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Real Options Advance Valuation Techniques What is an Option? n An option gives the holder the right, but not the obligation to buy (call option) or sell (put option) a designated asset at a predetermined price (exercise price) on or before a fixed expiration date n Options have value because their terms allow the holder to profit from price moves in one direction without bearing (or, limiting) risk in the other direction. Advanced Financial Management 2 Some Option Basics Option value Call option As _____ increase Option Value Call Put Asset price Ý ß Exercise price ß Ý Maturity Ý Ý Volatility Ý Ý Interest rate Ý ß Asset Option Some Terms In -the-money value Put option Out-of-the-money Intrinsic value Time value Asset Advanced Financial Management 3 What is a Real Option? n An option on a non-traded asset, such as an investment project or a gold mine n Options in capital budgeting n Delay a project (wait and learn) n Expand a project (“follow-on” investments) n Abandon a project n Real options allow managers to add value to their firms by acting to amplify good fortune or to mitigate loss. Advanced Financial Management 4 Managerial Decisions n Investment decision n Invest now Take into n Wait consideration n Miss opportunity time and price variabilities n Operational decision n Expand n Status quo n Close n Abandon Advanced Financial Management 5 Discounted Cash Flow Analysis n DCF analysis approach n Unknown risky future cash flows are summarized by their expected (mean) values n Discounted to the present at a RADR n Compared to current costs to yield NPV n Problem is sterilized of many problems n Managerial options are ignored. Advanced Financial Management 6 Management’s Interest n Experts explain what option pricing captures what DCF and NPV don’t n Often buried in complex mathematics n Managers want to know how to use option pricing on their projects n Thus, need a framework to bridge the gap between real-world capital projects and higher math associated with option pricing theory n Show spreadsheet models with “good enough” results. Advanced Financial Management 7 Investment Opportunities as Real Options n Executives readily see why investing today in R&D, a new marketing program, or certain capital expenditures can generate the possibility of new products or new markets tomorrow n However, the journey from insight to action is often difficult. Advanced Financial Management 8 Corporate Investments n Corporate investment opportunity is like a call option n Corporation has the right but not the obligation to acquire something n If we can find a call option sufficiently similar to the investment opportunity, the value of the option would tell us something about the value of the opportunity n However, most business opportunities are unique n Thus, need to construct a similar option. Advanced Financial Management 9 Two Sides of Uncertainty Economic uncertainty Technical uncertainty - Correlated with economy - Not correlated with economy - Exogenous, so learn by waiting - Endogenous, so learn by doing - Delays investment (NPV>0?) - Incentives for starting the investment (NPV<0?) Bad Good side side Investment: Governed quantitatively by the ‘bad news” principle (fear) Abandon: Governed quantitatively by the “good news” principle (hope) Advanced Financial Management 10 Two Sides of Uncertainty Value of flexibility to Bad Good alter decisions as info side side becomes available Expected value Expected value with flexibility Advanced Financial Management 11 Mapping a Project onto an Option n Establish a correspondence between the project’s characteristics and 5 variables that determine value of a simple call option on a share of stock n Slide 13 shows the variables n Use a European call n Exercised on only one date, its expiration date n Not a perfect substitute, but still informative. Advanced Financial Management 12 Mapping Investment opportunity Call option PV of a project’s operating S Stock price assets to be acquired Expenditure required to acquire the project assets X Exercise price Length of time the decision t may be deferred Time to expiration Time value of money rf Risk-free rate of return Riskiness of the project s2 assets Variance of returns on stock Advanced Financial Management 13 NPV & Option Value Identical n Investment decision can no longer be deferred Conventional NPV NPV = (value of project assets) Option Value When t = 0, s2 and - (expenditure required) r do not affect call f option value. Only S and X matter. This is S. This is X. At expiration, call option value is greater of S - X or 0. So: NPV= S - X We decide to “go” or “no go”. Here it’s “exercise” or “not”. Advanced Financial Management 14 Divergence n When do NPV & option pricing diverge? n Investment decisions may be deferred n Deferral gives rise to two sources of value n Better to pay later than sooner, all else equal n Value of assets to be acquired can change n If value increases, we haven’t missed out -- simply need to exercise the option n If value decreases, we might decide not to acquire them n Traditional NPV misses the deferral opportunity n It assumes the decision can’t be put off. Advanced Financial Management 15 1st Source: Capture Time Value n Suppose you just put enough money in the bank now so that when it’s time to invest, that money plus interest it earned is sufficient to fund the required expenditure n How much money is it? n Extra