Real Options

Decision Tree Analysis

Decisions and uncertainty resolution Assume you purchase goods on eBay and resell them in Sunday market. y
You are charged $500 by market in advance to set up your booth. Ignoring the cost of the booth, your average profit is $1100 per week. NPV of setting up a booth is $600 and is optimal
$1100 - $500 = $600
Go to market Stay home

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Mapping Uncertainties on a Decision Tree

Market attendance is weather dependent. In good weather you profits $1500, bad weather you lose $100. There is a 25% chance of bad weather.
Sunshine (75%) $1500

Go to market

-$500

Rain (25%) -$100

Stay home

You pay for the booth in advance, regardless of weather, however you can stay home if weather is bad and save $100.

Real Options
Option to wait until you find out what the weather is like before you decide to go to market is a real option. Assume you are weather risk neutral.
The value of the real option is computed as the difference between exp. profit without real option to wait until the weather is revealed to the value with the option to wait.

If you decide to go to market regardless:

0.75 $1500 + 0.25 ($100) = $1100

If you go when weather is good:

$ $ 0.75 $1500 + 0.25 $0 = $ $1125 Option value = $1125 -$1100 = $25

If you pay for the booth the day before, (Saturday) NPV = $1125 $500 = $625 (always pay for booth)
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 Corporations face similar options.

The option to delay, the option to grow, or abandon.

Real Options

In the example, once you pay for the booth example booth, there is no cost to wait, in the real world, there is often a cost to delay. By choosing to wait, a firm gives up any profits the project might generate. addition In addition, a competitor could use the delay to develop a competing product.
The decision involves a trade-off between these costs and the benefit of remaining flexible.
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Investment as a Call Option

Assume you have negotiated a deal with a dining chain to open one in your hometown.
di to th t t t th A According t the contract you must open the restaurant either immediately or in exactly one year.
If you do neither, you lose the right to open restaurant.

How much you should pay for this opportunity? Cost to open now or in a year is 5m, capital cost 12%. If you open the restaurant immediately, you expect it to generate $600,000 in free cash flow first year.
Future cash flows are expected to grow 2% per year.
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Restaurant Investment Opportunity

How much you should pay for this opportunity? The value of opening restaurant today is:

V=

$600,000 = $6m, with NPV = $6m - $5m = $1m 12% - 2%

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Investment as a Call Option

Given the flexibility you have to delay opening for one year, what should you be willing to pay? When should you open the restaurant? Payoff if you delay is equivalent to payoff of one-year Eup. call on with a strike price of $5m.
Assume:
The risk-free interest rate is 5%, volatility is 40%. If you wait to open the restaurant you have an opportunity cost of $600 000 (FCF in the first year). t f $600,000 i th fi t )
In terms of a financial option, the FCF is equivalent to a dividend paid by a stock. The holder of a call option does not receive the dividend until the option is exercised.

Use B-S model to evaluate this real option.

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Investment as a Call Option

The current value of the asset without the dividends that will be missed is: $ $0.6 million Sx = S - PV(Div) = $6 million = $5 46 million $5.46 1.12 The present value of the cost to open the restaurant in one year is: 5/1.05 = $4.76
d1 = ln[Sx / PV(K)] T ln(5.46 / 4.76) + = + 0.20 = 0.543 2 0.40 T

d2 = d1 - T = 0.543 - 0.40 = 0.143

C = S x N(d1 ) - PV(K)N(d2 ) = ($5.46 million) (0.706) - ($4.76 million) (0.557) = $1.20 million
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Investment as a Call Option

The value today from waiting to invest in the restaurant next year (and only opening it if it is profitable to do so) is $1.20 million.
This exceeds the NPV of $1 million from opening the restaurant today. Thus, you are better off waiting to invest, and the value of the contract is $1.20m.

Whether it is optimal to invest today or in one year will d the ill depend on th magnitude of any d it d f lost profits from the first year, compared to the benefit of preserving your right to change your decision.
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 Assume StartUp Inc is a new company whose only asset is a patent on a new medicine.
If produced, the medicine will generate certain p g profits of $ million per year for 17 years (after $1 then, competition will drive profits to zero). It will cost $10 million today to produce . Yield on a 17-year risk-free annuity is 8% per year.

