Investment Research Report

7/31/2019 Investment Research Report

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Investment Research report

Investment Research Report

By: Syed Imran Raza

For: International Research Association

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In prinipl, RO offrs potntil dvntgs ovr

trditionl nt prsnt vlu (NPV) nd disountd sh flow

(DF) pprohs, both of whih my ld to undr-invstmnt in

high-risk rs. It pls positiv vlu on risk by

xploiting th opportunity to phs invstmnts nd stg ky

disions so s to (i) llow trmintion of initil xplortory

R&D projts whih turn out to b unsussful, nd (ii) invst

mor in thos showing positiv futur prospts. By ontrst,

NPV nd DF viw risk ngtivly nd, by ignoring th option

pproh, impos highr disount rts to djust for highr

risk, thus rduing th vlu of futur xptd inom strms.

Th intuition bhind this potntil outom is s follows.

Trditionl invstmnt pprisl thniqus n b onivd s

bing onrnd with on-shot vlution of n invstmnt in n

sst. Th initil invstmnt is followd by sris of

(oftn) unrtin sh flows ovr tim. DF nlysis is th

industry stndrd vlution thniqu. It tks ount of th

tim-vlu of mony through th us of risk fr intrst

rt, nd of riskinss by dding risk prmium to th risk

fr rt in disounting futur sk flows.

This pproh nglts th insight whih riss from

rognising th phsd ntur of mny invstmnt disions,

whih my bgin with xplortory phss bfor finl sst

invtsmnt disions r md. Mny invstmnt projts hv in

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fft n options phs prior to th sst phs. During th

options phs, invstmnts r not bing md in n sst to

gnrt strm of sh flows but to stblish th opportunity

(but not th obligtion) to subsquntly invst in suh n

sst. Th invstmnt in R&D is fftivly n options - i n

xplortory - phs, whih is th nssry prursor in ordr

to llow futur invstmnt in th finl sst phs whih in

this s is th futur ommriliztion projt if th R&D is

susful.

NPV thniqus r inpproprit to vlu projts in

options phss, suh s R&D invstmnt, bus first thy do

not tk into ount th vlu of th option phs, nd sond

thy nglt th ft tht ommitmnts to futur invstmnts r

ontingnt on how th futur unfolds. In th s of R&D thy

will b ontingnt on thnil suss s wll s mrkt or

politil irumstns. Th bility to bndon projt - i

not xris th option for furthr invstmnt - mns tht

downsid risk n b rdud to th initil invstmnt whn

things go wrong. If irumstns r fvourbl, howvr, th

full upsid bnfit n b pturd. This ssymmtry gnrts

th rl options vlu. Th ttnds r listd t nnx 2.

Illustrtiv xmpl of Rl Options nysis

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Suppos n R&D projt rquirs n outly of 3m now to

nbl th invsmnt of 80m in nw produt ftr sussful

R&D. Suppos furthr tht th rtin vlu of th sh flow

from this sst is 100m.

If th R&D is blivd to hv 10% hn of suss,

stndrd vlution, tking into ount th thnil

unrtinty in th R&D ssigns to this projt vlu of

10% x (100m 80m) - 3m = minus 1m.

On this bsis it dos not sm to b worth doing.

Rl options rsoning howvr rogniss tht if th R&D

wr sussful, it would giv n option to invst th 80m in

nw produt, but rognizs thr is no obligtion to do so.

Suppos thr is 50% hn of fvourbl rgultion

rsulting in n stimtd sh flow from th nw produt of

160m. This is offst by 50% hn of n unfvourbl

rgultion, rsulting in vlu of th sh flow of only 40m.

Th vrg or xptd vlu of th sh flow is 100m, just

s in th s whr thr ws no unrtinty (Blk, F.,

Shols, M. 1973 pp.637-640).

In th unfvourbl s thr will b no furthr

invstmnt - invsting 80m for rturn of 40m mks no sns.

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So th projt will b bndond kping th downsid t th

sunk ost of 3m.

In th fvourbl s, th invstmnt will our nd thn

th vlu of th invstmnt will b 160m minus 80m or 80m.

Sin thr is 50% hn of fvourbl rgultion, w

thrfor xpt vlu of 0.5 x 80m or 40m in th sst

phs of th projt. Tking ount of th ft tht thr is

only 10% hn of sussful R&D, nd tking ount of th

sunk ost of 3m initil invstmnt w rriv t vlu of 0.1

x (40m) 3m = plus 1m.

Thus by introduing grtr unrtinty - i mor rlity

givn tht thr is usully mor thn on possibl outom - w

hv movd from ngtiv projt vlu of minus 1m to

positiv vlu of plus 1m.

