When you use discounted cash flow (DCF) to value a project, you implicitly assume that your firm will hold the project passively. In other words, you are ignoring the real options attached to the project—options that sophisticated managers can take advantage of. You could say that DCF does not reflect the value of management. Managers who hold real options do not have to be passive; they can make decisions to capitalize on good fortune or to mitigate loss. The opportunity to make such decisions clearly adds value whenever project outcomes are uncertain.
Chapter 10 introduced the four main types of real options:
· The option to expand if the immediate investment project succeeds.
· The option to wait (and learn) before investing.
· The option to shrink or abandon a project.
· The option to vary the mix of output or the firm’s production methods.
Chapter 10 gave several simple examples of real options. We also showed you how to use decision trees to set out possible future outcomes and decisions. But we did not show you how to value real options. That is our task in this chapter. We apply the concepts and valuation principles you learned in Chapter 21.
For the most part, we work with simple numerical examples. The art and science of valuing real options are illustrated just as well with simple calculations as complex ones. But we also describe several more realistic examples, including
· A strategic investment in the computer business.
· The option to develop commercial real estate.
· The decision to operate or mothball an oil tanker.
· Purchase options on aircraft.
· Investment in pharmaceutical R&D.
These examples show how financial managers can value real options in real life. We also show how managers can create real options, adding value by adding flexibility to the firm’s investments and operations.
We should start with a warning. Setting out the possible future choices that the firm may encounter usually calls for a strong dose of judgment. Therefore, do not expect precision when valuing real options. Often, managers do not even try to put a figure on the value of the option but simply draw on their experience to decide whether it is worth paying for additional flexibility. Thus, they might say, “We just don’t know whether gargle blasters will catch on, but it probably makes sense to spend an extra $200,000 now to allow for an extra production line in the future.”
22-1The Value of Follow-On Investment Opportunities
It is 1982 and the first personal computer has recently been launched. You are assistant to the chief financial officer (CFO) of Blitzen Computers, an established computer manufacturer casting a profit-hungry eye on the PC market. You are helping the CFO evaluate the proposed introduction of the Blitzen Mark I Micro.
The Mark I’s forecasted cash flows and NPV are shown in Table 22.1. Unfortunately, the Mark I can’t meet Blitzen’s customary 20% hurdle rate and has a $46 million negative NPV, contrary to top management’s strong gut feeling that Blitzen ought to be in the personal computer market.
TABLE 22.1 Summary of cash flows and financial analysis of the Mark I microcomputer ($ millions)
The CFO has called you in to discuss the project:
“The Mark I just can’t make it on financial grounds,” the CFO says. “But we’ve got to do it for strategic reasons. I’m recommending we go ahead.”
“But you’re missing the all-important financial advantage, Chief,” you reply.
“Don’t call me ‘Chief.’ What financial advantage?”
“If we don’t launch the Mark I, it will probably be too expensive to enter the micro market later, when Apple, IBM, and others are firmly established. If we go ahead, we have the opportunity to make follow-on investments that could be extremely profitable. The Mark I gives not only its own cash flows, but also a call option to go on with a Mark II micro. That call option is the real source of strategic value.”
“So it’s strategic value by another name. That doesn’t tell me what the Mark II investment’s worth. The Mark II could be a great investment or a lousy one—we haven’t got a clue.”
“That’s exactly when a call option is worth the most,” you point out perceptively. “The call lets us invest in the Mark II if it’s great and walk away from it if it’s lousy.”
“So what’s it worth?”
“Hard to say precisely, but I’ve done a back-of-the-envelope calculation, which suggests that the value of the option to invest in the Mark II could more than offset the Mark I’s $46 million negative NPV. [The calculations are shown in Table 22.2.] If the option to invest is worth $55 million, the total value of the Mark I is its own NPV, −$46 million, plus the $55 million option attached to it, or +$9 million.”
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Assumptions |
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1. The decision to invest in the Mark II must be made after three years, in 1985. 2. The Mark II investment is double the scale of the Mark I (note the expected rapid growth of the industry). Investment required is $900 million (the exercise price), which is taken as fixed. 3. Forecasted cash inflows of the Mark II are also double those of the Mark I, with present value of $807 million in 1985 and 807/(1.2)3 = $467 million in 1982. 4. The future value of the Mark II cash flows is highly uncertain. This value evolves as a stock price does with a standard deviation of 35% per year. (Many high-technology stocks have standard deviations higher than 35%.) 5. The annual interest rate is 10%. |
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Interpretation |
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The opportunity to invest in the Mark II is a three-year call option on an asset worth $467 million with a $900 million exercise price. |
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Valuation |
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TABLE 22.2 Valuing the option to invest in the Mark II microcomputer
“You’re just overestimating the Mark II,” the CFO says gruffly. “It’s easy to be optimistic when an investment is three years away.”