Valuing the Growth Potential of a Firm

u ( V) f W What is the value (NPV) of the p patent?

NPV =
Given todays interest rates, it does not make sense to invest in the medicine today.
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1m 1 1 0.08 1.0817

- 10m = - $878,362

Valuing the Growth Potential of a Firm

Lets use binomial model and risk-neutral probabiliy to solve this problem. b bili h h l f financial i l Th probability that set the value of a fi The asset today equal to the PV of its future cash flows at risk free rate. Todays value of a 17-year risk-free annuity p y $ p y that pays $1000 per year is:
S = 10 0 0 1 = $ 9 12 2 1 17 0 .0 8 1 .0 8
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Valuing the Growth Potential of a Firm

If interest rates rise to 10%, or fall to 5% in one year, the value of the annuity will be:

Su = 1000 +

10 00 1 1 = $ 11, 8 38 0 .0 5 1 .0 5 1 6 To calculate risk-neutral prob. of interest rate change, exp. , we still need to know the risk free exp return of the annuity, which is assumed to be 6%. Sd = 1 0 0 0 +

1000 1 1 - 16 = $8824 0.1 1.1

(1 + rf )S - Sd 1.06 9122 - 11, 838 = = 71.95% Su - Sd 8824 - 11, 838

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Valuing the Growth Potential of a Firm

The value today of the investment opportunity is the present value of the expected cash flows (using riskl b bl ) discounted at the risk-free d h k f neutral probabilities) d rate:

PV =

837, 770 (1 - 0.7195) + 0 0.7195 = $221, 693 1.06

In this example, even though the cash flows of the example project are known with certainty, the uncertainty regarding future interest rates creates substantial option value for the firm.
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The Option to Expand

An investment opportunity with an option to grow requires a $10 million investment today.
In one year you will find out whether the project is successful.
The risk neutral probability that the project will generate $1 million per year in perpetuity is 50%, otherwise, the project will generate nothing.
At any time we can double the size of the project on the original terms.

By investing today, the exp. annual cash flows are $0.5m (ignoring option to double the size)
$1 million 0.5 = $500,000
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The Option to Expand

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The Option to Expand

Computing the NPV gives:

NPV h growth option = without h

500,000 - 10 000 000 = - $1.667 million 10,000,000 $1 667 0.06

Now consider undertaking the project and exercising the growth option to double the size in a year.
The NPV of doubling the size of the project in a year is:

NPVdoubling after a year =

1,000,000 - 10,000,000 = $6.667 million 0.06

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The Option to Expand

The risk-neutral prob. of this state is 50%, so the exp. value of this growth option is 6.667 0.5 = $3.333m

PVgrow th option =

3 .3 3 3 3 = $ 3 .14 5 m illio n 1.0 6

Total NPV of this investment is the NPV without option, plus the value of growth option:

NPV = NPVwithout growth option + PVgrowth option

= - 1.667 + 3.145 = $1 478 million 1 667 3 145 $1.478 illi

It is optimal to undertake the investment today, only because of the future expansion option.
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The Option to Shutdown

Assume you are the manager of a souvenir store, considering opening a new branch in R k Rocks.
If you do not sign the lease on the store today, someone else will, so you will not have the opportunity to open a store later. There is a clause in the lease that allows you to break the lease at no cost in two years. b k th l s t st i t s Including the lease payments, the new store will cost $10,000 per month to operate.
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The Option to Shutdown

Because the building has just reopened, you do not know what the pedestrian traffic will be.
If your customers are limited to commuters, you expect to generate $8000 per month in revenue in perpetuity. If, however, the area becomes a tourist attraction, you expect to generate $16000 per month in perpetuity.

