The Strategy and Value of a New Venture:

The Case of Portlandia Ale

a supplement to
Uncertainty: The New Rules for Strategy
Journal of Business Strategy
May/June 1999
Glaze Creek Partners

Page 1
May, 1999

Note:
This example is taken from
Chapter 10 of
Real Options: Managing Strategic Investment in
an Uncertain World (HBS Press, 1999)
by
Martha Amram and Nalin Kulatilaka
Glaze Creek Partners

Page 2
May, 1999

A Step-by-Step Example

PORTLANDIA ALE:
Two brewmasters and a dream
Their business plan is straight DCF
The reality is that firm has options
Lets calculate the expanded value of the firm:
V = DCF + option value

Glaze Creek Partners

HBS Press, 1999. From Chapter 10, Real Options: Managing Strategic Investment in an Uncertain World

Page 3
May, 1999

Portlandia Ales Business Plan

Fixed Cash Flow

Optional Cash Flow

Spend $0.5M per quarter

on product development

Raise
$4M

If Launch,
Obtain Value of an
Established
Brewer

x
Spend $12M on
Market Launch

Year 1

Year 2

Year 3

Glaze Creek Partners

HBS Press, 1999. From Chapter 10, Real Options: Managing Strategic Investment in an Uncertain World

Page 4
May, 1999

Even with optimism, spreadsheet calculations

show that the DCF value is negative

Value of Portlandia Ale using discounted cashflow = ($0.23M)

Time
Y1-Q1
Revenues
Investment
(0.50)
Terminal Value
PV (Investment)
(0.50)
PV (Terminal Value)
DCF Value
($0.23)

Y1-Q2

Y1-Q3

Y1-Q4

Y2-Q1

Y2-Q2

Y2-Q3

(0.50)

(0.50)

(0.50)

(0.50)

(0.50)

(0.50)

(0.49)

(0.49)

(0.48)

(0.48)

(0.47)

(0.46)

Y2-Q4

Y3-Q1
1.5
(0.50) (12.00)
22.00
(0.46) (10.86)
14.46

Terminal Value =
$1.5M quarterly rev. x 4
x 3.66 (Market to sales ratio)
Glaze Creek Partners
1999, Amram and Kulatilaka. Downloadable file at www.real-options.com

Page 5
May, 1999

But there is no obligation to launch the product,

only an option
DCF has two parts

Hardwired investment schedule

Single roll of the dice on revenue

Recognizing the option to launch

Multitude of outcomes
Optimal response to each outcome, including the no
launch decision

Glaze Creek Partners

Amram and Kulatilaka, 1999.

Page 6
May, 1999

Valuing the option to launch

Black-Scholes formula was part of the Nobel

Prize winning breakthrough
When applicable, the Black-Scholes formula is
an easy-to-use and quick option calculator
Beauty of formula

No-arbitrage pricing
Only five inputs
No forecasting

Glaze Creek Partners

Amram and Kulatilaka, 1999.

Page 7
May, 1999

Inputs to the Black-Scholes formula for the

option to launch
The option to launch

Call option on a stock

Current estimate of
value of microbrewery

Stock price

Cost of launch

Exercise price

Launch date

Exercise date

Time value of money

Risk-free rate of return

Volatility of value

Standard deviation of return

on the stock

Glaze Creek Partners

Amram and Kulatilaka, 1999.

Page 8
May, 1999

The value of the option to launch is calculated

using the Black-Scholes equation
Definitions

The Black-Scholes Equation

F=

N(d1) S -

Expected value
of launch, if launch
Expected value of S if
S > X at T

N(d2) X e -rT
Probability of launch
times
PV of cost of launch
Probability of S>X at T
times
PV(cost of investment)

F=
S=
X=
r =
T=
=

Current value of call option

Stock price
Exercise price
Risk-free rate of return
Time to decision date
Volatility of the stock return

N(d1) and N(d2) are the value of the

normal distribution at d1 and d2
d1 = [ln(S/X) + (r + 0.5 2)T ]/ T
d2 = d1 - T
Probabilities refer to risk-neutral
probabilities

Glaze Creek Partners

HBS Press, 1999. From Chapter 8, Real Options: Managing Strategic Investment in an Uncertain World

Page 9
May, 1999

Two simple adjustments to the spreadsheet adds

the option to launch
PV(Investment before launch) = ($3.83)
Time
Elapsed time(years)
Revenues
Investment
Terminal Value
PV (Investment)
PV(Terminal Value)
Sum PV(Investment)
DCF Value of Portlandia

