Chapter 4
Real Options and Project Analysis
Capital Budgeting and Investment
Analysis by Alan Shapiro
Option valuation and Investment
Decisions
• The ability of companies to change course in
response to changing circumstances create
what often termed real or growth options
• Many investments have very uncertain payoffs
that are best valued with an options approach
• The down payment agreement is a call option
– Option price
– Strike price
– Stock price
Option valuation and investment
decisions cont.
• A lease with an option to cancel can be
viewed as a put option
• The purchase of an insurance policy on
property can be also thought of as a put
option
• Black-Scholes formula
Option valuation and investment
decisions cont.
• The opportunities that a firm may have to
increase the profitability of its existing lines
and benefit from expanding into new products
or markets may be thought of as growth
options
• Growth options are of great importance to
new firms
• Very high P/E
Option valuation and investment
decisions cont.
• The owners of a gold mine may increase or
decrease gold output depending on the
current price
• The mine can be shutdown and then
reopened when production and market
conditions are more favorable or it can be
abandoned permanently
Valuing a Gold Mine
•
•
•
•
•
•
•
Reopening a gold mine would cost $1 million
40,000 ounces of gold remaining
Variable cost $390 per ounce
Expected gold price $400 per ounce
15% yield required on such risky investment
Do you think the NPV is negative?!
DO NOT ignore the option not to produce gold
if it is unprofitable to do so
Valuing a Gold Mine cont.
• Suppose two possibilities:
• $300 per ounce and $500 per ounce each with
probability of 0.5
• Mine gold if and only if the price of gold at
year’s end is $500 per ounce
• Incorporating the mine owner’s option NOT to
mine gold when the price falls below the cost
of extraction reveals a positive NPV of
$913,043
• The current value of mine can be thought of
as a call option on the value of the gold in the
mine
• The strike price equals the cost of reopening
• The stock price equals the value of the gold
that could subsequently be produced
• Firms have 3 choice:
– Continue to invest in a project
– Abandon the project
– Delay the project
Evaluating R&D investments using
an option valuation approach
• The ability to alter decisions in response to
new information may contribute significantly
to the value of a project
• An investment in R&D gives the investor the
right to acquire the outcomes of the R&D at
the cost of commercialization
• Both investors in R&D and mine owner have
put options, they can abandon their projects
at an exercise price equal to the costs of
shutdown
Example
• Product development cost $5 million a year
from 2005 to 2007
• Build a plant which cost $100 million in
beginning of 2008
• $13 million annual cash flow from yearend
2008 to 2017
• Terminal value at yearend 2017 is $105 million
• Discount rate of 14%
• Costs are assumed to occur at the start of the
year and OCF at the end of the year
• Option valuation allows for the decision NOT
to build the plant and also values only those
outcomes that will follow if the plant is built.
• Clearly, if R&D investment does not pan out or
if market conditions are unfavorable, the plant
will not be built
• Option valuation approach properly values
ONLY positive NPV outcomes, whereas the
traditional DCF analysis values ALL outcomes,
negative as well as positive
PV of CF items for new product
development ($ millions)
CF item
PV as of Jan 1st 2005
PV as of Jan 1st 2008
R&D expense
-13.2
0
Plant cost (2008, beginning
of year)
-67.5
-100
Post 2007 OCF (2008-2017) 45.8
67.8
Terminal value (2017)
16.8
28.3
NPV
-18.2
-3.9
PV on Jan 1
2005 R&D
expense
2008 Plant
cost
2008
possible
payoff
2005 project
NPV
DCF Analysis
Assumes
one
outcome
-13.2
-100
96.1
-18.2
I
-13.2
-100
223.9
70.4
II
-13.2
-100
118.1
-1
III
-13.2
0
33.9
-13.2
IV
-13.2
0
8.6
-13.2
Option
Analysis
Assumes
many
Possible
outcomes
and
measures
each one
separately
each with
probability
0.25
Expected NPV of R&D investment
in 2008 ($ millions)
Scenario
Decision
Cost
Payoff
NPV
Prob.
Value
I
Build plant
-100
223.9
123.9
0.25
31
II
Build plant
-100
118.1
18.1
0.25
4.5
III
Don’t build 0
0
0
0.25
0
IV
Don’t build 0
0
0
0.25
0
35.5
• The expected project NPV in 2008 valuing only
favorable outcomes is $35.5 million
• This yields PV in 2005 of $24 million
• Subtract the $13.2 million PV of the R&D
investment and the result is a $10.7 million
NPV
• Invest in new product development and
exercise the option of proceeding forward in
2008 if the outcome looks favorable.
Otherwise, the project should be abandoned
at that point
Strategic investments and growth
options
• Many strategically important investments such
as investments in R&D, factory automation, a
brand name, or distribution network, provide
growth opportunities because they are often
but the first link in a chain of subsequent
investment decisions
• Creating options on investment in other
products, markets, or production processes
are sometimes referred to as Growth option
Strategic investments and growth
options cont.
• Valuing investments that embody
discretionary follow up projects requires an
expanded NPV rule hat considers the
attendant options
Valuing a growth option
• According to option pricing theory, the
discretion to invest or not in a project depends
on:
• 1. The length of time the project can be
deferred
• 2. The risk of the project
• 3. The level of interest rates
• 4. The proprietary nature of the option
The length of time the project can
be deferred
• The ability to defer a project gives the firm
more time to examine the course of future
events and to avoid costly errors if
unfavorable developments occur
The risk of the project
• Surprisingly, the riskier the investment is, the
MORE valuable the option on it will be!
• The reason is the asymmetry between gains
and losses
• Losses are limited by the option not to
exercise when the project NPV is negative
• The riskier the project is, the greater the odds
will be of a large gain without a corresponding
increase in the size of the potential loss
The level of interest rate
• The net effect is that high interest rates
generally raise the value of projects that
contain growth options
The proprietary nature of the
option
• Consideration of competitive conditions is
what separates growth options from stock
options
• Growth options are valuable because they
allow the firm to delay investments to learn
more about the value of the underlying
growth opportunities
Investment decisions and Real
options
• Value of Project = Project’s value using
traditional DCF + Value of strategic options
• VPROJ=VDCF + VSTRAT
• The value of an option increases with
uncertainty
• An option represents a right but not an
obligation to buy or sell an asset. There is no
commitment to future investments unless
conditions are favorable
Investment decisions and real
options cont.
• A company can exploit a project’s upside
potential without incurring significant
downside risks
• Decision to build a pilot plant to manufacture
a new product. This mitigate losses if sales are
disappointing
• If sales take off, the firm can invest in a higher
capacity plant that would be more efficient
Investment decisions and real
options cont.
• The ability to abandon a project represents a
put option for the firm
• A project should be abandoned if the
abandonment value exceeds the PV of
subsequent CFs
• Flexibility of a project represents a set of
operating options
• A power plant that burns only oil VS. a plant
that is capable of burning both oil and coal
• The firm can use different raw material mixes
to produce the same final product, or the
same inputs (e.g., crude oil) to produce a
variety of outputs (e.g., gasoline, heating oil)
• Other operating options:
– Changing marketing (pricing/promotion)
strategies
– Temporarily closing a plant in response to a
decline in demand
– Reducing or increasing output in response to
demand
– Redesigning a product in response to changing
demand or input costs
Investment decisions and real
options cont.
• According to Graham and Harvey (2002), more
than one-fourth of the companies claimed to
be using real options evaluation techniques
• NPV(project) + X = 0
• Management would have to decide whether
they would be prepared to pay X dollars to
acquire the strategic options associated with
it.