International Jl.

on E-Learning (2010) 9(3), 363-383

Real Options Valuation of e-Learning Projects

Angilberto Freitas
Unigranrio, Brazil
angilberto.freitas@gmail.com

Luiz Brandão
Pontifical Catholic University of Rio de Janeiro, Brazil
brandao@iag.puc-rio.br

New information and communication technologies have been

gaining widespread use in Distance Education (DE) models.
At the same time, the uncertainty in the market demand for
this form of higher education is such that the valuation of e-
Learning projects has become increasingly difficult and com-
plex. This is due to the fact that uncertainty and flexibility
are central to DE projects, and traditional valuation models
such as the Discounted Cash Flow (DCF) method fail to cap-
ture the value of the management flexibility that is inherent
in these types of projects. We analyze a typical college level
MBA DE project and show how option pricing methods can
be used to determine both the project value and the optimal
investment strategy. We develop a real options model which
allows managers to optimize their decision making process
when there is the option to postpone project implementation
for a limited period of time. We conclude that this approach
allows for a more comprehensive valuation of the strategic
flexibilities that exist in this class of project, improves the
quality of managerial decisions and reduces the risk of invest-
ment under uncertainty.
364 Freitas and Brandão

Introduction

Project evaluation of Distance Education (DE1) is a problem that chal-

lenges the managers of teaching institutions due to the complexity of the
analysis and the large quantity of intangible results and benefits. Within the
Distance Education panorama for the 21st century, the uncertainty factor is
crucial in this kind of project due to the fact that information and commu-
nication technologies used for online education are constantly evolving and
affect the variability of the costs involved in these technologies (Oberlin,
1996). These factors, along with uncertainty over the size and potential of
the DE market, increase the difficulties that managers face in the decision
making process.
This uncertainty limits the manager’s long term vision, and makes the
decision to invest in an e-Learning project a high risk proposition, which in
the worst case may lead to the loss of the invested capital. Hence, a valua-
tion method capable of dealing with market uncertainties must be pursued
so that e-Learning projects may be adequately analyzed and managers can
identify the optimal time to invest. A delay in entering this market could
represent a loss in potential market share, and the choice of the most ad-
equate moment to invest should be taken based on a quantitative model
which gives clear indications as to the optimal decision. In addition, capi-
tal investment in distance education is for the most part an irreversible sunk
cost (Oslington, 2004; Rumble, 1997), as the resale value, which is primar-
ily composed of investments in hardware, may be only a fraction of its orig-
inal purchase value. The same applies to the content and material costs as
they also tend to be project-specific.
The traditional methods of project valuation, particularly the Discount-
ed Cash Flow method (DCF), are based on the static analysis of expected
future cash flows and do not capture the managerial flexibility that may be
present in the project. An alternative approach is the use of option pricing
methods known as real options, which have become increasingly popular in
recent years (Dixit and Pindyck, 1994, Trigeorgis, 1996). Real options mod-
els consider the managerial flexibility that may be present in a project as
uncertainties are resolved, rather than assuming that all relevant operational
and strategic decisions will be defined beforehand as in the case of the DCF
model. This approach more accurately reflects the actions of a manager that
will choose the best course of action throughout the life of a project accord-
ing to the evolution of market conditions. For example, if market demand
turns out to be more favorable than expected, the manager may choose to
continue or even expand the project. On the other hand, if market demand
Real Options Valuation of e-Learning Projects 365

is lower than expected, the optimal course of action may be to abandon the
project.
Even though the use of real options theory in projects dealing with un-
certainty and flexibility has been thoroughly studied, the literature on the
application of option pricing methods to DE projects is scarce. Sachs (2000)
and Zweildler, Wedge and Metz. (2005) propose the use of this method in
the DE context, but don’t provide details on how this can be achieved in
practical terms. On the other hand, Oslington (2004) presents a study in
which he illustrates this case in a practical application, although in a simple
and rudimentary way.
In this article we introduce the real options approach and shown how
it can be applied to the valuation of an e-Learning project subject to a high
degree of uncertainty, managerial flexibility and investment irreversibility,
and discuss the advantages of this approach relative to the traditional DCF
methods. This article is organized as follows: After this introduction we
present a brief review of the real options approach and the characteristics
of the distance education projects market. In Section 3 we analyze an actual
e-Learning project under both the DCF and the real options method and in
Section 4 we present the results. In section 5 we conclude.

