REAL OPTIONS ANALYSIS AND
STRATEGIC DECISION MAKING
Authors:
Edward H. Bowman and Gary T. Moskowitz
Presenter:
Cheng (Orange) Wang
THE STRUCTURE OF THIS PRESENTATION
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Introduction
The motivation of this paper
The definition of important terms in this paper
Valuing a Strategic Real Option
The project
Merck’s analysis
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Limitations of the Quantitative Approach to Real Options
Modeling assumptions
Determining the inputs
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Conclusions: The Role of Option Analysis in Strategic Planning
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The Discussion and Future Research
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INTRODUCTION - MOTIVATIONS
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The investment decision represents how organizations commit
resources to future growth; and real option offers a positive and
radical reassessment of the value of risk and exploration;
However, organizational theories and financial theories are
rarely considered in tandem;
How to allocate capital?
Traditional corporate finance – DCF
DCF does not account for flexibility of a project
Real Option assumes underlying source of uncertainty and accounts for the future
flexibility
There is theoretical attractiveness; but limited in use
This paper:
Case study of Merck’s real options calculation
Illustrate the practical organizational issues using real options
Show how results of strategic analysis can differ from typical
options model assumptions
INTRODUCTION - DEFINITIONS
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Options: In finance, an option is a derivative financial instrument that
specifies a contract between two parties for a future transaction on an
asset at a reference price (the strike). The buyer of the option gains
the right, but not the obligation, to engage in that transaction,
while the seller incurs the corresponding obligation to fulfill the
transaction.
The price of an option derives from the difference between the
reference price and the value of the underlying asset plus a premium
based on the time remaining until the expiration of the option.
Call option vs. Put option: A call option gives the buyer the right,
but not the obligation to buy an agreed quantity of a particular
commodity or financial instrument (the underlying) from the seller of
the option at a certain time (the expiration date) for a certain price (the
strike price). The seller (or "writer") is obligated to sell the commodity
or financial instrument should the buyer so decide. The buyer pays a
fee (called a premium) for this right. Vice versa for the put options.
Real option: It is used for firm’s investment decisions. It can be
understand as an alternative or choice that becomes available with
a business investment opportunity. Real options can include
opportunities to expand and cease projects if certain conditions
arise, amongst other options.
INTRODUCTION - DEFINITIONS
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Patent: A patent gives the owner an exclusive right to
prevent others from practicing the patented technology
in the country issuing the patent for the term of the
patent. The right may be enforced in a lawsuit for
monetary damages and/or imprisonment for violation on
the patent.
Patent Royalty: In accordance with a patent license,
royalties are paid to the patent owner in exchange for
the right to practice one or more of the four basic patent
rights: to manufacture with, to use, to sell, or to
advertise for sale of a patented technology.
Patent rights may be divided and licensed out in
various ways, on an exclusive or non-exclusive basis.
The license may be subject to limitations as to time or
territory. The royalty rate varies depending on
industries, whether the patent is issued or pending.
VALUING A STRATEGIC REAL OPTION
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Corporate decisions and strategic options
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Termination of joint ventures, Kogut 1991
Venture Capital investment, Kogut and Kulatilaka 1994
R&D programs, Brealy and Myers 1981, etc.
Capital Budgeting decisions, Dixit and Pindyck 1994
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The common theme in these decisions – two stage process
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First stage: the company made a small investment; it gives the company the right to
participate in the projects (the purchase of the option)
Second stage: the company make a decision whether or not to make a larger
investment in the project (the exercise the option)
Capital Budgeting, a real option need to be analyzed multiple times
by the firm
Whether or not to purchase the real option
If the real options are purchased
Whether to exercise the real option or not
When to exercise the real option
VALUING A STRATEGIC REAL OPTION:
THE PROJECT
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Merck used the real options to justify an investment in an R&D
project – Project Gamma
The biotech company Gamma has patented its technology but has not developed any
commercial applications from it.
Merck wants to enter a new line of business but needs the new technology from
Gamma.
If Merck licenses the technology, it will take 2 years of research and development on
the new tech; but it is uncertain whether the new tech product was commercially
feasible or not;
If after 2 years, the new product is commercially feasible, it will take another year to
do the start-up, e.g. build plants, marketing, working capital, etc.
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The Proposed Gamma Agreement – resembles/ a call option
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Merck pays Gamma $2 million license fee over 3 years period
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Merck will pay Gamma Royalty fee if the product is commercially feasible
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Merck can terminate the agreement anytime if Merck is dissatisfied with the process
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The theoretical value should compare to the actual cost of the option: Σ(license fee + R&D cost)
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Merck expects the start-up costs to be independent of the future value of the new tech.
VALUING A STRATEGIC REAL OPTION:
MERCK’S ANALYSIS
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Important parameters
in Black Scholes Model
(Black and Scholes 1973)
Value of the option: C
It is on the left side of the
equation.