“No, no,” you reply patiently. “The Mark II is expected to be no more profitable than the Mark I—just twice as big and therefore twice as bad in terms of discounted cash flow. I’m forecasting it to have a negative NPV of about $100 million. But there’s a chance the Mark II could be extremely valuable. The call option allows Blitzen to cash in on those upside outcomes. The chance to cash in could be worth $55 million.
“Of course, the $55 million is only a trial calculation, but it illustrates how valuable follow-on investment opportunities can be, especially when uncertainty is high and the product market is growing rapidly. Moreover, the Mark II will give us a call on the Mark III, the Mark III on the Mark IV, and so on. My calculations don’t take subsequent calls into account.”
“I think I’m beginning to understand a little bit of corporate strategy,” mumbles the CFO.
Questions and Answers about Blitzen’s Mark II
Question: I know how to use the Black–Scholes formula to value traded call options, but this case seems harder. What number do I use for the stock price? I don’t see any traded shares.
Answer: With traded call options, you can see the value of the underlying asset that the call is written on. Here the option is to buy a nontraded real asset, the Mark II. We can’t observe the Mark II’s value; we have to compute it.
BEYOND THE PAGE
Blitzen
mhhe.com/brealey13e
The Mark II’s forecasted cash flows are set out in Table 22.3. The project involves an initial outlay of $900 million in 1985. The cash inflows start in the following year and have a present value of $807 million in 1985, equivalent to $467 million in 1982 as shown in Table 22.3. So the real option to invest in the Mark II amounts to a three-year call on an underlying asset worth $467 million, with a $900 million exercise price.
TABLE 22.3 Cash flows of the Mark II microcomputer, as forecasted from 1982 ($ millions)
Notice that real options analysis does not replace DCF. You typically need DCF to value the underlying asset.
Question: Table 22.2 uses a standard deviation of 35% per year. Where does that number come from?
Answer: We recommend you look for comparables—that is, traded stocks with business risks similar to the investment opportunity.1 For the Mark II, the ideal comparables would be growth stocks in the personal computer business or perhaps a broader sample of high-tech growth stocks. Use the average standard deviation of the comparable companies’ returns as the benchmark for judging the risk of the investment opportunity.2
Question: Table 22.3 discounts the Mark II’s cash flows at 20%. I understand the high discount rate because the Mark II is risky. But why is the $900 million investment discounted at the risk-free interest rate of 10%? Table 22.3 shows the present value of the investment in 1982 of $676 million.
Answer: Black and Scholes assumed that the exercise price is a fixed, certain amount. We wanted to stick with their basic formula. If the exercise price is uncertain, you can switch to a slightly more complicated valuation formula.3
Question: Nevertheless, if I had to decide in 1982, once and for all, whether to invest in the Mark II, I wouldn’t do it. Right?
Answer: Right. The NPV of a commitment to invest in the Mark II is negative:
NPV(1982) = PV(cash inflows) − PV(investment) = $467 − 676 = −$209 million
The option to invest in the Mark II is “out of the money” because the Mark II’s value is far less than the required investment. Nevertheless, the option is worth +$55 million. It is especially valuable because the Mark II is a risky project with lots of upside potential. Figure 22.1 shows the probability distribution of the possible present values of the Mark II in 1985. The expected (mean or average) outcome is our forecast of $807,4 but the actual value could exceed $2 billion.
FIGURE 22.1 This distribution shows the range of possible present values for the Mark II project in 1985. The expected value is about $800 million, less than the required investment of $900 million. The option to invest pays off in the shaded area above $900 million.
Question: Could it also be far below $807 million—$500 million or less?
Answer: The downside is irrelevant because Blitzen won’t invest unless the Mark II’s actual value turns out higher than $900 million. The net option payoffs for all values less than $900 million are zero.
In a DCF analysis, you discount the expected outcome ($807 million), which averages the downside against the upside, the bad outcomes against the good. The value of a call option depends only on the upside. You can see the danger of trying to value a future investment option with DCF.
Question: What’s the decision rule?
Answer: Adjusted present value. The best-case NPV of the Mark I project is −$46 million, but accepting it creates the expansion option for the Mark II. The expansion option is worth $55 million, so
APV = −46 + 55 = +$9 million
Of course, we haven’t counted other follow-on opportunities. If the Mark I and Mark II are successes, there will be an option to invest in the Mark III, possibly the Mark IV, and so on.
Other Expansion Options
You can probably think of many other cases where companies spend money today to create opportunities to expand in the future. A mining company may acquire rights to an ore body that is not worth developing today but could be very profitable if ore prices increase. A real estate developer may invest in worn-out farmland that could be turned into a shopping mall if a new highway is built. A pharmaceutical company may acquire a patent that gives the right but not the obligation to market a new drug. In each case, the company is acquiring a real option to expand.