Real Options and Distance Education Projects

The most widely used method for project valuation is the Discounted
Cash Flow (DCF) approach, where the expected Net Present Value (NPV)
of an investment is determined by discounting the project’s net cash flows
at the firm’s cost of capital rate. A positive NPV indicates that the project
will create value to the firm and thus should be implemented, while proj-
ects with negative NPVs destroy value and should be rejected. This method,
however, does not capture the value of embedded flexibilities that the proj-
ect may have and which may command significant value. These managerial
flexibilities, or options, allow managers to react to market conditions and
maximize shareholders returns by exercising operational decisions such as
expanding, contracting, suspending or even canceling the project altogether
if demand turns out to be much lower than expected, or to consider the stra-
tegic value of new opportunities of investment derived from a new techno-
logical development (Trigeorgis, 1996). Due to their option-like character-
istics, these flexibilities can only be analyzed with option pricing methods
such as the real options approach (Pindyck, 1991; Copeland & Antikarov,
2001; Brandão, Dyer and Hahn, 2005).
366 Freitas and Brandão

Financial and Real Options

The development of the real options approach is a result of the applica-

tion of the option pricing methods developed by Black & Scholes (1973)
and Merton (1973) for financial options. A financial option is a contract that
provides the holder with the right, but not the obligation, to purchase (Call
Option) or sell (Put Option) a financial asset for a previously defined price
(Exercise Price) during a predetermined period of time (Hull, 2002). Op-
tions can also be classified according to their exercise rule as European-type
options, where the exercise can only occur at the end of its life, and Ameri-
can options, where the option can be exercised at any time up to the expira-
tion date. Since project valuation involves real rather than financial assets,
the application of these concepts to project analysis is known as the real op-
tions approach.
One can find similarities between these two approaches. The decision
to invest in a business opportunity is equivalent to the exercise of a financial
option, such as exercising the right to buy an asset with a current value S
for a predetermined price X. The real option equivalent is the right to make
an investment I in order to receive the present value of the cash flow stream
generated by this investment, where the cost I of the investment corresponds
to the exercise price X of the financial option. The present value V of the
project, which is assumed to behave stochastically over time, is equivalent
to the market price S of the asset. The timeframe during which the firm or
organization can delay the decision to invest without losing the investment
opportunity corresponds to the expiration deadline T of the option. The un-
certainty in relation to the future value of the project cash flows (the project
risk) corresponds to the standard deviation σ of the project returns. Table 1
summarizes the analogy between the parameters of financial and real op-
tions.
Table 12
Financial Option and Real Options
Financial Option Parameter Investment Opportunity (Real Option)
Present Value of the Free Cash Flows of the
Asset or stock price V
Project
Investment cost, or costs to convert the
Exercise Price I investment opportunity into an operational
project.
Expiration T Time period necessary to make a decision
Risk Free rate r Risk free rate
Stock Volatility σ Project Volatility (risk)
Source: Adapted from Iatroupoulos & Angelous, 2004
Real Options Valuation of e-Learning Projects 367

The option value is the difference between the project’s expected NPV
determined with the DCF method and the expected NPV of the real options
approach. The greater the market uncertainty, the greater the option value,
since manager may actively operate the project to maximize market op-
portunities and minimize losses (Dixit & Pindyck, 1994; Trigeorgis, 1996).
Thus, the value of a flexible project can be represented as the sum of the
static expected NPV derived from the DCF and the managerial flexibility
derived from the real options approach (Trigeorgis, 1999):
Expanded NPV (strategic) = Static NPV (passive) + Option value (mana-
gerial flexibility)
If the use of the real option approach provides a more accurate valua-
tion of the firm’s projects, then why is it not more widely used in the indus-
try? One of the problems in the use of option pricing methods, especially in
the case of e-Learning projects, is the difficulty of estimating some of the
parameters such as the volatility of key variables, technology costs, market
demand, etc. Aside from that, the continuous time models that have been
prevalent until recently require a level of mathematical sophistication that
many managers may not possess. On the other hand, new computational
tools and techniques have been developed to aid in the modeling and solu-
tion of this problem, simplifying its application.

