Agenda
Investment Theory
Real Options Approach
Uncertainties
Implications for Economics
Conclusions
Real Options: Overview
James Alleman
University of Colorado & PHB Hagler Bailly, Inc.
Copyright © 1998 & 1999, James Alleman. All Rights Reserved.
James Alleman
Overview
University of Colorado
Agenda
Investment Theory
"The new view of investment
opportunities as options …. has
shown that the traditional "net present
value" rule can give very wrong
answers."
Olde Tyme View
Decision Tree Analysis
Dixit & Pindyck
Investment under Uncertainty, page ix
James Alleman
University of Colorado
James Alleman
Investment Theory: Olde Tyme View
University of Colorado
Investment Theory: Olde Tyme View
Investment Valuation:
Traditional DCF
Net Discounted Present Value
Jorgenson's User cost of capital
Tobin's q
Management's flexibility not
captured
Adapt
Revise decisions
Dixit & Pindyck
Investment under Uncertainty, Chapters 1 & 2
James Alleman
University of Colorado
James Alleman
1-6
University of Colorado
Investment Theory: Olde Tyme View
Investment Theory
Traditional DCF
Traditional DCF
Real world
Management's flexibility not
captured
Change
Uncertainty
Competitive interactions
adapt
revise decisions
DCF
Static operating strategy
Cash flows are projected with certainty
Discount rate accounts for uncertainty
James Alleman
University of Colorado
James Alleman
Investment Theory
Investment Theory: Olde Tyme View
Traditional DCF
Real world
New information
Traditional
Discounted Present Value
DPV > 0, invest
Also called NDPV or DPV or PV
Flexibility to alter strategy
Flexibility similar to financial options
Modelled with financial option tools
James Alleman
T
DPV =
ΣCF /(1 + r)
t=0
University of Colorado
James Alleman
Olde Tyme: Discounted Value
i
t
University of Colorado
Investment Theory: DCF
Discounted Present Value
What is the appropriate
risk-adjusted discount rate?
DPV = ΣCFi /(1 + r)t , summed over t = 0, T
"r" Constant
One based on a comparable
security.
Constant discount rate over time
Opportunity cost of capital
James Alleman
University of Colorado
University of Colorado
James Alleman
7-12
University of Colorado
Investment Theory: DTA
Investment Theory: DTA
Investment Theory
q2
Olde Tyme View
Decision-tree Analysis (DTA)
q1
1 - q2
q3
1 - q1
1 - q3
James Alleman
University of Colorado
James Alleman
Investment Theory: DTA
Investment Theory: DTA
Ex Ante Decision
Expected Value of DTA
Risk-adjusted Rate?
∞
<I0>
Σ(CFi )/(1 + ra)t
q1
University of Colorado
t=1
∞
Σ(CFj )/(1+ra)t
1 - q1
t=1
James Alleman
University of Colorado
James Alleman
Investment Theory: DTA
go
Investment Theory: DTA, example
q2
q1
q1
1 - q2
1 - q1
University of Colorado
stop q3
1 - q1
I0 = $ 104
rf = 8%
ra = 20%
q1= .5
1 - q3
James Alleman
University of Colorado
James Alleman
13-18
University of Colorado
Investment Theory: DTA
q1 = .5
1
q1
<$104>
1 - q1
Investment Theory: DTA, example
T=1
DCF =
- $ 104 + .5($240)/(1+.2)1 =
= $100 - $104
=<$4>
Σ($180)/(1+.2)1
t=1
1
Σ($60)/(1+.2)1
t=1
James Alleman
University of Colorado
James Alleman
Investment Theory: DTA, example
University of Colorado
Opportunity Cost of Capital
Divine Discount Rate!?
