Tanoy kumar Dutta

Roll :27
Beyond NPV ………………………………… Real option

Traditional DCF
Management's flexibility not
captured
adapt
revise decisions

Real world
Change
Uncertainty
Competitive interactions
 Real option

EXAMPLE : Airtel DTH Service

Let’s take an example from India’s DTH (Direct To Home)
Industry,particularly Airtel DTH services. Most of the DTH service
provider unable to break even, since the market is still in
introduction stage. As a result, let assume the Airtel DTH service
has a negative NPV of Rs 3 million.

Now there is a fair possibility that within next two year market
volume of DTH service will expand significantly. However the
opportunity to accommodate this higher level of demand will not
be available unless a first stage investment is made now.

Let’s assume there is a fifty – fifty chance that the market

will be much larger in two years. If it is, the NPV of the
second stage investment (expansion) at the end of two
year will be Rs 15million.
 Real option

When this value is discounted to the present at the

required rate of return, the NPV at time ‘0’ is 11 million. If the
market falters over the next twoyears, the company will not
invest further, and the incremental NPV at the end of year 2, by
definition, is zero. The situation is depicted in the following way.

The mean of the distribution of possible NPVs associated with the option is:
(0.5) * 11 million + (0.5) * 0 = 5.5 million.
Using Eq. 1 we determine the project’s worth as follows:
Project Worth = (-) 3 + 5.5 = Rs 2.5 million.

Conclusion: Although our initial view of the project revealed a negative NPV
we find the option to expand more than offsets the negative NPV. Because
the project embraces a valuable option, it should be accepted.
 Real option

WHAT IS REAL OPTION?

Real options are those strategic elements in investments that
help creating flexibility Of operations , or that have the
potential
of generating profitable opportunities in the future for the firm.
Real options exist when managers can influence the size and
risk of a project’s cash flows by taking different actions during
the project’s life in response to changing market conditions.

Real options provide discretion to managers to take certain

investment decisions, without any obligation, for a given price.
Alert managers always look for real options in projects. Smarter
managers try to create real options.
 Real option

How real options differ from financial options?

Financial options have an underlying asset that is traded—usually a

security like a stock.

A real option has an underlying asset that is not a security--for example

a project or a growth opportunity, and it isn’t traded.
.

The payoffs for financial options are specified in the contract.

Real options are “found” or created inside of projects. Their payoffs can
be varied.
 Real option

TYPES OF REAL OPTIONS:

1. Option to Expand (or Contract): An important
Option is one that allows the firm to expand production if
conditions become favorable and to contract production if
conditions become unfavorable.

2. Options to Postpone: For some projects there is the

Option to waitand thereby to obtain new information.

3. Option to Abandon: If a project has abandonment

value, this effectively represents a put option to the project’s
owner.
 Real option

FIVE PROCEDURES FOR VALUING REAL OPTIONS:

2. DCF analysis of expected cash flows, ignoring the

option.

2. Qualitative assessment of the real option’s value.

3. Decision tree analysis.

4. Standard model for a corresponding financial
option.

5. Financial engineering techniques.

 Real option

Alternative use of Real option

Valuation of natural resources : In a natural resource

investment the underlying price is the natural resource and the
exercise price is the cost of development.
Example : oil reserve valuation, Coal reserve valuation.

Valuation of R&D project : an R&D project involve stages

of investments ( which depend on the outcomes in previous stages)
and hence is eminently suitable for real options analysis.
 Real option

Valuing an oil Reserve

ONG, an oil major, is assessing the value of the option to extract oil
From a particular oil basin. The following information has been
gathered:

The estimated oil reserve in the basin is 100 million barrels of oil.
The development cost is $1 billion.
The right to exploit the basin will be enjoyed for 25 years.
The marginal value per barrel of oil presently is $20 i.e.profit =R-C
Once developed, the net production revenue each year will be 4%
of the value of the reserve.
The risk-free rate is 8%.
The development lag is two years.
 Real option

Valuation. . . . . . . . . .
Given the preceding information, the inputs to the Black-Scholes
formula can be estimated as follows:

S0 = current value of the asset = value of the developed reserve

discounted back for two years
(the development lag) at the dividend yield =$1849.11 million.

E = exercise price = development cost = $1000 million. This is

assumed to be fixed over time.
σ =standard deviation of the ln (oil price)= 0.2
t = life of the option = 25 years
r = risk-free rate = 8 percent
y =dividend yield = net production revenue/value of reserve = 4%
 Real option

Given these inputs, the call option is valued as follows:

Step 1:Calculate d1 and d2

d1 ={ln(1849.11/1000)+[.08-.04+(.04/2)]25}÷0.2√25
=0.6147 + 1.5 = 2.1147

d2 =d1 - σ √t
=2.1147 – 1.000 = 1.1147

Step 2:Find N(d1) and N(d2)

N(d1) = N(2.1147) = 0.9828

N(d2) = N(1.1147) = 0.8675
 Real option

Step 3 : Estimate the present value of the exercise price

E/e rt
= 1000/e.08*25 = $135.33 million

Step 4 :Plug the numbers obtained in the previous steps in the

Black-Scholes model

C0 = S0 N(d1) – E / e rt
N (d2)

C0 = $1849.11 million × 0.9828 - $135.33 million × 0.8675

= $1699.91 million
 Real option

Conclusion:
The managerial options discussed -- expansion, abandonment,
and postponement – have a common thread. Because they limit
downside outcomes, the greater the uncertainty associated with
future the more valuable these options become. Recognition of
management flexibility can alter an initial decision to accept or
reject a project.

A decision to reject arrived at using at traditional DCF method

can be reversed if the option value is high enough. A decision to
accept can be turned into a decision to postpone if the option
value more than offsets that of missing out an early cash flow.
Though a DCF approach to determining NPV is an appropriate
starting point, in many cases this approach needs to be
modified to allow for managerial (real) options.