Option Pricing Models

Real options problems can typically be solved with continuous time

models derived from the Black & Scholes model (Black & Scholes, 1973),
simulation models or the binomial model of Cox, Ross and Rubinstein
(1979).
In the Black & Scholes model, it is assumed that S is the market value
of an asset that follows a Geometric Brownian diffusion process of the form
dS = µ Sdt + σ Sdz , where μ is the expected growth rate of the assets value,
σ the asset volatility and dz = ε dt ε ≈ N (0,1) is the standard Wiener
increment. The value of a non-dividend paying European Call option C on
this asset is then defined by Equation (1),

C = SN (d1 ) − e − rT XN (d 2 ) , (1)
where N(.) is the normal cumulative distribution, r is the free risk
ln( S / X )rT 1
rate, X the exercise price of the option, d1 = + σ T and
σ T 2
 368 Freitas and Brandão

d2 = d1 − σ T .
Although the Black & Scholes equation was originally developed to
price non-dividend paying European-type options, it has been applied to a
few simple cases of real options, such as technology projects (Benaroch and
€ Kauffman, 1999; Benaroch and Kauffman, 2000; Härkönen 2003; Iatroup-
oulos & Angelous, 2004), but otherwise the use of this approach for real
options is limited, since the majority of real options projects involve Ameri-
can-type options.
The value of an option can also be determined by simulation, which gen-
erates a number of iterations where the future values of an asset subject to
market uncertainties is modeled stochastically and the option value for each
iteration is calculated. The average of all iterations then provides the option
value. While this method is reasonably simple to use for European-type op-
tions, it becomes more cumbersome when American-type options are in-
volved.
Cox et al. (1979) developed a discrete method that uses a bino-
mial lattice to approximate the same diffusion process that is used in the
Black & Scholes model. In this model, the value V of a project can take
on two values in each period ∆t: either it increases to Vu, with probability
p, or decreases to Vd, with probability 1-p, where u = eσ ∆t
, d = 1/u, and

1+ r − d
p= , as illustrated in Figure 1.
u−d
€
V u3
V u2

Vu
V u2d
p
V ud
V

(1-p)
V ud 2
Vd

V d2
V d3

Figure 1. Binomial Lattice with a probability distribution of V

The parameter u is governed by the volatility of the project value,

where volatility describes the amount of uncertainty in the value. Once the
binomial lattice is modeled, the options can be inserted with ease at the ap-
Real Options Valuation of e-Learning Projects 369

propriate nodes (i.e., where flexibility exists) and the project value in the
resulting decision tree can be determined as usual by rolling back the tree
payoffs. For a more detailed description of this model we refer the reader to
Copeland & Antikarov (2001) and Brandão et al (2005).

Distance Education Projects

The development of an e-Learning course requires careful analysis of

the costs and investments that are required. The cost structure of a program
of this nature differs greatly from those of other learning projects and also
of the traditional distance education projects based on printed materials. De-
spite the great potential for economies of scale, monitoring and managing
the budgets for these types of projects is more complex, given that the costs
involved behave differently. On the other hand, e-Learning projects, espe-
cially those developed in partnerships, can be as cost effective as conven-
tional courses (Bartolic-Zlomislic & Bates, 1999).
 When analyzing a Distance Education � project, the following
factors must be taken into consideration (Rumble, 1997Capital
costs – Costs allocated to the purchase of equipment and materials;
 Recurring costs – Costs necessary to maintain the flow of opera-
tions (for example, hardware maintenance costs)
 Production costs – Costs associated with the production of teach-
ing materials;
 Distribution costs – Costs associated with the distribution of
course material;
 Fixed costs – Costs incurred by the organization throughout
the life of the project which are independent on the number of
students enrolled;
 Variable Costs – Costs incurred by the organization throughout
the life of the project which are proportional to the number of
students enrolled.

Given that the e-Learning market is still in the initial phases of innova-
tion and growth, it is generally assumed that its risks are greater than that of
traditional education projects (Sachs, 2000), due to rapid technology evolu-
tion, low market entry barriers, the need for a change in the culture of the
institutions that offer traditional education and the behavior changes expect-
ed in the market. The greater risks and the significant managerial flexibili-
ties embedded in distance education information technology projects make
370 Freitas and Brandão