There is a 50% probability that area become a tourist attraction. attraction The costs to set up the store will be $400,000. Risk-free = 7% per year (or 0.565% per month).
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The Option to Shutdown

The number of tourists visiting Rocks represent uncertainty. Since this is the kind of i l l di if uncertainty you can costlessly diversify away, the appropriate cost of capital is the risk-free rate. If you were forced to operate the store under all circumstances, the expected revenue will be $12000. $12000
$8000 0.5 + $16,000 0.5 = $12,000 12, 000 10, 000 NPV = - 400, 000 = - $46, 018 0.00565 0.00565
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The Option to Shutdown

In reality, you would not have to keep operating the store. You have an option to get out of the lease after two years at no cost cost.
After the store is open, it will be immediately obvious whether the area is a tourist attraction. The decision tree is shown on the next slide.

If the Rocks is a tourist attraction, the NPV of the investment opportunity is:
NPV = 16, 000 10, 000 - 400, 000 = $661,947 0.00565 0.00565
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The Decision Tree

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The Option to Shutdown

If the area does not become a tourist attraction, you will close the store after two years with NPV of the investment opportunity: opportunity
NPV = = - $444,770

8000 1 1 10,000 1 1 - 400,000 0.00565 1.0056524 0.00565 1.0056524

The NPV of opening the store is (equal Prob.): $ 6 6 1, 94 7 0 .5 - $ 44 4, 7 7 0 0 .5 = $ 10 8 , 5 8 9

By exercising the option to abandon the venture, you limit your losses and the NPV of investment becomes positive.

Option value = $108,589 (46,018) = $154,607

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The Option to Prepay

An important real world abandonment option is the option to prepay or refinance a mortgage. Prepayment option
An abandonment option that allows mortgage holders to pay off a mortgage before the end of the scheduled term.

Refinance
Repaying an existing loan, and taking out a new loan at a lower rate.

Mortgage interest rates are higher than Treasury rates because mortgages have the abandonment options of prepayment and refinancing .
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The Option to Prepay Corporate bonds also often contain embedded abandonment options. p
The issuing firm may issue callable bonds, bonds that have an option that allows the issuer to repurchase (or call) the bonds at a predetermined price (usually at face value).

Convertible bonds are corporate bonds that give the holders the option to convert the bond into equity.
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Deciding Between Mutually Exclusive Investments of Different Lengths

An engineering firm was asked to design a new machine for use in production.
The firm has produced two designs
The cheaper design cost is $10m, last five years. More expensive design cost is $17m and last 10 years. In both cases, the machines are expected to save the company $3 million per year.

10%, If the cost of capital is 10% which design should be approved?

N PV = 3 1 1 - 1 0 = $ 1 .3 7 m illio n 0 .1 1 .1 5

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NPV of Each Design

The NPV of adopting the longer-lived design is:

N PV =

If the cost of the machine in the shorter-lived design will either increase by 3% or decrease by 3% and that the risk-neutral prob. of each state is 50%. What is the optimal decision? machine, If costs rise, company will not replace the machine rise but will use the original technology instead. If costs fall, then the machine will cost $8.9 million.
10 (1 0.03)5 = $8.59
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3 1 14 1 - 17 = $ 1.4 3 m illion 0 .1 1.1 10

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NPV if Future Costs Are Uncertain

At that point, the NPV of replacing the machine is:
NPV = 3 1 1 - 5 - 8.59 = $2.78 million 0.1 1.1

The NPV of adopting the five-year design is g therefore the NPV of using the machine for five years plus the NPV of optimally replacing the machine in five years, as shown in the following decision tree:
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NPV if Future Costs Are Uncertain

NPV = 1.37 +

0.50 2.78 = $2.23 million 1.15

NPV of adopting the five-year design and optimally replacing it in five years exceeds the NPV of adopting the ten-year design, so the five-year design is the superior investment.

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Equivalent Annual Benefit (EAB) Method

NPV of shorter-lived design is $1.37 million.
Let x be the equivalent annual benefit. L t th qu a nt annua n f t. The present value of the equivalent annual benefit each year equals the NPV today. The EAB of the shorter-lived design is given by:
1.37 1 37 = x 1 1 - 5 0.1 1.1 1.37 0.1 x= = $0.361 million 1 1- 5 1.1
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EAB Method
Repeating the process for the longer-lived design gives: g g
1.43 = x 1 1 - 10 0.1 1.1 1.43 0.1 x= = $0.233 million 1 1 - 10 1.1

Based on EAB method, the analyst should select the shorter-lived design.

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