Real Options

Topics Covered
The Value of Follow-On Investment
Opportunities
The Timing Option
The Abandonment Option

Corporate Options
3 types of Real Options
1 - The opportunity to expand and make follow-up
investments.
2 - The opportunity to wait and invest later.
3 - The opportunity to shrink or abandon a project.
Value Real Option = NPV with option
- NPV w/o option

Micro computers case (1982)

You are Asst. to CFO, Micro Computers. You are helping
him evaluate proposed introduction of Mark I chip.
DCF analysis is given below. NPV at hurdle rate is
$(46) Mn. (Accept/Reject).. You say For Strategic
reasons LAUNCH You have to prove to CFO
regarding MARK-Is value as an option..
(i) Decision to invest in Mark II after 3 years.
(ii) Mark II investment will be double that of Mark I
(iii) PVCF $807 in 85 means 807/(1.2)2 = $467 in 82
(Given below).
(iv) Sigma=35% and risk free rate is 10%

Microcomputer Forecasts
Example Mark I Microcomputer ($ millions)

Microcomputer Forecasts
Example Mark II Microcomputer ($ millions)
Forecasted cash flows from 1982

NPV(1982) =PV(inflows) -PV(investment)

= 467 676
= - $209 million

Microcomputer Forecasts
Example Mark II Microcomputer

PV (exercise price)

900
676
3
1.1

OC N ( d1 ) P N ( d 2 ) PV ( EX )

d1

log[ S / X ] (r

)T

2
(35%)
log(467 / 676) (10%
)3
2

0.1879
35% 3

d 2 d1 t .4184
N (d1 ) .574508

N ( d 2 ) .337844

Call Value [0.574508 467} [0.337844 676] $99.11million

Microcomputer Forecasts
Example Mark II Microcomputer (1985)
Distribution of possible Present Values
Probability

Present value in 1985

Expected value

Required investment

($807)

($900)

Option to Wait
Intrinsic Value
Option
Price

Stock Price

Option to Wait
Intrinsic Value + Time Premium = Option Value
Time Premium = Vale of being able to wait
Option
Price

Stock Price

Option to Wait
More time = More value

Option
Price

Stock Price

Option to Wait
If you commit an investment worth $ 180Mn, you have a
project worth $ 200 Mn immediately. If the demand
turns out to be low in yr. 1, the cash flow will be $ 16
Mn and the value of the project will fall to $ 160 Mn.
But if the demand is high in year 1, the cash flow is $
25 Mn. And the value rises to $250 Mn. Should you
invest immediately or wait. Use the risk free rate of
5%.
Note: If you undertake the investment right away, you
capture the first years cash flow ($16 or $25). If you
delay you miss out on this.

Option to Abandon
Example - Abandon
Mrs. Mulla gives you a non-retractable offer to buy your
company for $150 mil at anytime within the next year.
Given the following decision tree of possible outcomes,
what is the value of the offer (i.e. the put option) and
what is the most Mrs. Mulla could charge for the option?
Use a discount rate of 10%

Option to Abandon
Example - Abandon
Mrs. Mulla gives you a non-retractable offer to buy your company for
$150 mil at anytime within the next year. Given the following decision
tree of possible outcomes, what is the value of the offer (i.e. the put
option) and what is the most Mrs. Mulla could charge for the option?

Year 0

Year 1

Year 2
120 (.6)

100 (.6)
90 (.4)
NPV = 145
70 (.6)
50 (.4)
40 (.4)

Option to Abandon
Example - Abandon
Mrs. Mulla gives you a non-retractable offer to buy your company for
$150 mil at anytime within the next year. Given the following decision
tree of possible outcomes, what is the value of the offer (i.e. the put
option) and what is the most Mrs. Mulla could charge for the option?

Year 0

Year 1

Year 2
120 (.6)

100 (.6)
90 (.4)
NPV = 162

Option Value =
150 (.4)

162 - 145 =
$17 mil

Option to Abandon
Dawn East, the chief financial officer of Maine Subductor
Corp., has to decide whether to start production of
zircon subductors. The investment required is $12 Mn.
$ 2 Mn. For roads and site preparation and $10 Mn.
For the equipment. To operate the equipment it costs
$ 0.7 Mn. p.a. (a fixed cost). The expected life of the
project is 10 years and the depreciation of the
machine is done following WDV method @ 10% p.a.
The revenue at todays prices is $1.7 Mn and shall
grow @ 9% p.a. Also, the S.D. of earnings is 14%.
The risk free rate is assumed to be 6% p.a.

Option to Abandon
Example Ms. East Value
u e T e0.14*1 1.15
1
d 0.87
u
Expected return 0.15* p 0.13*(1 p) .06
Prob of up change 0.6791
Prob of down change 0.3209

Option to Abandon
Example Ms. East - Revenues
2.25
1.96
1.7

1.7

1.48
1.29

Option to Abandon
Example Ms. East Cash Flows
1.55
1.26
1.0

1.0

0.78
0.59