value = rf * PV(X) compounded t periods or X - PV(X) n Conventional NPV misses the extra value. Advanced Financial Management 16 “Modified” NPV n NPV = S - X n Rewrite using PV(X) instead of X “Modified” NPV = S - PV(X) S is value; PV(X) is cost adjusted for TVM n “Modified” NPV ³ NPV n Implicitly includes interest to be earned while waiting n Modified NPV can be positive, negative, or zero n Express the relationship between cost and value so that the number > 0. Advanced Financial Management 17 NPV as a Quotient n Instead of expressing modified NPV as a difference, express it as a quotient n Converts negative value to decimals between 0 and 1 NPVq = S ¸ PV(X) n NPV and NPVq are not equivalent n S = 5, PV(X) = 7, NPV = -2 but NPVq = 0.714 n When modified NPV > 0, NPVq > 1 n When NPV < 0, NPVq < 1 n When modified NPV = 0, NPVq = 1. Advanced Financial Management 18 Relationships: NPV & NPVq NPV < 0 NPV = S - X NPV > 0 NPV 0.0 NPVq < 1 NPVq = S / PV(X) NPVq > 1 NPVq 1.0 When time runs out, projects here When time runs out, projects here are rejected (option isn’t exercised). are accepted (option is exercised). Advanced Financial Management 19 Interpretation of Real Options n NPVq > 1 Þ Positive NPV & call options “in the money” n NPVq = Asset value / PV(exercise price) n NPVq < 1 Þ Negative NPV & call options “out of the money” n Call option value increases as n NPVq increases n Cumulative variance increases n Traditional DCF treats management as passive n Real options treat management as active. Advanced Financial Management 20 2nd Source: Cumulative Volatility n Asset value can change while you wait n Affect investment decision n Difficult to quantify since not sure asset values will change, or if they do, what the future value will be n Don’t measure change in value directly n Measure uncertainty and let option-pricing model quantify the value n Two steps n Identify a sensible way to measure uncertainty n Express the metric in a mathematical form. Advanced Financial Management 21 Measure Uncertainty n Most common probability-weighted measure of dispersion is variance n Summary measure of the likelihood of drawing a value far away from the average value n The higher the variance, the more likely it is that the values drawn will be either much higher or much lower than average n High-variance assets are riskier than low-variance assets n Variance is incomplete because need to consider time. Advanced Financial Management 22 Time Dimension n How much things can change while we wait depends on how long we can afford to wait n For business projects, things can change a lot more if we wait 2 years than if we wait only 2 months n Must think in terms of variance per period n Total uncertainty = s2 * t n Called cumulative variance n Option expiring in 2 periods has twice the cumulative variance of an identical option expiring in one period, given the same variance per period. Advanced Financial Management 23 Adjustments to Cumulative Variance n Don’t use variance of project values n Use variance of project returns n Instead of working with actual dollar values of the project, we’ll work with percentage gain or loss per year n Express uncertainty in terms of standard deviation n Denominated in same units as the thing being measured n Convert to cumulative volatility = Advanced Financial Management 24 Valuing the Option n Call-option metrics NPVq and contain all the info needed to value a project as a European call option n Capture the extra sources of value associated with opportunities n Composed of the 5 fundamental option-pricing variables onto which we map our business opportunity n NPVq: S, X, rf, and t n Cumulative volatility combines s with t. Advanced Financial Management 25 Digress: Black-Scholes Model Call = S N(d1) - E e -rt N(d2) S = stock price N(d) = cumulative normal d1 = [ln(S/E) + (r + s2/2)t] / sÖt distribution E = exercise price d2 = d1 - sÖt r = continuous risk-free rate t = time to maturity Put = E e -rt + C - S s = std deviation in returns n Known as put-call parity n No early exercise or payment of dividends n Inputs are consistent on time measurement n All weekly, quarterly, etc… Advanced Financial Management 26 Interpretation of N(d) n Think of N(d) as risk-adjusted probabilities that the option will expire in-the-money n Example: n S/E >> 1.0 Þ Stock price is high relative to exercise price, suggesting a virtual certainty that the call option will expire in-the-money n Thus, N(d) terms will be close to 1.0 and call option formula will collapse to S - E e-rt Þ Intrinsic value of option n S/E << 1.0 Þ Both N(d) terms close to zero and option value close to zero as it is deep out-of-the-money. Advanced Financial Management 27 N(d): Risk-Adjusted Probabilities n ln(S/E) = % amount the option is in or out of the money S = 105 and E = 100, the option is 5% in the money n ln(S/E) = 4.9% S = 95 and E = 100, the option is 5% out of the money n ln(S/E) = -5.1% n sÖt adjusts the amount by which the option is in or out of the money for the volatility of the stock price over the remaining life of the option. Advanced Financial Management 28 Linking Black-Scholes to Real Options Combining values allows Investment opportunity us to work in 2-space PV of a project’s operating S assets to be acquired NPVq Expenditure required to acquire the project assets X Length of time the decision t may be deferred Time value of money rf Riskiness of the project s2 assets Advanced Financial