Real Option Valuation of
Technology
Application of Precision Tree
Palisade Risk Conference
2011
© 2011Captum Capital Limited
Michael Brand

Valuation of Real Options
ƒ What are Real Options?
ƒ How are they valued?
ƒ Precision Tree models
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Amsterdam – in year 1637
Bubble Tulips by Nancy Ethiel
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The Viceroy Tulip
Source: Wikipedia
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Tulip prices escalated x 20
Source: Wikipedia
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Future Value of a Tulip Bulb
ƒ In February 1637, a Viceroy Tulip bulb was worth 3,000fl.
ƒ You are offered an option to acquire 1000 bulbs in six months time at 3,000fl per bulb
ƒ What would you pay to acquire this option?
Futures markets flourished in Amsterdam in 1637
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Tulip prices crashed
Source: Wikipedia
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Future Options are Risky
Newton lost £20,000 of his own money in the South Sea Bubble of 1720
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Gold Mine Option
ƒ You own a gold mine
ƒ Geological survey estimates it contains
1 metric tonne of gold
ƒ What is the value of the mine?
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Value of Gold Mine
ƒ Its value depends on the price of gold
ƒ Risk
ƒ You can start or stop mining depending on the price of gold
ƒ Flexibility in outcome
This is a classic Real Option
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Historic Gold Price Trends
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Real Options
ƒ Risk or Uncertainty in the…outcome
ƒ Non-linearity: flexibility to react in different ways…so that a new set of outcomes is achieved
Source: Michael Rees, Financial Modelling in Practice (2008)
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Technology Development
R&D
Project
Fund
Option Price
Success
Failure
Commercial
Development
Fund
Option Exercise
Price
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Risk Adjusted NPV rNPV
=
( 1
P t
+
C t
R ) t rNPV depends on 3 factors:
• Probability, P
• Cash Flow, C
• Discount Rate, R
Most commonly used method for valuing technology
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Technology Project Value
Year 0
Cash Flow -100
P
PV
1
-100
1 2
0 -1255
0.5
-1000
Cash Flow in £000s
Discount Rate R = 12% rNPV = -100 + 0.5 x -1000 + 0.45 x 10000 = £3,900,000
3 4
0 15735
0.5x0.9
10000
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Decision Tree Value
Cash Flow in £000s
Discount Rate R = 12%
All Cash Flows discounted to PV
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Real Option Valuation
ƒ Key variables
ƒ Underlying Asset Value – Enterprise Value
ƒ Exercise Price
ƒ Term to Exercise
ƒ Volatility of Underlying Asset
ƒ Discount Rate
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RO Valuation Methods
ƒ Black Scholes Option-Pricing Model*
ƒ Binomial Model*
ƒ Monte Carlo Simulation
ƒ Decision Tree
* Developed for financial option valuation
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Black Scholes Equation
Present Value of a Call Option:
PV
=
PN ( d
1
)
−
EXe
− r f t
N ( d
2
) where: d
1
= log( P / EX )
+ r f t
σ t
+ σ 2 t / 2
N(d) = normal probability function
EX = exercise price t = time to exercise d
2
= log( P / EX )
+ r t t
σ t
− σ
2 t / 2
P = price of security
σ = variance on return =
(
_
P
−
N
P ) 2
−
1 r f
= risk free rate
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Binomial Model
EV p
1 - p t
EV u
= S x u
EV d
= S x d
Enterprise Value each year goes: up by a factor u , or down by a factor d u
= exp(
σ t ) d p
=
=
1 u
( 1
+ u r f
)
− d
− d
σ = sales volatility, between 20% and 40% for R&D projects
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Monte Carlo Simulation
ƒ @Risk Model for rNPV
ƒ Binomial Functions model decision nodes
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@Risk Model
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@Risk Model Output
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Abandonment Options
R&D Project
£000s rNPV = 3900
-1000
-100 rNPV = -600 rNPV = -100
Mean rNPV = £635k Max rNPV = £3900k
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Strategic Decision Options
ƒ Defer Investment
ƒ Default
ƒ Expand
ƒ Contract
ƒ Shut Down and Restart
ƒ Abandon
Lenos Trigeorgis, Real Options (1996)
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Multiple Milestones
Scale up CT1
Medical Device Development Project
CT2
0
0.6
- 0.5
0.4
- 0.2
-1.5
0.7
-0.2
0.9
FDA
4.5
- 0.3
Cash Flow £m
- 0.1
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Medical Device Decision Tree
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Clinical Trial 1
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Exercise Options
1.
Invest in further R&D
2.
Rerun test
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Summary
ƒ Decision Trees are a viable approach to
Real Option Valuation:
ƒ Simple to construct using Precision Tree
ƒ Flexible – changes of strategy
ƒ Transparent – ease of communication
ƒ Credible - not a “Black Box”
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About Captum…
ƒ Formed in 2004
ƒ Transatlantic presence
ƒ Life science sector consulting:
ƒ Business development, valuation, partnering
ƒ MasterClasses:
ƒ Valuation Masterclass attended by over 500 executives in UK and Europe
ƒ Internet virtual communities
ƒ Sensor100
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Coming Events
ƒ MasterClass : Company Valuation
London, 25 th May 2011
ƒ Workshop : Evaluating Technology
LES International Conference
London, 8 th June 2011
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Captum Growth Series
Valuing Technology
2 nd edition
To be published
May 2011
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Contact
Michael Brand e: mjb@captum.com
t: +44 (0) 115 988 6154 m: +44 (0) 7980 257 241
Captum Capital Limited
Cumberland House
35 Park Row
Nottingham NG1 6EE
United Kingdom www.captum.com
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