FIN 614: Financial Management
Larry Schrenk, Instructor
1. Real Option Example
2. Analysis of Real Options
3. How Real Option Analysis is Used
The SuperCom Project:
A large telecommunications company faces an opportunity to invest in an R&D
project that will revolutionize the way consumers use telephones, internet, and TV.
I1: Required investment in the
R&D project.
I2: Required investment in the
commercial-scale plant,
marketing, and distribution if the R&D effort is successful,
and if market conditions are
favorable..
Real Options in the SuperCom Project
R&D Stage
0 (Years)
Commercialization Stage
3
5
7
T = 15
I1
Ic
IE: Flexibility in the design of
the production process
allows for output expansion
with an outlay of IE.
Defer
( up to 1 year)
IE
I3
Expand
Switch Use
(Abandon for salvage)
Contract
( save Ic )
I2
Abandon
(forgo I2)
I3: Final investment in the
project; can be decreased
by Ic if the market is weak.
V: Gross present value of the
completed project’s
expected operating cash
flows.
Option to Defer Investment
Congress is currently debating the viability and the process by which to allocate or
auction the airwaves that are crucial to the commercial success of SuperCom. Our
lobbyist in Washington advises us that the debate would be resolved within a year.
We could initiate the R&D project immediately, or wait a year to see what Congress
does.
Option to Expand
Given an initial design choice, management may deliberately favor a more
expensive technology for the built-in flexibility to expand production/sales if and
when it becomes desirable. If the market’s response to SuperCom is better than
expected, management can accelerate the rate or expand the scale of production
by x% by incurring a follow-on cost IE.
The option to expand also applies to complementary markets: Investing in SuperCom
in a new geographical area allows for the possibility to expand to other similar
markets; for example besides local and long-distance tele-communication, the
market for telephone-via-internet could be explored in the new geographical area.
Option to Default during Staged Construction (Time-to-Build-Option)
Investing in the R&D project, or investing I1, provides the opportunity to invest in
the commercial stage by investing I2 or to abandon the project if the R&D and
initial test-marketing is unsatisfactory.
Option to Contract
If the market does not respond to SuperCom as expected, management can
reduce the scale of operations by c%, thereby saving Ic of the planned
investment outlays.
Option to Abandon for Salvage Value
If SuperCom does significantly worse than expected in the market,
management may choose to abandon the project permanently in exchange for
its salvage value: the resale value of the capital equipment, license, etc. for A.
The underlying for a financial option is a
security such as a share of common stock or a
bond (or interest rates), while the underlying
for a real option is a tangible asset, for
example, a business unit or a project.
Both types of option are the right, but not the
obligation, to take an action.
The fact that financial options are written on
traded securities makes it much easier to
estimate their parameters.
With real options, the underlying risky asset
is usually not a traded security
They are not issued by the company on
whose shares they are contingent, but
rather by independent agents who write
them and buy those that are written.
Consequently, the agent that issues a call
option has no influence over the actions of
the company and no control over the
company’s share price.
Real options are different because management
controls the underlying real assets on which they are
written.
The act of enhancing the value of the underlying real
asset also enhances the value of the option.
Finally, with both financial and real options, risk – the
uncertainty of the underlying – is assumed to be
exogenous.
The actions of a company that owns a real option may
affect the actions of competitors, and consequently
the nature of uncertainty that the company faces.
Advantages:
Successfully explains valuation of multiple companies believed to
have substantial real options
Explain some of the difference in markets not accounted by
traditional techniques
The real options method applies financial options theory to quantify
the value of management flexibility in a world of uncertainty.
Real options capture the value of managerial flexibility to adapt
decisions in response to unexpected market developments.
The real option method enables corporate decision-makers to
leverage uncertainty and limit downside risk.
Companies create shareholder value by identifying, managing
and exercising real options associated with their investment
portfolio.
Disadvantage:
Real Options can be miscalculated/misused and may incorrectly
value a company
A survey of 39 managers at 34 companies conducted in
Spring 2001 revealed ways in which real option analysis is
currently used in practice:
Real Options as a ‘Way of Thinking’
Real Options as an Analytical Tool
See “Real Options: State of the Practice” by Alex Triantis and Adam Borison, Journal of
Applied Corporate Finance, Summer 2001 (pp. 8-24).
Mindset of thinking about uncertainty in positive light
Heightened awareness of creating or extinguishing
options
Increased appreciation for learning/information
acquisition
Framing exercise to map out future scenarios and
decisions
Contractual arrangements as bundles of options
There are four approaches used in practice to value
options:
Black-Scholes Formula
Binomial Option Pricing Model
Risk-Adjusted Decision Trees
Monte-Carlo Simulation
FIN 614: Financial Management
Larry Schrenk, Instructor