Options Pricing Model
Wait one period:
max[$180 - $ 104(1.08)] =
$ 67.68
Security of equivalent risk
Calculate implied rate
max[$ 60 - $ 104(1.08)] =
$ 0.00
James Alleman
University of Colorado
James Alleman
Real Options Approach
Real Options Approach
Investment Theory
Real Options Approach
Option definition
The "right" to purchase an asset in
the future but not the obligation
Definition
Characteristics
Investment characteristics
James Alleman
University of Colorado
Uncertainty of future
Asymmetry of returns
University of Colorado
James Alleman
19-24
University of Colorado
Real Options Approach
Value of Option
Options characteristic
Value of Options
$14
Time limited
"Killed" or exercised terminates
$12
Value: max(V - Ix,0)
$10
$8
$6
$4
$2
$0
$50
$70
$90
$110
$130
Stock price
James Alleman
University of Colorado
James Alleman
Non-linear
University of Colorado
Call Option v. Real Options
Uncertainty
Contingent Decision
Value of stock
Exercise price
Expiration
Uncertainty of
value
Riskless interest
PV of E(CF)
Investment costs
Opportunity goes
Project value
uncertainty
Riskless interest
Trigeorgis (1996), p.125
James Alleman
Call Options v. Investment
Stock price
Exercise price
Expiration
Variance of
return
Risk-free RoR
Financial v. Real Options
PV of assets
Expenditure
Deferral
Riskiness
Specified in
contract
Off the shelf `
software
Output: $'s
Search for
Tailored
solutions
Way of thinking
Time value of
money
Amram and Kubtibka, (1996)
Amram and Kubtibka, (1996)
James Alleman
University of Colorado
University of Colorado
James Alleman
25-30
University of Colorado
Types of Real Options
Investment Theory: DTA
Natural
What is the appropriate
risk-adjusted discount rate?
Option to defer a capital investment
Option to abandon
Planned for and created
Research & development
New services/products
Alter investment levels
As state of nature revealed
James Alleman
University of Colorado
James Alleman
Investment Theory: DTA
University of Colorado
Investment Theory: RO
What is the appropriate
risk-adjusted discount rate?
$180
<$104>
q1 =.5
Enter Real Options!
$60
1 - q1 =.5
James Alleman
University of Colorado
James Alleman
Investment Theory: RO
University of Colorado
Investment Theory: RO
Comparable Security
uS = 1.8 ($20) = $36
uS = 1.8 ($20) = $36
q1 =.5
S = $20
S = $20
q1 =.5
$20 = [.5 ($36) + .5($12)]/(1+r)
dS = 0.6 ($20) = $12
1 - q1 =.5
1 - q1 =.5
James Alleman
University of Colorado
James Alleman
31-36
dS = 0.6 ($20) = $12
University of Colorado
Investment Theory: RO
$180
$180
<$104>
<$104>
$60
$60
DCF = Σ[(qit)CFit/]/(1+ r) t
DCF = Σ[(qit)CFit/]/(1+ r) t
= - $104 + {[.5($180) + .5($60)]/(1+.20)}
= {[.5($180) + .5($60)]/(1+.20)} - $104
James Alleman
University of Colorado
James Alleman
Investment Theory: RO
Investment Theory: RO
$180 max [V,0]
= $180 - $104(1.08)
= $67.68
q1 =.5
defer
$180
go
start
$60
stop
max [V,0]
= [$60 - $104(1.08),0]
=0
James Alleman
University of Colorado
defer
University of Colorado
DCF = <$4>
DCF = 0
DCF = ?
James Alleman
University of Colorado
Twin Portfolio
Twin Portfolio
m(uS) - (1+ rf)B = $67.68
m(dS) - (1+ rf)B = $ 0.00
m(uS) - (1+ rf)B = $67.68
m(dS) - (1+ rf)B = $ 0.00
uS = $36, dS =$12, & rf = 8%
B = $31.33 and
m = 2.82 shares
James Alleman
University of Colorado
James Alleman
37-42
University of Colorado
Twin Portfolio
Investment Theory: DTA, example
m(uS) - (1+ rf)B = $67.68
m(uS) - (1+ rf)B = $ 0.00
Value of Option to Delay =
uS = $36, dS =$12, & rf = 8%
Expanded - static DCF
B = $31.33 and
m = 2.82 shares
mS - B = $25.07
James Alleman
University of Colorado
James Alleman
Twin Portfolio
University of Colorado
Investment Theory: RO
m(uS) - (1+ rf)B = $67.68
m(uS) - (1+ rf)B = $ 0.00
defer
B = $31.33 and
m = 2.82 shares
= [.5($67.68) + .5($0)]/(1 .20)
= $28.20
University of Colorado
James Alleman
Benefits of Option
University of Colorado
Real Options Approach: Flexibility
Total Risk Addressed
Avoids Mis-valuation
Market Disciple
Compatible Evaluation
James Alleman
q1 =.5
max [V,0]
= [$60 - $104(1.08),0]
=0
DCF = Σ[(qit)CFit/]/(1+ r)t