it difficult to create effective valuation models that can provide the decision
makers a more accurate assessment of the impact of investment and expect-
ed returns (Bartolic-Zlomislic & Bates, 1999; Bates, 1999; Cukier, 1997;
Massy, 2003; Rumble, 1997).
To deal with the issue of risk in the valuation of educational projects,
Hough (1993) suggests that the discount rate be adjusted upwards to com-
pensate for the increased market uncertainty which has the effect of reduc-
ing the value and the chances that the project will be accepted. A problem
with this approach is that in the context of rapid advances in information
technology, communication and internet applications to DE projects, an
accurate estimation of the required adjustment is difficult. In addition, this
static approach also fails to adequately account for the benefits of manage-
rial flexibility.
Oslington (2004) proposes the use of real options analysis to model and
value the decision making process, and uses a simple two-period model to
show the benefits of incorporating into the valuation model the option to
delay. Although his suggestion is an improvement over the traditional DCF
methods generally used in these types of projects (Rumble, 1997; Bartolic-
Zlomislic & Bates, 1999; Rumble, 2001), his analysis is limited in the sense
that he does not explore the full range of managerial flexibilities that may be
available.

e-learning project valuation

DCF Analysis and Assumptions

We illustrate the use of the real options method with an actual e-Learn-
ing project developed by a Higher Education Institution (HEI)3 in Brazil.
For this example we use the following assumptions:
Demand: The demand for Distance Education is still very uncertain.
However, studies by Sachs (2000) of the North-American market for sec-
ondary, higher and executive education and estimated a value of U$17.1 bil-
lion dollars for the e-Learning market in the year 2000, with the corporate
sector responsible for the major portion of this (US$10.4 billion). He esti-
mated an average yearly growth was of 30% for secondary education, 25%
for higher education and 40% for corporate education, which represents a
weighted average growth rate of 37% for this market.
INEP4 educational census data indicates that there is a lack of reli-
Real Options Valuation of e-Learning Projects 371

able information on the distance education market in Brazil. According to

the ABRAEAD Annual Report (ABRAEAD, 2006), from 2004 to 2005 the
number of institutions licensed to offer DL grew by 30.7% and there was
an increase of 62.6% in the number of enrolled students in Brazil, while
the annual growth rate of students enrolled in online university courses was
18.2%. This research, however, may underestimate the true market poten-
tial, since not all HEI programs were included in the report. On the other
hand, the e-Learning Brasil website (www.elearningbrasil.com.br) esti-
mates an annual rate of 40% in Distance Education for the Brazilian market
through 2010.
For the purposes of this article, we assume a compounded annual
growth rate of 30% for the demand for the first five years, and zero after-
wards. As is standard in the real options literature, we assume that the mar-
ket demand grows exponentially according to a Geometric Brownian sto-
chastic diffusion process.
Market Share: We assume that the HEI has the option to defer the im-
plementation of the project while it waits for addition information on the
market potential to be revealed. On the other hand, since entry barriers are
low (Sachs, 2000; Wilson, 2002), we consider this delay to be costly in
terms of loss of market share due to the entrance of new competitors into
the market, as illustrated in Figure 2. This is loss is assumed to be 15% per
year.
Market Demand

Loss due to decision to defer

t0 Defer t1 Invest t
Decision Decision

Figure 2. Market Share loss due to delaying investment

Project Life: We conservatively assume that the project has a five-year

life from the time of the decision to enter the market, and that the growth in
372 Freitas and Brandão

the market demand is limited to the first five years (t0 to t5), after which the
market will become mature and no further growth will occur. Hence, if the
HEI decides to defer the project for two years and enter the market in t2, it
will benefit from only three years of growth (t3, t4, t5) and two year of con-
stant cash flows (t6 and t7).
Cost of Capital and Risk Free Rate: The weighed average cost of capi-
tal (WACC) of the project is assumed to be 12% per year. The risk free rate
considering a yield of the Brazilian government bonds in 2007 of 11.5%
less a 4.5% annual inflation rate is 7%.
Initial Investment: The investment required for an e-Learning project
will depend on the scope of the project and the choice of technology that is
adopted. We considered a new executive education course customized for
the specific needs of a corporate client. The initial investment involving the
preparation of academic materials, course content and technological adapta-
tion and hardware is US$ 510,400.00 ( Table 2). The investment in materials
and content are sunk costs which are fully expensed, while the remaining
50% are linearly depreciated during a five year period

Table 2
Initial Investment for an e-Learning program in an HEI
Item US$
Material and Content 230,400.00
Synchronous communication tool 75,000.00
Course management Software 75,000.00
Hardware (Computers, servers and others) 30,000.00
Others 100,000.00
Total US$ 510,400.00