If th unrtinty in th sst phs is furthr inrsd,

for xmpl if in th upsid snrio th produt is worth

200m, but in th downsid it nnot b lunhd t ll nd is

worth zro, thn w still hv n vrg vlu of 100m in th

invstmnt phs.

But now th vlu ftr rl options rsoning is 0.1 x 0.5

x (200m 80m) - 3m = plus 3m. In othr words, th inrsd

unrtinty hs givn th projt highr vlu this is quit

diffrnt to n NPV nlysis, whr n inrsd unrtinty

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would b djustd for by highr disount rt, rsulting in

lowr vlu of th projt.

RO modlling is wll dvlopd in finnil mrkts -

whih hv sophistitd nd wll dvlopd mthods of priing

risk nd wll dvlopd thory justifying th us of thos

pris. Howvr thr r onptul nd mpiril problms to

b ovrom in using th thniqu to obtin quntittiv

vlutions in rl sst invstmnt dision-tking.

Nvrthlss thr r xmpls of th us of RO in mking suh

invstmnt disions, prtiulrly in th phrmutils nd

tlommunitions industris . RO hs lso bn usd s prt

of th Forsight projt on xploiting th ltromgnti

sptrum .

Th ntrl qustion, whih th Workshop onsidrd, ws

whthr RO ould b usd to hlp th DTIs Thnology Strtgy

Bord (TSB) in mking finnil llotions btwn diffring

thnologis, nd lso btwn diffrnt projts within

prtiulr thnologis. Th Workshop lso onsidrd brifly

whthr RO ould b pplid to thos invstmnts by Govrnmnt

whih ly furthr upstrm, in prtiulr to th grnts md by

th Rsrh ounils to univrsitis to support strtgi

rsrh. Ths unrtintis dd diffiultis to th vlution

pross of th finnil vibility of th projt, spilly

givn long onssion priods (Ho nd Liu, 2002). Thy n ply

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signifint rol in th totl vlu of th projt; for

instn, givn n unrtinty in dmnd, thr is potntil

for th projt to hv dditionl vlu if th dmnd

inrss. Howvr, thr is lso potntil for rdution in

th vlu of th projt if th dmnd drss.

Ths unrtintis r onsidrd s dynmi

unrtintis. ording to Ford t l. (2002), dynmi rfrs

to th volution ovr tim of th unrtin onditions, or th

prption of thos onditions, tht dtrmin th optiml

strtgy for th prty riving th bnfits nd bsorbing th

osts of tht unrtinty. In th s of wtr infrstrutur

systms, th dynmi unrtintis r rltd to, mong othr

spts, th dtriortion of th infrstrutur omponnts

(min pips, vlvs, wtr pumps). If ths omponnts

dtriort t highr rt, omprd to th ssumption md t

th bidding tim, th privt invstor hs to llot mor

rsours to mintin th oprtion of th wtr ntwork. Th

rturn on invstmnt my onsquntly drs givn ths

pitl invstmnts. (Bitti, ., Rymond, P. 2005, Pp. 56-59)

Trditionlly, risk mngmnt strtgis suh s

mitigtion, divrsifition, nd limintion hv fousd on th

ngtiv impt of th dynmi unrtintis. For instn, in

ordr to rdu th risk of dditionl osts for n importnt

mintnn tivity, th privt oprtor of th wtr systm

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my fix th vlu of th mintnn srvi with

subontrtor, whih mns tht ny futur hng in th pris

of mtrils, lbor, nd quipmnt will b ssumd by th

subontrtor. Obviously, this strtgy prvnts dditionl

osts to th gnrl ontrtor, but it lso limits th

opportunitis for ost rdution if th mrkt pris of

mtrils drs t th ommnmnt of th mintnn

tivitis. Givn th dynmi bhvior of th unrtintis,

(ost rdution ovr tim, nw thnologis, omptition btwn

subontrtors, nw mtrils) thr is positiv point of viw

tht should b tkn into ount during th vlution of th

projt. For xmpl, nw thnologis nd mtrils my hlp to

mintin th infrstrutur for longr priod of tim t th

sm ost. In ordr to ssss th dynmis of th unrtinty

nd its impt on th vlu of th projt, it is nssry to

pproh th pitl invstmnt problm with nw mthodologis

tht hv bn pplid sussfully in othr domins, suh s

th finnil mrkts, sin trditionl mthodologis suh s

disountd sh flow do not ount for flxibl mngril

strtgis by th privt invstor. On of ths novl

mthodologis is rl options nlysis (RO).

ording to D Nufvill (2004), th dvlopmnt of RO

holds th promis of nbling th nginring profssion to

lult th vlu of flxibility. Hr, th onpt of

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flxibility rfrs to th bility of th projt mngrs to

mk hngs in th oprtionl strtgis of th filitis

bsd on th urrnt onditions of th infrstrutur systms.