Option Value = mS - B - DCF
= $25.07 - (-$ 4)
= $29.07 > $28.20
James Alleman
max [V,0]
= $180 - $104(1.08)
= $67.68
Defer
Expand
Abandon
Start up (Shut down)
University of Colorado
James Alleman
43-48
University of Colorado
Real Options Approach: Defer
Real Options Approach
Investment Characteristics
Irreversibility
Irreversibility
Uncertainty
Timing
Investments become sunk cost
(irreversible) when:
Firm or Industry specific
Regulations/laws
Partially irreversible, "lemons"
Dixit & Pindyck
Investment under Uncertainty, Chapters 1 & 2
James Alleman
University of Colorado
James Alleman
Real Options Approach
University of Colorado
Real Options Approach
Irreversibility
Waiting
Opportunity cost of option
Include in valuation
i.e. if the DCF plus the
Option Value > 0, invest
Preempt investments preclude
Cost of delay
Competitive entry
Foregone revenues
James Alleman
University of Colorado
James Alleman
Agenda
Uncertainties
Investment Theory
Real Options Approach
Uncertainties
James Alleman
University of Colorado
Regulation/Legislative
Competition
Technologies
Costs
Market
University of Colorado
James Alleman
49-54
University of Colorado
Uncertainties
Uncertainties
Regulation/Legislative
Regulation/Legislative
Competition
Courts: Suspension of FCC Orders
Regulation: Decisions on RBOC LD
Legislative: Re-regulation of Cable
etc.
Traditional: ATT/MFS/TPG
Incumbent's reaction(s)
Cable's Strategies
Entry into exchange market
Broadband modems
James Alleman
University of Colorado
Uncertainties
Uncertainties
Regulation/Legislative
Competition
Technologies
Regulation/Legislative
Competition
Technologies
Costs
Wireless impact
WinStar
Wireless local loop
Spectrum costs
Unbundled Network Elements
Right of way
Leases
ISP/Packet Network versus circuit
James Alleman
University of Colorado
James Alleman
Uncertainties
University of Colorado
Agenda
Regulation/Legislative
...
Costs
Market
Investment Theory
Real Options Approach
Uncertainties
Implications for Estimation
Product acceptance
Price and cross-elasticities
Size
Growth
James Alleman
University of Colorado
James Alleman
55-60
University of Colorado
Implications for Estimation
Implications for Estimation
Investment Function
Specification
Desirable Properties
Economic Theory
Most obvious impact
Interest Rates
High hurdle rates (3- 4 times expectation)
Limited stimulation effect
Shutdown point invalid
Price below AVC, not exit
Price substantially above LRAC, Invest
James Alleman
University of Colorado
James Alleman
Implications for Estimation
Implications for Estimation
Specification
Specification
Desirable Properties
Based on theory
Available information
James Alleman
Theoretically plausibility
Compatible with economic theory
Describes the phenomenon
University of Colorado
James Alleman
Implications for Estimation
University of Colorado
Implications for Estimation
Economic Theory
Lagged Variables
Stock Adjustment Models
Basis for estimation
Not data mining
James Alleman
University of Colorado
Koyck
Nerlove's Partial Adjustment
Adaptive Expectations
University of Colorado
James Alleman
61-66
University of Colorado
Agenda
Conclusions
Investment Theory
Real Options Approach
Uncertainties
Implications for Estimation
Conclusions
DPV & DTA Inadequate
Economic Models Redefined
Implications for Estimation
James Alleman
University of Colorado
James Alleman
Summary/Conclusions
Summary/Conclusions
DPV & DTA Inadequate
DPV & DTA Inadequate
Economic Models Redefined
No dynamics
Risk adjusted rate?
No Uncertainties
No Options Valuation
James Alleman
University of Colorado
Inadequate Specifications
Alternative view of dynamics
Implications for models
Rethink models
University of Colorado
James Alleman
University of Colorado
Conclusions
DPV & DTA Inadequate
Economic Models Redefined
Implications for Estimation
Real Options: Overview
James Alleman
Inadequate Specifications
Investment estimations
Lagged models
Others?
University of Colorado & PHB Hagler Bailly, Inc.
Copyright © 1998 & 1999, James Alleman. All Rights Reserved.
James Alleman
University of Colorado
67-72