The project cash free cash flows can be expressed as a function

F = f ( S ) of the market demand for the course as shown in Equation :

Ft = Pt St (1 − VC ) − FC − Deprt )(1 − T ) + Deprt (2)

Real Options Valuation of e-Learning Projects 373

where: St: Market demand (# of students) in period t

Pt: Price in period t
VC: Project Variable Costs Rate
FC: Fixed Costs
Depr t: Depreciation in period t
T: Income tax rate

The initial demand (time zero) is 400 students, each paying the full cost
for the course of US$ 5,000.00, which we assume constant throughout the
life of the project. The income tax rate is 25%, and the variable costs, which
include the operational costs, represent 64.2% of the annual revenue, while
the administrative costs are assumed to be fixed. The expected project cash
flows and the DCF analysis is shown in table 3:

Table 3
DCF analysis of the project
Year: 0 1 2 3 4 5
Price = 5,000 5,000 5,000 5,000 5,000 5,000
No. Students = 400 520 676 879 1,142 1,485
Growth Rate = 30% a.a.

Revenues 2,600,000 3,380,000 4,394,000 5,712,200 7,425,860

Operating Expenses
Academic Personnel (1,576,027) (2,048,835) (2,663,486) (3,462,531) (4,501,291)
Other Expenses (93,600) (121,680) (158,184) (205,639) (267,331)
(1,669,627) (2,170,515) (2,821,670) (3,668,171) (4,768,622)
Admin Expenses
Personnel (604,925) (604,925) (604,925) (604,925) (604,925)
Other Expenses (756,355) (756,355) (756,355) (756,355) (756,355)
(1,361,280) (1,361,280) (1,361,280) (1,361,280) (1,361,280)

Depreciation (51,040) (51,040) (51,040) (51,040) (51,040)

Operating Income (481,947) (202,835) 160,010 631,709 1,244,918

Taxes 120,487 50,709 (40,003) (157,927) (311,230)

Net Income (361,460) (152,126) 120,008 473,782 933,689

Depreciation 51,040 51,040 51,040 51,040 51,040

Free Cash Flow -510,400 (310,420) (101,086) 171,048 524,822 984,729

PV = 656,297 IRR = 16.5%

CAPEX = (510,400) WACC = 12.0%
NPV = 145,897
374 Freitas and Brandão

Real Option Analysis

To value the project under the real options approach we used the dis-
crete binomial model of Cox, Ross and Rubinstein (1979) (CRR). Copeland
& Antikarov (2001) suggest the use of the project value as the underlying
asset over which the options will be exercised, where the parameters re-
quired for the stochastic modeling of the project value are determined from
the application of simulation methods to the dynamic project cash flow. In
our e-Learning example, on the other hand, the underlying asset is the de-
mand for the e-Learning services, since the exercise of the option to defer
the investment will depend on the evolution of the market demand for stu-
dents, rather than the project value.
Accordingly, we model the evolution of student demand as a dif-
fusion process that follows a Geometric Brownian Motion in the form of
dS = µ Sdt + σ Sdz , where μ is the expected growth rate for student de-
mand σ is the demand volatility and dz = ε dt ε ≈ N (0,1) is the stan-
dard Wiener increment. As defined previously, we assume that the annual
growth rate μ is of 30%. The volatility may be determined from historical
time series data of student enrollment, either at the HEI level or regional
and national aggregate data. For the purposes of this article we assume a
volatility (σ) of 30%.
Option pricing methods require the use of neutral risk analysis, where
the risk premium λ is deducted from the market rate of return of the underly-
ing asset, which allows the resulting project cash flows to be discounted at
the risk free rate. The lower drift rate in the diffusion process of the underly-
ing asset compensates for the lower cash flow discount rate, so that in the
absence of options, the results from the traditional DCF and the risk neu-
tral analysis are rigorously the same. Accordingly, the risk neutral process
for the student demand is dS R = ( µ − λ ) S R dt + σ S R dz , where SR is the risk
neutral stochastic demand for students.
For market-traded assets, the risk premium can be observed direct-
ly or determined by means of the CAPM model, where µ = r + λ and
λ = β ( E[ Rm] − r ) . For these assets, the use of the risk neutral analysis is
equivalent to adopting the risk free risk rate r for the asset, since µ − λ = r
. On the other hand, for assets that are not traded in the market such as the
demand for students, we must instead use indirect methods to determine
their risk premium.
One way to determine the risk premium of the student demand is based
on the fact that the expected value of the DCF analysis of the project un-
Real Options Valuation of e-Learning Projects 375