Ths onditions my b diffrnt whn omprd to th

onditions ssumd during th bidding pross.

Utilizing PPP for wtr nd wstwtr systms rquirs

dtild vlution of th projt sh flow. s prt of this

vlution pross, it is nssry to onsidr th xptd

rvnus nd osts. n importnt lmnt of th ost stimtion

is ssssmnt of th dtriortion pross of th diffrnt

infrstrutur omponnts. Bsd on this ssssmnt, th privt

prtnr n stimt th rsours (pitl invstmnts)

rquird to oprt nd mintin th infrstrutur systm

throughout th onssion priod without ompromising th

qulity of srvi. Dtriortion modls r nssry to

dtrmin th projt's pitl invstmnts bus th

dtrmintion of ost-fftiv mintnn tions rquirs

informtion bout its urrnt ondition, s wll s th

ntiiptd futur onditions of th infrstrutur's omponnts

(Wirhdikusumh, 1999).

Stohsti prosss hv bn usd to modl th

dtriortion pross of infrstrutur systms (Rmswmy nd

Bn-kiv, 1990; Morous t l., 2002). ommon stohsti

pross usd is th Mrkov hins mthodology, whih ssums

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tht th ondition of th infrstrutur t tim t+1 dpnds on

th ondition t tim t nd dos not dpnd on th stts th

hin pssd through until tim t (Winston, 2004). Givn tht

th futur ondition of n infrstrutur systm is unrtin,

it is possibl to onsidr tht this unrtinty my provid

flxibl mintnn strtgis to th oprtor of th

infrstrutur (privt prtnr), givn tht th rl

ondition t tim t is urrntly unknown but will b known in

th futur (i.. t t+1). Thrfor, thr is vlu in witing

until th ondition of th infrstrutur omponnt is known to

dtrmin th mount of th pitl invstmnt rquird to

mintin th oprtion of th infrstrutur. If th ownr of

th infrstrutur (publi prtnr) is bl to stimt th

vlu of unrtinty (flxibility), it is possibl to xpt

highr bidding pris from th privt invstors intrstd in

th oprtion nd mintnn of n xisting infrstrutur

systm. This hppns bus th totl mrkt vlu of th

projt is th sum of two omponnts:

1. Vlu without flxibl ltrntivs (fixd mintnn

poliy); nd

2. Th vlu of th mngril options.

Th mthodology proposd in this ppr uss Mrkov hins

trnsition probbilitis s msur of th systm's

unrtinty nd is rprsntd by th dtriortion urvs of

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th infrstrutur omponnts. This unrtinty is onsidrd in

th RO in ordr to stimt n urt vlu of th projt.

In this ppr, th nlysis nd vlution of th flxibility of

th pitl invstmnts rquird to mintin th oprtion of

th infrstrutur systm will b ssssd from th ownr's

prsptiv. Howvr, similr produrs n b pplid by th

projt's potntil invstor. In ordr to obtin n urt

projt vlu, it is nssry to xpnd th onpt of disount

sh flows nd to ount for th vlu of th flxibility

(unrtinty) in th xisting infrstrutur systms.

mthodology tht hs bn usd to vlu flxibility in pitl

invstmnts is rl options nlysis (RO). vn though th

onpt is not nw (Lunbrgr, 1998), its pplition in th

vlution of pitl invstmnts is rnt (Ho nd Liu, 2002;

Ford t l., 2002; Yo nd Jfri, 2003; Grvin nd hh,

2004; oplnd nd Tufno, 2004; Vn Puttn nd MMilln, 2004).

ording to Ross t l. (2002), n option is ontrt giving

its ownr th right to buy or sll n sst t fixd pri on

or bfor givn dt, whih mns tht it is possibl t tim

t+1, givn nw informtion olltd in th tim priod btwn

t nd t+1, to mk bttr dision bsd on th urrnt vlu

of th sst t tim t+1. For instn, if th futur pri of

n importnt onstrution mtril in projt is unrtin,

ontrtor my py prmium to supplir in ordr to hv th

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option of buying givn mount of mtrils t pri

(xris pri) dtrmind tody (tim t). Dpnding on th

mrkt ondition t tim t+1, th ontrtor will hv th

flxibility of diding whih pri is th most onvnint. If

th mrkt pri is highr thn th xris pri, th

ontrtor will buy th mtrils t th xris pri, sving

mony omprd to th urrnt mrkt pri. If th mrkt pri

is lowr thn th xris pri, th ontrtor will not us

his option nd h will buy th mtrils t th mrkt pri.

Th originl prmium is not rovrd in ny s. This simpl

xmpl illustrts tht th onpt of rl options n ptur

th flxibility of mngmnt disions undr unrtinty.