Management 29 Locating the Option Value NPVq Higher lower values 1.0 higher values NPVq: lower X; lower higher S, values rf or t Call option value increases in these directions Locating various projects reveals their higher relative value values to each other Higher s and t increase the option value Advanced Financial Management 30 “Pricing the Space” Black-Scholes value expressed as % of underlying NPVq asset Suppose S = $100, X = $105, t = 1 year, rf = 5%, s = 50% per year Then NPVq = 1.0 and sÖt = 0.50 Table gives a value of 19.7% Viewed as a call option, the project has a value of: Call value = 0.197 * $100 = $19.70 Conventional NPV = $100 - $105 = -$5. Advanced Financial Management 31 Interpret the Option Value n Why is the option value of $19.70 less than the asset value (S) of $100? n We’ve been analyzing sources of extra value associated with being able to defer an investment n Don’t expect the option value > S = $100; rather expect it to be greater than NPV = S - PV(X) n For NPVq = 1, then S / PV(X) = 100 / ($105 / 1.05) n Thus, conventional NPV = S - X = $100 - $105 = -$5. Advanced Financial Management 32 Estimate Cumulative Variance n Most difficult variable to estimate is s n For a real option, s can’t be found in a newspaper and most people don’t have a highly developed intuition about uncertainty n Approaches: n A(n educated) guess n Gather some data n Simulate s. Advanced Financial Management 33 A(n Educated) Guess n s for returns on broad-based U.S. stock indexes = 20% per year for most of the past 15 years n Higher for individual stocks n GM’s s = 25% per year n s of individual projects within companies > 20% n Range within a company for manufacturing assets is probably 30% to 60% per year. Advanced Financial Management 34 Gather Some Data n Estimate volatility using historical data on investment returns in the same or related industries n Computed implied volatility using current prices of stock options traded on organized exchanges n Use Black-Scholes model to figure out what s must be. Advanced Financial Management 35 Simulate n Spreadsheet-based projections of a project’s future cash flows, together with Monte Carlo simulation techniques, can be used to synthesize a probability distribution for project returns n Requires educated guesses about outcomes and distributions for input variables n Calculate s for the distribution. Advanced Financial Management 36 Capital Budgeting Example Advanced Financial Management 37 Capital Budgeting Example Discount at 5.5% -325.3 -69.2 X = -382 rf = 5.5 t=3 S = 256.1 Assume s = 40% -53.2 Advanced Financial Management 38 Valuing the Option n Combine the option-pricing variables into our two option-value metrics: n Look up call value as a % of asset value in table About 19% of underlying asset (S) or $48.6 million. Advanced Financial Management 39 Value of Project Project value = NPV(phase 1) + call value (phase 2) Project value = $16.3 + $48.6 = $64.9 n Original estimate = $0.2 n A marginal DCF analysis project is in fact very attractive n What to do next? n Check and update assumptions n Check for disadvantages to deferring investment n Simulate, ... Advanced Financial Management 40 Another Example Using NPVq: “Follow-on” Investment Option NPV at 20% = -$46.45 million. Project fails to meet hurdle rate. If the company doesn’t make the investment now, it will probably be too cost prohibitive later. By investing now, the opportunity exists for later “follow-on” investments. The project gives its own cash flows & the call option to go to the next step. Advanced Financial Management 41 Valuing the “Follow-on” Option... n “Follow-on” investment must be made in 3 years n New investment = 2 * initial investment ($900 M) n Forecast cash inflows = 2 * initial inflows n PV = $800 M in 3-years; $463 M today @ 20% n Future cash flows highly uncertain n Standard deviation = 35% per year n Annual risk-free rate = 10% n Interpretation: n The opportunity to invest is a 3-year call option on an asset worth $463 M with a $900 M exercise price. Advanced Financial Management 42 Valuing the “Follow-on” Option NPVq = Underlying asset value / PV (exercise price) = $463 / [$900 / (1.1)3 ] = .68 Cumulative variance = s Ötime = .35 Ö3 = .61 Call value = Asset value * BS value as % of asset = $463 * 11.9% = $55 M n Value of project = -$46 M + $55 M = $9 M n Interpretation: n “Follow-on” has a NPV = -$100, 3 years from now. The project may be very profitable because of its high variance. n The call option allows you to cash in on the opportunity. Advanced Financial Management 43 NPV Rules vs. Real Options NPV Real Options n Invest in all projects n Invest when the project with NPV > 0 is “deep in the money” n Reject all projects with n Can recommend to start NPV < 0 “strategic projects” n Among mutually n Frequently chooses exclusive projects, smaller projects choose the higher NPV sufficiently deep in the money Advanced Financial Management 44 Practical Considerations n Difficult to estimate project’s value and variance n Behavior of prices over time may not conform to the price path assumed by option pricing models n How long can the investment be deferred? n Need to know the probability distribution for X and joint probability distribution of S and X n Does uncertainty change over time? n Is the option an American type as opposed to European? n Do the Black-Scholes assumptions hold? Advanced Financial Management 45 The End Advanced Financial Management 46