der the true diffusion process, and the expected value of the risk neutral ap-
proach under the risk neutral process must be the same for a project with no
options. Hence we have:
 n f (S )   n f (SR ) 
E ∑ i 
= E  ∑ i 
(3)
 i =1 (1 + µ )   i =1 (1 + µ − λ ) 
Where dS = µ Sdt + σ Sdz is the true process for the demand for students,
dS R = ( µ − λ ) S R dt + σ S R dz is the risk neutral process for the demand
for students,
λ is the risk premium of S and
f (.) are the project cash flows

Considering that all the remaining variables in Equation (3) are known,
the value for λ can be determined with the use of the “Goal Seek” tool in
the risk neutral project cash flow Excel spreadsheet in Excel by setting the
expected value of this spreadsheet to the value of the DCF analysis. In this
case a value of λ = 1.624% is obtained, as shown in table 4.

Table 4
Risk Neutral Analysis of Project
Year: 0 1 2 3 4 5
Price = 5,000 5,000 5,000 5,000 5,000 5,000
No. Students = 400 514 659 846 1,086 1,395
Growth Rate = 28.376% a.a.

Revenues 2,567,513 3,296,062 4,231,342 5,432,014 6,973,384

Operating Expenses
Academic Personnel (1,556,335) (1,997,955) (2,564,888) (3,292,693) (4,227,016)
Other Expenses (92,430) (118,658) (152,328) (195,553) (251,042)
(1,648,765) (2,116,613) (2,717,217) (3,488,245) (4,478,058)
Admin Expenses
Personnel (604,925) (604,925) (604,925) (604,925) (604,925)
Other Expenses (756,355) (756,355) (756,355) (756,355) (756,355)
(1,361,280) (1,361,280) (1,361,280) (1,361,280) (1,361,280)

Depreciation (51,040) (51,040) (51,040) (51,040) (51,040)

Operating Income (493,572) (232,871) 101,805 531,449 1,083,006

Taxes 123,393 58,218 (25,451) (132,862) (270,752)

Net Income (370,179) (174,653) 76,354 398,586 812,255

Depreciation 51,040 51,040 51,040 51,040 51,040

Free Cash Flow (510,400) (319,139) (123,613) 127,394 449,626 863,295

PV = 656,297 Risk Premium = 1.624%

CAPEX = (510,400) r= 7.0%
NPV = 145,897
376 Freitas and Brandão

Once we have determined the risk premium of the market demand for
students, we model the stochastic evolution of this variable with a discrete
binomial lattice using DPL decision tree software (Figure 3)5. For each pos-
sible future state of this variable there will be a corresponding project cash
flow determined from Equation , where S represents the market demand for
students in the year i and in state j, i = 1, 2, ..., 5, j = 1, ..., i, and the expres-
sion in the branches of the decision tree represent the project cash flows as
specified in Equation . The binomial tree generated by the DPL software is
illustrated in Figure 4, where the expected value for the project cash flows
are discounted at the risk free rate to obtain the original DCF project value
of US$ 656.297,00, or a NPV of US$ 145.897,00 after deducting the invest-
ment cost.

S1 S2
up up
((S1*Price*(1-VC)-FC-Depr)*(1-T)+Depr)/(1+r) ((S2*Price*(1-VC)-FC-Depr)*(1-T)+Depr)/(1+r)^2 a
down down
((S1*Price*(1-VC)-FC-Depr)*(1-T)+Depr)/(1+r) ((S2*Price*(1-VC)-FC-Depr)*(1-T)+Depr)/(1+r)^2

S3 S4
up up
((S3*Price*(1-VC)-FC-Depr)*(1-T)+Depr)/(1+r)^3
a ((S4*Price*(1-VC)-FC-Depr)*(1-T)+Depr)/(1+r)^4 b
down down
((S3*Price*(1-VC)-FC-Depr)*(1-T)+Depr)/(1+r)^3 ((S4*Price*(1-VC)-FC-Depr)*(1-T)+Depr)/(1+r)^4