Y1-Q1
0

Y1-Q2
0.25

Y1-Q3
0.5

Y1-Q4
0.75

Y2-Q1
1

Y2-Q2
1.25

Y2-Q3
1.5

Y2-Q4
1.75

(0.50)

(0.50)

(0.50)

(0.50)

(0.50)

(0.50)

(0.50)

(0.50)

(0.50)
14.46
(14.69)
($0.23)

(0.49)

(0.49)

(0.48)

(0.48)

(0.47)

(0.46)

(0.46)

Y3-Q1
2
1.5
(12.00)
22.00
(10.86)

Value of
Option to
Launch =
$4.96M
(includes

Sum PV(Investment before launch)

(3.83)

Option Value ($M)

A
X
r
T
sigma
delta
d1
d2

cost of
launch) Value of Option

$ 14.46
$ 12.00
5.00%
2.00
40.0%
0.00%
0.7887
0.2230
$4.96

Value of Portlandia Ale = $1.13M

Firm Value ($M)
Option Value
- PV(Investment before launch)
= Value of Portlandia

$4.96
($3.83)
$1.13

Glaze Creek Partners

1999, Amram and Kulatilaka. Downloadable file at www.real-options.com

Page 10
May, 1999

The Value of Portlandia Ale

(in millions)

Discounted cashflow

($.23)

With option to launch

$1.13

Glaze Creek Partners

Page 11
May, 1999

The traditional business plan is based on a single

forecasted trajectory
Planned Investment
Cashflow Forecast

Value

Value of
Business at
End of Forecast
Horizon (Terminal
Value)

$12
$4

Today

2 years

3 years

Time

Glaze Creek Partners

HBS Press, 1999. From Disciplined Decisions: Aligning Strategy with the Financial Markets, HBR, Jan.-Feb., 1999.

Page 12
May, 1999

But the real world is uncertain

The Cone
of
Uncertainty

Value

Today

2 years

3 years

Time

Glaze Creek Partners

HBS Press, 1999. From Disciplined Decisions: Aligning Strategy with the Financial Markets, HBR, Jan.-Feb., 1999.

Page 13
May, 1999

The initial investment creates the option to

make the subsequent investment

Value

Today

2 years

3 years

Time

Glaze Creek Partners

HBS Press, 1999. From Disciplined Decisions: Aligning Strategy with the Financial Markets, HBR, Jan.-Feb., 1999.

Page 14
May, 1999

Now lets make the decisionmaking a bit more

realistic: Each quarter Portlandia can abandon
the project
Cash
flow

$0
?
Today

2 years

3 years

Time

European option; Black-Scholes

American option; Numerical Methods

Glaze Creek Partners

1999, Amram and Kulatilaka

Page 15
May, 1999

We used the binomial method to value

Portlandia, including the option to launch and the
option to abandon
Quarter
Quarterly Value Tree
(Uncertain value of the
market opportunity)

Option Value Tree

(Value of the firm,
assuming optimal launch
decision is made.)

0
14.46

1
17.66
11.83

2
21.56
14.46
9.69

3
26.34
17.66
11.83
7.93

4
32.17
21.56
14.46
9.69
6.50

5
39.29
26.34
17.66
11.83
7.93
5.32

6
47.99
32.17
21.56
14.46
9.69
6.50
4.35

7
58.62
39.29
26.34
17.66
11.83
7.93
5.32
3.56

8
71.60
47.99
32.17
21.56
14.46
9.69
6.50
4.35
2.92

0
1.74

1
4.24
0.42

2
7.88
1.95
0.00

3
12.71
4.57
0.53
0.00

4
18.79
8.35
2.16
0.00
0.00

5
26.25
13.30
4.93
0.62
0.00
0.00

6
35.29
19.47
8.87
2.36
0.00
0.00
0.00

7
46.27
26.94
13.99
5.30
0.67
0.00
0.00
0.00

8
59.60
35.99
20.17
9.56
2.46
0.00
0.00
0.00
0.00

Portlandias value increases to $1.74M

Glaze Creek Partners
1999, Amram and Kulatilaka. Downloadable file at www.real-options.com

Page 16
May, 1999

The Value of Portlandia Ale

(in millions)

Discounted cashflow

($.23)

With option to launch

$1.13

With option to launch

and option to abandon

$1.74

The ratio of Real Options Value to DCF Value is

fairly typical for growth applications.
Glaze Creek Partners
1999, Amram and Kulatilaka

Page 17
May, 1999