Chapter 1
Getting Started
Chap 1 --- Getting Started
We take value creation as a company’s objective,
through its investments in real assets.
 On the make-or-break investments that are
strategic in nature.
 We want it to be a useful tool that shows how to
use Real Options Analysis ( ROA ) in enough
detail that today’s managers, most of whom are
familiar with the use of a personal computer, can
work through a problem from start to finish and
fully understand the results.

 Estimating
the NPV without flexibility,
 Modeling the uncertainties that drive
the value of the investment,
 Putting decision nodes into the event
tree that is built to reflect the
uncertainties, and
 Valuing the real options using a
replicating portfolio approach
An analogy - Getting from here to there
 Turnpike
theorem, which says that it’s
preferable to go a little out of your way to
take advantage of higher speed paths.
your expected route – no detours,
no traffic jams, no bad weather – no ability
to respond to uncertainty.
 Using
 There
are at least five different types of
managerial flexibility to respond to
uncertainties.
Definition of a real option
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A real option is the right, but not the obligation, to take an action
( e.g., deferring, expanding, contracting, or abandoning ) at a
predetermined cost called the exercise price, for a predetermined
period of time – the life of the option.
We would go so far as to say that NPV systematically undervalues
every project.
1. The value of the underlying risky asset, a project, investment,
or acquisition.
2. The exercise price.
3. The time to expiration of the option.
4. The standard deviation of the value of the underlying risky
asset.
5. The risk-free rate of interest over the life of the option.
The sixth variable is the dividends that may be paid out by the
underlying asset : the cash outflows or inflows over its life.

It seems that Thales read the tea leaves and interpreted them as
forecasting a bountiful olive harvest that year.

The underlying risky asset was the rental value of the olive presses.

The driving cause of the uncertainty was the variability of the olive
harvest, but the actual variable of interest ( the underlying risky
asset ) was the standard derivation of the value of the rental fee on
the olive presses.

The exercise price was the normal rental rate, a value that had
been written into the contract.

The risk-free rate was, presumably, an observable market rate.

And the time to maturity was the time until the olive harvest.

The value of the option was the money that Thales paid to the
owners of the presses – his life’s savings.

You have the opportunity to buy a toy bank that allows you to put in
a dollar today and guarantees you $1.05 with absolute certainty a
year later if you do. The offer is good for one year. However,
interest rates at real bank are 10 percent right now. How much is
the toy bank worth?
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Real options dictionary

A call option where the price of the underlying is above the
exercise price so that an immediate profit could be made
by exercising the option is said to be in-the-money.
Conversely, if the price of the underlying is below the
exercise price the option is out-of-the-money.

Options that can be exercise only on their maturity date are
called European options. Those that can be exercised any
time during their life are called American options.
There are also boundary conditions called caps and floors
that bound the value of the underlying.
Taxonomy of real options
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Real options are classified primarily by the type of flexibility
that they offer.
For example, an option is just what it seems to be - the
right, but not the obligation to invest in a project at a later
date.
A deferral option is an American call option found in most
projects where one has the right to delay the start of a
project. Its exercise price is the money invested in getting
the project started.
The option to abandon a project for a fixed price ( even that
price decrease through time ) is formally an American put.
So is the option to contract ( scale back ) by selling a
fraction of it for a fixed price.
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The option to expand a project by paying more to scale up
the operations is an exercise price is also an American call.
Switching options are portfolios of American call and put
options that allow their owner to switch at a fixed cost ( or
costs ) between two modes of operations.
There are also options on options, called compound
options. Phased investments fit into this category.
Options that are driven by multiple sources of uncertainty
are called rainbow options.
Most real options are affected by uncertainty regarding the
price of a unit of output, the quantity that might be sold,
and by uncertain interest rates that affect the present
value of the project.
Many real-world applications require modeling as
compound rainbow options.
Real options are everywhere – war stories
First, isn’t the option value of managerial flexibility
always positive and consequently isn’t the use of
real option just an attempt to justify projects that
should be turned down?
 First, the appropriate mind-set is to recognize that
the net present value technique systematically
undervalues everything because it fails to capture
the value of flexibility.
 And second, while the value of flexibility is always
positive, the price that you have to pay for it often
exceeds its value.
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The second question is, when is the use of real options
likely to change the answer a lot?
Real options have the greatest value when three factors
come together.
When there is high uncertainty and when managers
have flexibility to respond to it, real options are important.
But the value of real options relative to NPV is large
when the NPV is close to zero, in the gray area.
If the NPV is high, then most options that provide
additional flexibility will have a very low probability of
being exercised, and therefore have low relative value.
If the NPV is extremely negative, no amount of
optionality can rescue the project.
Deferral call option
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Having a deferral option, allowing them to postpone their
development decision until the price of coal increased
enough to make them relatively certain that they could
recover their development costs before the price turned
around and fell again.
Node that this example illustrates a fundamental
difference between NPV and ROA that will be discussed
in detail later on.
Real options analysis combines them into a single present
value – a go or no go decision today – with a decision rule
about when to develop the lease.
American put option : a cancelable
operating lease
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The lease could be canceled either redelivery or for a
period of time after delivery of the aircraft – a walk-away
option.
If he stopped offering the cancellation feature.
Subsequently, we segmented the market into categories
based on the variability of estimated operating income,
which in turn depends on the variability of passenger
revenue miles.
The jet engine manufacturer decided to stop offering the
cancellation feature to these airlines where the value of the
cancellation feature was greatest, preferring to lose their
business to competitors.
Opening and closing mines : switching
options
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Switching options are the right to close an operation that is
currently open by paying fixed shutdown costs and the
right to open it later for a different fixed cost to a common
type of option, actually a portfolio of puts and calls.
Application of switching options in mining. Not only does
the real options approach reveal the added value from the
ability to close then reopen the mine, but it also provides
rules of thumb about when to do so.
Real options approaches to this problem show that the
flexibility to shut down and reopen adds value to the mine,
adds more value if the switching costs are low, and tells the
mining company exactly what trigger prices to use for
optimal operation.
Phased investment in a chemical plant : a
compound option
A real option approach viewed the project as a
series of compound options – each option
depending on the exercise of those that preceded
it.
 Thus Phase II is a call option that is contingent on
Phase I.
 Many executive decisions are made in phase
without recommitment to undertake all phases
regardless of how uncertainties that drive the
value of the project might evolve.

Exploration and development：A
compound rainbow option
 Compound
rainbow options are perhaps the
most realistic and the most complex real
options that we will show you how to value.
 But they cover a wide and important class of
decision : In addition to exploration and
development, they are useful for research
and development, and new product
development decisions.
The speed and capacity of personal computers
have advanced so rapidly that only recently have
managers had at their disposal enough easy-toaccess computer power to bring realism and
transparency to the table.
 Now we realize that real options can be applied to
almost any situation where it is possible to
estimate the understand and to value real options
for many realistic applications including those that
are compound options and that have multiple
sources of uncertainty.

Conclusion
 Real
options analysis values the flexibility to
respond to uncertain events – net present
value techniques do not and consequently
undervalue everything.