S5
up
((S5*Price*(1-VC)-FC-Depr)*(1-T)+Depr)/(1+r)^5
b down
((S5*Price*(1-VC)-FC-Depr)*(1-T)+Depr)/(1+r)^5

Figure 3. Basic Project Binomial Model

Results

We have adopted the assumption that there is a loss of market share of

15% for each year that the project is deferred. If the project is deferred for
one year, it will still have a life of five years, but there is no growth from the
fifth calendar year (t5) onwards, such that t6 = t5. The first three years of this
model are illustrated in Figure 6. We can observe that the option to defer the
project for one year increases its NPV to US$ 427,784.00. In this case, it is
always optimal to delay the project since the value of the deferment option
is significant, adding US$ 281,887.00 to the value of the project without the
option to defer. This increase is due to the fact that the total increase of the
Real Options Valuation of e-Learning Projects 377

market in the first year, which grows 30% annually, more than compensates
for the loss of market share and growth in the last year.

S4
up [1319.483]
S3 89% 254.686
up [1127.428]
89% -26.353 S4
down [-450.038]
S2 11% -231.550
up [902.946]
89% -265.101 S4
up [-835.465]
S3 89% -231.550
down [-940.867]
11% -411.780 S4
down [-1806.599]
S1 11% -498.401
[656.298]
S4
up [-1140.984]
S3 89% -231.550
up [-1246.385]
89% -411.780 S4
down [-2112.117]
S2 11% -498.401
down [-1369.584]
11% -570.620 S4
up [-2323.644]
S3 89% -498.401
down [-2381.490]
11% -623.306 S4
down [-2856.614]
11% -644.853

Figure 4. Basic Project Decision Tree

S1 S2 S3

up up up
No ((S1*Price*(1-VC)-FC-Depr)*(1-T)+Depr)/(1+r) ((S2*Price*(1-VC)-FC-Depr)*(1-T)+Depr)/(1+r)^2 ((S3*Price*(1-VC)-FC-Depr)*(1-T)+Depr)/(1+r)^3
-510400 down down down
((S1*Price*(1-VC)-FC-Depr)*(1-T)+Depr)/(1+r) ((S2*Price*(1-VC)-FC-Depr)*(1-T)+Depr)/(1+r)^2 ((S3*Price*(1-VC)-FC-Depr)*(1-T)+Depr)/(1+r)^3

Defer0 Defer1 S2 S3
S1 up up
No ((S2*Price*MKT*(1-VC)-FC-Depr)*(1-T)+Depr)/(1+r)^2 ((S3*Price*MKT*(1-VC)-FC-Depr)*(1-T)+Depr)/(1+r)^3
-510400/(1+r) down down
up
Yes ((S2*Price*MKT*(1-VC)-FC-Depr)*(1-T)+Depr)/(1+r)^2 ((S3*Price*MKT*(1-VC)-FC-Depr)*(1-T)+Depr)/(1+r)^3
down
Yes
0

Figure 5. Model with Delay Option of one year.

378 Freitas and Brandão

S3
up [617.028]
S2 89% -26.353
up [392.546]
89% -265.101 S3
down [-1451.267]
S1 11% -411.780
No [145.898]
-510.400 S3
up [-1756.785]
S2 89% -411.780
down [-1879.984]
11% -570.620 S3
Defer0 down [-2891.890]
[427.784]
11% -623.306
S2
Defer1 No [479.866]
up [479.866] -477.009
89% Yes [0.000]
S1 0.000
Yes [427.784]
S2
Defer1 No [-1694.978]
down [0.000] -477.009
11% Yes [0.000]
0.000

Figure 6. Project Value with option to delay for one year.

We next extended the model to allow deferral for up to three years,
where we continued to assume a 15% loss of market for each year
the project is deferred. This American type option provides a NPV of
US$ 449,455.00, which indicates that there is a positive probability that the
option to defer will be exercised beyond the first year, since the result is
greater than the one obtained for the one-year deferral case. In fact, we can
observe in Figure 7 that it is never optimal to invest in years 0 and 1, and
that 79% of the time the option will be exercised in year 2. If the project is
not implemented before year 3, which occurs 21% of the time, it will nev-
er be executed. Because the penalties of loss of market share and reduced
growth increase with time, it is never optimal to invest in the later years.
Finally, we also analyzed the sensitivity of the project relative to the
volatility parameter and the market share loss factor. The results indicated
that the project is quite sensitive to changes in the volatility of demand for
students; a mere 5% variation in volatility increases the project value by ap-
proximately US$ 200,000.00, and higher volatilities, which represent great-
er uncertainty in the future demand for students, increase the value of defer-
ring project start even more significantly, as illustrated in Figure 8.
Real Options Valuation of e-Learning Projects 379

