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Real Option Valuation of Early Stage Technology
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Real Option Valuation of Technology
Application of Precision Tree
Palisade Risk Conference 2011
Michael Brand
© 2011Captum Capital Limited
6
Future Value of a Tulip Bulb
§ In February 1637, a Viceroy Tulip bulb was worth 3,000fl. § You are offered an option to acquire 1000 bulbs in six months time at 3,000fl per bulb § What would you pay to acquire this option?
Futures markets flourished in Amsterdam in 1637
9
Gold Mine Option
§ You own a gold mine
§ Geological survey estimates it contains 1 metric tonne of gold
§ What is the value of the mine?
10
Value of Gold Mine
§ Its value depends on the price of gold § Risk
§ You can start or stop mining depending on the price of gold § Flexibility in outcome
This is a classic Real Option
12
Real Options
§ Risk or Uncertainty in the…outcome
§ Nonlinearity: flexibility to react in different ways…so that a new set of outcomes is achieved
Source: Michael Rees, Financial Modelling in Practice (2008)
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Technology Development
R&D Project
Fund
Failure
Success Commercial Development
Fund
Option Price
Option Exercise Price
14
Risk Adjusted NPV
∑ + = t
t t
R C P rNPV ) 1 (
rNPV depends on 3 factors:
•Probability, P
•Cash Flow, C
•Discount Rate, R
Most commonly used method for valuing technology
15
Technology Project Value
10000 1000 100 PV
0.5x0.9 0.5 1 P
15735 0 1255 0 100 Cash Flow
4 3 2 1 0 Year
rNPV = 100 + 0.5 x 1000 + 0.45 x 10000 = £3,900,000
Cash Flow in £000s
Discount Rate R = 12%
17
Real Option Valuation
§ Key variables § Underlying Asset Value – Enterprise Value § Exercise Price § Term to Exercise § Volatility of Underlying Asset § Discount Rate
18
RO Valuation Methods
§ Black Scholes OptionPricing Model*
§ Binomial Model*
§ Monte Carlo Simulation
§ Decision Tree
* Developed for financial option valuation
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Black Scholes Equation
Present Value of a Call Option: ) ( ) ( 2 1 d N EXe d PN PV t r f − − =
where:
t t t r EX P
d f
σ σ 2 / ) / log(
1
2 + + =
t
t t r EX P d t
σ
σ 2 / ) / log( 2
2 − +
=
= variance on return σ
= price of security P
= time to exercise t
= exercise price EX = normal probability function N(d)
1 ) ( 2
_
− −
= N P P
r f = risk free rate
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Binomial Model
) exp( t u σ =
u d 1
=
EV
EV u = S x u
EV d = S x d
t
p
1 p
Enterprise Value each year goes: up by a factor u, or down by a factor d
d u d r
p f
−
− + =
) 1 (
σ = sales volatility, between 20% and 40% for R&D projects
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Abandonment Options
R&D Project
100
rNPV = 100
1000
rNPV = 600
rNPV = 3900
Mean rNPV = £635k Max rNPV = £3900k
£000s
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Strategic Decision Options
§ Defer Investment § Default § Expand § Contract § Shut Down and Restart § Abandon
Lenos Trigeorgis, Real Options (1996)
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Multiple Milestones
FDA CT2 CT1 Scale up
0.7
0.4
0.6
0.9
1.5
0.1
0.5
0.2
0
0.2
4.5
0.3
Cash Flow £m
Medical Device Development Project
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Summary
§ Decision Trees are a viable approach to Real Option Valuation: § Simple to construct using Precision Tree § Flexible – changes of strategy § Transparent – ease of communication § Credible not a “Black Box”
31
About Captum…
§ Formed in 2004 § Transatlantic presence § Life science sector consulting: § Business development, valuation, partnering
§ MasterClasses: § Valuation Masterclass attended by over 500 executives in UK and Europe
§ Internet virtual communities § Sensor100
32
Coming Events
§ MasterClass: Company Valuation London, 25 th May 2011
§ Workshop: Evaluating Technology LES International Conference London, 8 th June 2011
34
Contact
Michael Brand e: [email protected] t: +44 (0) 115 988 6154 m: +44 (0) 7980 257 241
Captum Capital Limited Cumberland House 35 Park Row Nottingham NG1 6EE United Kingdom
www.captum.com