FIN 453: Cases In Strategic Corporate Finance
REAL OPTIONS
OLD FASHION IDEAS FOR
NEW METHODOLIGIES IN
CAPITAL BUDGETING
1
GOAL OF THIS PRESENTATION

ARE THE TRADITIONAL CAPITAL BUDGETING
METHODS OPTIMAL?

DO REAL OPTIONS ADD SOMETHING TO THE
TRADITIONAL METHODS?

CONCERNS WITH REAL OPTIONS IN CAPITAL
BUDGETING
2
PROBLEMS WITH THE TRADITIONAL NPV

Expected Cash Flows cannot be altered by managers.
No operating flexibility.

The discount rate is known and constant.

NPV is additive: no interactions or synergies.

The variability of the expected cash flows reduces the
value of the project.
3
VALUATION WITH REAL OPTIONS
time (t)
+
Options
Risk()
+
Interest (r)
-
+
+
Project’s Value
Beta
-
Basic NPV
Project Value = Basic NPV + Options
4
OPTIONS APPLIED TO PROJECTS






OPTION TO DELAY AN INVESTMENT: Option to delay the
investment and to undertake it at a future time. It is usually
associated to patents, copyrights or ownership of land.
(Pharmaceutical Industry)
OPTION TO EXPAND: It gives the option to the management to do
follow-on investments. (Movie Industry: Lord of the Rings).
OPTION TO EXTEND: It gives the option to the management to
extend the life of an asset.
OPTION TO ABANDON: Option to sell the project obtaining a
liquidation value.
OPTION TO PAUSE: Option to pause the production under a bad
environment. (Mining industry)
OPTION TO LEARN: Option to transfer knowledge gained to future
projects. (Consulting)
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Tendency to keep the options until a
weaker competitor exercises them,
Shared options
Lack of opportunity to obtain the
whole value of an investment
opportunity.
Fast exercise of the option to defend
or to surpass competitors
Maximum Competition
Risk of being surpassed by competitors,
but dominant companies have a high
probability of obtaining the whole
value of the option.
Minimum Competition
STRATEGIC MAP FOR REAL OPTIONS
Dominant companies are able to obtain the
whole value of the option.
No risk of being surpassed by competitors.
Keep the options until the vesting date.
Exclusive Option
No expropriation risk by competitors, but
their actions can reduce the option value.
Trend to an early exercise of the option, for
obtaining the higher value of it.
KESTER, W. Carl :”Today’s options for tomorrow’s growth” Harvard Business Review, March-April 1984, pp 153-160
6
GOAL OF THIS PRESENTATION

ARE THE TRADITIONAL CAPITAL BUDGETING
METHODS OPTIMAL?

DO REAL OPTIONS ADD SOMETHING TO THE
TRADITIONAL METHODS?

CONCERNS WITH REAL OPTIONS IN CAPITAL
BUDGETING
7
EXAMPLE

a)
b)
c)
d)
An oil company has the right to exploit a property during one year
to find petroleum. Being A0 the outlays from the operating costs,
construction of paths and the creation of other infrastructure
needed. In addition, A1 is the outlays needed to get the new
process system; whose are made later than A0. After the last
outlay the company will be able to generate cash flows.
The management has flexibility to make the decisions:
Continue with the project
Reduce the scale of production a x%, saving a part of the
payments Ac
Design a flexible production process. When prices exists one
determined level, the company can increase the production in
x% with a associated cost of AE
At any time management can liquidate the investment obtaining
the residual value
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TRADITIONAL NPV ANALYSIS

Initial Investment A0 = 104
PV (FCF) PV+1=180
50%
PV (FCF) PV-1=60
50%
0,5
180
100
0,5
60
k =20%
rf = 8%
NPV = - A0+ PV0= - 104 +
(0,5 x 180)+ (0,5 x 60 )
= -104 + 100 = - 4 < 0
1,20
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CREATING RISK NEUTRAL PROBABILITIES

Use the concept of arbitrage = calculate risk neutral
probabilities.
p PV+1 + (1-p)PV-1
(1+ rf ) PV0 - PV-1
PV0 =
P=
PV+1 - PV-1
(1+ rf )


Risk Neutral Probabilities
Probability (good)
P=
(1+ rf ) PV0 - PV-1
PV+1 - PV-1

Probability (bad)
(1+0,08)x 100 - 60
=
= 0.4
180 - 60
P = 1 – p = 0.6
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CREATING RISK NEUTRAL PROBABILITIES

PV Project (E0)
pE+1 +(1 – p) E-1
0,4 x 180 + 0,6 x 60
=
Eo =
(1+ rf )
= 100
1 + 0,08
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OPTION TO DELAY THE INVESTMENT

Possibility to delay the project investing A1 at the end of the
year
E = Max [ PV1-A1;0]
A1=104 x 1,08 = 112,32
Present value of the project at t=1:
E1+ = Max [ PV+1-A1;0] = Max [180 – 112,32;0] = 67,68
E1- = Max [ PV-1-A1;0] = Max [60 – 112,32;0] = 0
Project’s value including the option to delay is
pE+1 +(1 – p) E-1
E0 =
0,4 x 67,68 + 0,6 x 0
=
(1+ rf )
= 25,07
1 + 0,08
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
Try to apply the same rationality to the
following proposed situations
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OPTION TO EXPAND

When product prices are much more favorable than
expected management can expand the production x%,
incurring in a cost AE. Call Option at AE.
Assumption: the company can increase production a 50% (x=50%) with a cost of 40 million
(AE)
14
OPTION TO REDUCE

With unfavorable prices management may reduce
production (x%) saving some percentage of the estimated
cash outflows (AR).
Assumptions: Initial outlay 104 million, in two stages 50 million at t=0 and
58.32 million at t=1, which can be divided in 18.32 million in fixed costs
and the rest is variable, being 33.32 million in marketing and 6.68 million
in maintenance.
Next year management can decrease production 50% (C=0.5) with an
outlay of 25 million (savings 33.32)
15
OPTION TO ABANDON

In a adverse environment management can make the decision to
abandon the project. The company will get the residual value (RV).
This is an American Put option on the sale value.
Residual Value Scheme
180
120
108
80
72

64,5
RV0= 80 million < PV0 =100
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OPTION TO ABANDON
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OPTION TO PAUSE


Assumptions: Initial outlay 104 million, in two stages 50 million at t=0
and 58.32 million at t=1, which can be divided in 20 million in
maintenance (20m fixed and the rest variable) and 33.32 million in
marketing (variable). That is, Fixed Costs = 20m and Variable Costs
= 38.32m
Income is expected to be equal to 30% of the present value of the
project at that time:
C+ =0,3 VA+ = 0,3 x 180 = 54
C- =0,3 VA- = 0,3 x 60 = 18
 Management will have to incur in variable cost in order to achieve
those revenues.
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OPTION TO PAUSE
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