Defer0 Defer1

No No
0% 0%
Yes Yes
100% 100%
(does not occur) (does not occur)
0% 0%

Defer2 Defer3
No No
79% 0%
Yes Yes
21% 21%
(does not occur) (does not occur)
0% 79%

Figure 7. Probability of option exercise.

1200000

1000000

800000
Project Value

600000

400000

200000

0.25 0.3 0.35 0.4 0.45 0.5

Volatility

Figure 8. Sensitivity to Volatility.

The variation in the market loss factor is nonlinear in nature due to

the more complex nature of option exercise relative to simple linear payoff
functions where no decision-making is modeled. We can see that in the case
of zero market loss (market = 100%), the project value is extremely high,
as waiting to invest until the last moment allows time to observe the evolu-
tion of the e-Learning market with no penalty for the investment delay. This
380 Freitas and Brandão

value is reduced as the loss factor increases until the annual loss is so great
that any delay on investment is suboptimal and the value of a project reverts
to the static DCF value. The breakeven point, above which the project value
reaches its minimum value of US$145,898.00, is 20% (market = 80%), as
illustrated in Figure 9.
3000000

2500000

2000000
Project Value

1500000

1000000

500000

0.7 0.75 0.8 0.85 0.9 0.95 1

Market Share Loss Factor

Figure 9. Sensitivity to the Market Share Loss Factor.

ConClusion

Many Higher Education Institutions (HEI) began developing Distance

Education programs in the early 90’s, particularly in e-Learning models
which have been gaining widespread acceptance as an alternative to meet
the growing demand for education (Howell, Williams & Lindsay, 2003). In
Brazil, distance education programs have been authorized by the Govern-
ment since 19966, which has helped create a market with many opportuni-
ties for the entry of HEI into this market. Due to this continually changing
landscape, the accurate assessment of Distance Education opportunities for
HEI has become increasingly important.
Real Options Valuation of e-Learning Projects 381

In this article we analyzed the problem of valuing an e-Learning proj-

ect under uncertainty where there are significant managerial flexibilities,
and we showed that traditional valuation methods do not capture the value
that can be derived from optimal decision-making. We propose a real op-
tions model that takes into consideration the typical characteristics of these
types of projects, and applied this model to a practical case of a Distance
Education program where project implementation can be deferred for up to
three years. In this model, we accounted for the fact that HEI would incur
a loss of market share if it decides to defer the project, due to the entry of
new competitors into this market. Relative to typical cases in the standard
real options literature, we more accurately model the exercise of the options
modeling an operating variable as the underlying asset; namely, the demand
for students that the HEI can expect to attract. This is in contrast to using
the aggregate value of the project as the underlying asset. To the best of our
knowledge, this contribution is original. Given that the demand for students
is not a market variable, we show how the risk premium required for the
real options valuation can be determined in this case.
The results obtained show that the flexibility to defer the entry into this
market increases the project NPV significantly, from US$ 145,879.00 to
US$ 427,784.00, as it allows the HEI to maximize its return by only making
the investment after market uncertainties are resolved. The sensitivity analy-
sis indicates that the project is affected not only by variations in the volatil-
ity of demand, but also in the market loss factor. This real options approach
shows that the use of a method that captures the value of these embedded
options allows managers to make the optimal decisions given the market
conditions.
A few important notes should be made concerning the results of this
model. The sensitivity analysis shows that the project value is strongly af-
fected by changes in some of the input parameters; however, the estimation
of those parameters, such as the stochastic behavior of a new market or the
impact of new competitors, is not a trivial task. Therefore, even though a
real option model provides a more accurate depiction of actual operating
conditions, relative to DCF methods, the values from the model should not
be interpreted as the sole determinant of project feasibility, but rather as an
indication of the value and the relevant factors in the decision making pro-
cess. Thus, project valuation with the real options method should be used in
combination with the sensitivity analysis to provide insight into investment
decisions and the associated value for HEI.
382 Freitas and Brandão

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