the Black-Scholes option pricing model to value the strategic options associated with LaserTalk :

Value of Strategic (real) option = V e-yt N(d1) - X e -rt N(d2) .

where,

d1 = [ ln (V/X) + (r - y + (2)/2) t ] / (t) ½ .

d2 = d1 - (t) ½ .

N (.) = Cumulative normal density function.

V = Present value of expected cash inflows from investing in point-to-multipoint radio technology and/or end-to-end solutions in the new geographical territories = $2459 million.

X = Present value of the costs of investing in point-to-multipoint radio technology and/or end-to-end solutions in the new geographical territories = $3014 million.

Hence, NPV of this project is -$555 million; that is, this project would be rejected on the basis of just considering the traditional NPV.

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Real Options and LaserTalk - 4

Value of strategic (real) option = V e-yt N(d1) - X e -rt N(d2) .

where,

d1 = [ ln (V/X) + (r - y + (2)/2) t ] / (t) ½ .

d2 = d1 - (t) ½ .

where,

2 = Variance in the expected net cashflows over time, allowing for technological, legal, and market changes = (40%)2.

t = Number of years during which the real option can be exercised

= 4 (given LaserTalk obtains the licenses in these new geographical markets).

y = Dividend yield.

r = Riskfree interest rate for t years = 6.40%.

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Real Options and LaserTalk - 5

Price charged as % of price in existing market = 90%WACC = 12.63%Life of Project (years) = 10New Territory Market Size (fraction of TCOM’s current market) = 0.3Operating Costs (as a % of operating costs in existing market) = 120%Capital expenditure (as a % of cap. exp. in existing market) = 110%Cashflow standard deviation = 40%Riskfree rate = 6.40%

Strategic Option value of investing in the new territory = $ 809 million

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Sensitivity Analysis of Real Option Value of Investing in LaserTalk

Option Value vs. New Territory Market Size

0

500

1000

1500

0.1 0.2 0.3 0.4 0.5

New Territory Market Size (fraction of current market)

Op

tio

n V

alu

e ($

M.)

Option Value vs. Price Charged

0

200

400

600

800

1000

1200

100 80 60 40 20

Price (as a % of price in current market)

Op

tio

n V

alu

e ($

M.)

Option Value vs. WACC

0

200

400

600

800

1000

1200

10 12.63 14 16 18 20

WACC (in %)

Op

tio

n V

alu

e ($

M.)

Option Value vs. Life of Project

0

500

1000

1500

5 10 15

Life (in years)

Op

tio

n V

alu

e ($

M.)

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Sensitivity Analysis of Real Option Value of Investing in LaserTalk

Option Value vs. Operating Costs

0

500

1000

1500

90 100 110 120 130 140 150

Operating Costs (% of costs in current market)

Op

tio

n V

alu

e ($

M.)

Option Value vs. Capital Expenditure

0

500

1000

110 150 200 250 300

Capital expenditure (as % of current cap.exp.)

Op

tio

n V

alu

e ($

M.)

Option Value vs. Cashflow Standard Deviation

0

500

1000

1500

10 20 30 40 50

Std. Dev. (%)

Op

tio

n V

alu

e ($

M

.)

Option Value vs. Riskfree Rate

650700750800850900

4 5 6 7 8

Riskfree Rate (%)

Op

tio

n V

alu

e ($

M.)