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Stock price: S
Exercise price: K
Time to expiration: t
Volatility: N
Use standard normal dist
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Risk-free interested rate: r
VALUING A STRATEGIC REAL OPTION:
MERCK’S ANALYSIS USING THE BLACK-SCHOLES MODEL
Merck agrees to license and the sensitivity
cases are using a variety of less-favorable
assumptions
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Stock price:
The DCF value from the project, assuming
project successful;
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two categories of cost-CFs are excluded:
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The start-up cost including building plant.
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Upfront licensing and development cost.
Exercise price:
Cost of start-up cost including building plant
if decides to commercialize the technology.
Time to expiration:
Based on expected time to develop product
and build the factory
Volatility:
Based on annual standard deviation of
returns of the biotechnology company
Risk-free interested rate:
Based on the then-prevailing yield on 2- to 4year treasury bonds.
LIMITATIONS OF THE QUANTITATIVE APPROACH TO
REAL OPTIONS
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Lander and Pinches 1998: there are three general
categories of implementation problems when using
quantitative model to value strategic real options
Finding a model whose assumptions match those of the project
being analyzed;
Determining the inputs to the selected model;
Mathematically solve the option pricing algorithm
This paper discuss the first two problems in Merck case
Modeling assumptions
Determining the inputs
LIMITATIONS OF THE QUANTITATIVE APPROACH TO
REAL OPTIONS: MODELING ASSUMPTIONS
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The Black-Scholes’ model assumes lognormal distribution of underlying
stock price with constant volatility:
Over time, the distribution of stock prices gets wider, as the path of potential stock prices
increases exponentially at the high end and asymptotically approaches zero at the low end
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The assumption can be misleading for Merck:
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The longer Merck could wait to exercise its option, the more valuable the option is.
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The increase in value is due to the lognormal assumption where price has more time to move to
higher values.
The present value of the exercise price is lower for a longer option.
However, the longer Merck waits to exercise the option, the lower the
value of the option:
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The bulk of the value of the project comes from the patent protection.
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The patent has expiration data.
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Merck should adjust the model to account for the negative effects of
having to wait longer to exercise the option.
Create separate set of inputs for the 2-year, 3-year and 4-year analysis.
LIMITATIONS OF THE QUANTITATIVE APPROACH TO
REAL OPTIONS: DETERMINING THE INPUTS
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Stock price:
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In exchange-traded option, the current and future stock prices are readily
observable to the option holder
Strategic options in the form of research projects do not have a readily observable
stock price
The lack of visible stock price make it hard to draw conclusions about the
appropriate course of action at the expiration date
Any errors make in the NPV becomes error in the option valuation
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Exercise price:
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Option valuation model assumes that the exercise price is fixed in advance
Many strategic investments do not have fixed exercise price
Merck use start-up costs as exercise price; but on the date to exercise, Merck could
license the tech to another firm or to build a plant of a smaller or larger size, etc.
Time to expiration:
The research project could be extended to a long period of time;
Volatility:
Merck uses the volatility of stocks with similar risk profile as input
For strategic option, there are no publicly traded instruments whose risk profile
matches that of the proposed investment
Risk-free interested rate: N/A
CONCLUSIONS: THE ROLE OF OPTION ANALYSIS
IN STRATEGIC PLANNING
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Real options presents planners a Dilemma
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Theoretically, good way to think about flexibility inherent in investment proposals;
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Practically, many difficulties in making accurate calculations; and the errors are
hard to find;
How to solve the dilemma?
Create more advanced and customized valuation models that better matches the
characteristics of the investment proposal;
The benefit of real options wasn’t simply the improved estimation:
In the Merck case, the firm fail to correct for the shortfall in the equilibrium CF in
the B-S model;
the firm does not consider the reasonableness of a random walk process to the CF;
Numerical results are unlikely to be very sensitive to reasonable mathematical
specifications of CF’s dynamics; Whereas small deviations are worth fortunes in
financial markets, they are fairly inconsequential in product market;
CONCLUSIONS: THE ROLE OF OPTION ANALYSIS IN
STRATEGIC PLANNING
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For Merck’s case:
The key insight was to see the license as granting the rights to exercise a
future investment;
Assign probabilities to good/bad decision and calculate CF is not accurate;
Investment decision is contingent on buying the option, therefore, it is not
reasonable one must make the future investment;
To value the experimentation, the firm should break up the investment.
A formal quantitative valuation model is a part of strategic planning
and capital allocation process
Firm need both financial and strategic analysis;
Use multiple models to check on each other; DCF relies sole on financial
analysis while strategic analysis does not provide information of returns
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Potential advantage of using the real option:
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It may change the type of investment proposals that are reviewed;
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An option perspective inverts the usual thinking about uncertainty absorption
in the organizational literature (Kogut and Kulatilaka 2001)
An option approach encourages experimentation and the proactive exploration
of uncertainty.
DISCUSSION AND FUTURE RESEARCH
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By analyzing the case of Merck, the paper shows us the
potential practical difficulties of using real options to
value investments;
The authors suggest that an advanced and customized
model should be created when a firm tries to use real
option;
There are opportunities to customize finance models
and use them in strategic planning;
A dynamic view will be needed when customizing and
using the finance model;
The future research can be done by finding out
generalizable models for firms in specific industries