Th privt oprtor of th infrstrutur systms mks pitl

invstmnt disions (rstortion, mintnn, nd oprtion)

bsd on th sttus of th infrstrutur throughout th

projt's lif. This dt is olltd from th thnil

vlution (on-sit insption) of th urrnt onditions of th

diffrnt omponnts. So, th privt invstor is mking

disions bsd on xisting dt (no unrtinty) during th

oprtion of th infrstrutur. Howvr, th originl bid ws

prprd bsd on ssumptions (forsting) of th sttus of th

infrstrutur x yrs from th dt of th bid submission. t

th tim of th bid submission, thr ws unrtinty, but whn

th pitl invstmnt disions r md, this unrtinty no

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longr xists bus urrnt ondition dt of th

infrstrutur omponnts boms vilbl. Trditionl DF

mthodologis r unbl to ptur th unrtinty in th

ondition of th infrstrutur systms, nd th nlyst t most

my rt snrios to rprsnt diffrnt infrstrutur

onditions. Ths snrios sk to rprsnt th rng of

possibl outoms in simpl, trtbl mnnr. In gnrl,

thr r thr snrios:

1. Bst s;

2. Bs s; nd

3. Worst s.

nothr mthodology tht n b usd to stimt th vlu of

th option is pplying ontinuous-tim modl (Lunbrgr,

1998; Grvin nd hh, 2004). This mthodology rquirs

thorough undrstnding of diffrntil lulus to solv th

diffrntil qution (gomtri Brownin motion) tht dsribs

th bhvior of th undrlying sst. numril produr tht

is lso usd to vlu options is th binomil mthod, nd this

mthod is sir to dpt to th vlution of rl options

omprd to th Blk-Shols modl or th ontinuous tim

modl. Th binomil mthod uss binomil trs to pproximt

th bhvior of th undrlying sst, ssuming tht th

invstors r risk-nutrl. In this s, it is ssumd tht th

invstors dmnd no dditionl ompnstion byond th risk-fr

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rt, rgrdlss of th risk of th sst in qustion (Ross t

l., 2002). Th binomil trs ssum tht ovr singl priod,

th undrlying sst pri n mov from its urrnt pri to

on of two possibl lvls: up or down. This movmnt is rltd

to th voltility of th undrlying sst.

On of th bnfits of RO in PPPs is th pprition of

th diffrnt ltrntivs ssoitd with th projt. For

instn, th publi ntity my did to postpon th

ommnmnt of th projt in ordr to gthr bttr

informtion rgrding th dtriortion pross of th

infrstrutur systms or to dtrmin th vribility of th

projt's dmnd. It is nssry to ontmplt wht typs of

options xist (dfr, bndon, swith) in th projt, how ths

options n b rtd, how thy dd vlu to th projt, nd

how th mngmnt tm n tk dvntg of th unrtinty

involvd in th projt. This dos not mn tht trditionl

mthods should b ignord, rthr tht RO provids dditionl

tools to do bttr ssssmnt of th onomi bnfits of th

projt.

onlusions

t prsnt, th prinipl vlu of RO s n id to

Govrnmnt invstmnt disions ws likly to b in dtrmining

th qulittiv pross to nbl nlysts to look t

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prtiulr invstmnt opportunity nd brk it down into its

omponnt stgs. Using RO s qulittiv disiplin nd

dopting n xpliitly phsd pproh ws vry vlubl in

stimulting thinking bout th rng of invstmnt options

vilbl, how ths might hng with tim, whr th

invstmnt ut-off points wr, wht th probbility of suss

of h option t h stg in th pross might b, nd s

lrning mhnism for futur disions. RO ws t rltivly

rly stg of dvlopmnt s quntittiv nlytil tool for

publi stor dision-mking, omprd with othr thniqus

suh s NPV nd DF. Morovr thr ws som unrtinty s to

th xtnt to whih it ws usd in th privt stor nd th

rsons for its pprntly pthy doption. Thr ws, howvr,

n tiv intrntionl dmi nd prtitionr rsrh

intrst in its dvlopmnt nd pplition nd som mjor

ompnis wr vluting its potntil. Mor dvlopmnt work

on RO would b ndd bfor it ould b pplid quntittivly

in publi stor ontxt to th sort of disions tht th TSB

wr mking bout th lvl of invstmnt in prtiulr ky

thnologis. In prtiulr, it ws urrntly not wll suitd t

prsnt to dtrmining invstmnt lvls t high lvl of

gnrlity, for xmpl invstmnt in imging thnologis vs

nrgy thnologis, or mission to Mrs vs stm ll rsrh.

It ws lso snsitiv to th ft tht th diffrnt stgs in

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limitd th pplition of RO to invstmnt disions in

diffrnt projts within prtiulr thnology r, lthough

hr ths ffts wr likly to b lss signifint.

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Investment Research Report