22-2The Timing Option
The fact that a project has a positive NPV does not mean that you should go ahead today. It may be better to wait and see how the market develops.
Suppose that you are contemplating a now-or-never opportunity to build a malted herring factory. In this case, you have an about-to-expire call option on the present value of the factory’s future cash flows. If the present value exceeds the cost of the factory, the call option’s payoff is the project’s NPV. But if NPV is negative, the call option’s payoff is zero because, in that case, the firm will not make the investment.
Now suppose that you can delay construction of the plant. You still have the call option, but you face a trade-off. If the outlook is highly uncertain, it is tempting to wait and see whether the malted herring market takes off or decays. On the other hand, if the project is truly profitable, the sooner you can capture the project’s cash flows, the better. If the cash flows are high enough, you will want to exercise your option right away.
The cash flows from an investment project play the same role as dividend payments on a stock. When a stock pays no dividends, an American call is always worth more alive than dead and should never be exercised early. But payment of a dividend before the option matures reduces the ex-dividend price and the possible payoffs to the call option at maturity. Think of the extreme case: If a company pays out all its assets in one bumper dividend, the stock price must be zero and the call worthless. Therefore, any in-the-money call would be exercised just before this liquidating dividend.
Dividends do not always prompt early exercise, but if they are sufficiently large, call option holders capture them by exercising just before the ex-dividend date. We see managers acting in the same way: When a project’s forecasted cash flows are sufficiently large, managers capture the cash flows by investing right away. But when forecasted cash flows are small, managers are inclined to hold on to their call rather than to invest, even when project NPV is positive.5 This explains why managers are sometimes reluctant to commit to positive-NPV projects. This caution is rational as long as the option to wait is open and sufficiently valuable.
Valuing the Malted Herring Option
Figure 22.2 shows the possible cash flows and end-of-year values for the malted herring project. If you commit and invest $180 million, you have a project worth $200 million. If demand turns out to be low in year 1, the cash flow is only $16 million and the value of the project falls to $160 million. But if demand is high in year 1, the cash flow is $25 million and value rises to $250 million. Although the project lasts indefinitely, we assume that investment cannot be postponed beyond the end of the first year, and therefore we show only the cash flows for the first year and the possible values at the end of the year. Notice that if you undertake the investment right away, you capture the first year’s cash flow ($16 million or $25 million); if you delay, you miss out on this cash flow, but you will have more information on how the project is likely to work out.
FIGURE 22.2 Possible cash flows and end-of-period values for the malted herring project are shown in black. The project costs $180 million, either now or later. The red figures in parentheses show payoffs from the option to wait and to invest later if the project is positive NPV at year 1. Waiting means loss of the first year’s cash flows. The problem is to figure out the current value of the option.
We can use the binomial method to value this option. The first step is to pretend that investors are risk neutral and to calculate the probabilities of high and low demand in this risk-neutral world. If demand is high in the first year, the malted herring plant has a cash flow of $25 million and a year-end value of $250 million. The total return is (25 + 250)/200 − 1 = .375, or 37.5%. If demand is low, the plant has a cash flow of $16 million and a year-end value of $160 million. Total return is (16 + 160)/200 − 1 = −.12, or −12%. In a risk-neutral world, the expected return would be equal to the interest rate, which we assume is 5%:
Therefore, the risk-neutral probability of high demand is 34.3%. This is the probability that would generate the risk-free return of 5%.
We want to value a call option on the malted herring project with an exercise price of $180 million. We begin as usual at the end and work backward. The bottom row of Figure 22.2 shows the possible values of this option at the end of the year. If project value is $160 million, the option to invest is worthless. At the other extreme, if project value is $250 million, option value is $250 − 180 − $70 million.
To calculate the value of the option today, we work out the expected payoffs in a risk-neutral world and discount at the interest rate of 5%. Thus, the value of your option to invest in the malted herring plant is
But here is where we need to recognize the opportunity to exercise the option immediately. The option is worth $22.9 million if you keep it open, and it is worth the project’s immediate NPV (200 − 180 = $20 million) if exercised now. Therefore, we decide to wait and then to invest next year only if demand turns out high.
We have, of course, simplified the malted herring calculations. You won’t find many actual investment-timing problems that fit into a one-step binomial tree. But the example delivers an important practical point: A positive NPV is not a sufficient reason for investing. It may be better to wait and see.
Optimal Timing for Real Estate Development
Sometimes it pays to wait for a long time, even for projects with large positive NPVs. Suppose you own a plot of vacant land in the suburbs.6 The land can be used for a hotel or an office building, but not for both. A hotel could be later converted to an office building, or an office building to a hotel, but only at significant cost. You are therefore reluctant to invest, even if both investments have positive NPVs.
In this case, you have two options to invest, but only one can be exercised. You therefore learn two things by waiting. First, you learn about the general level of cash flows from development—for example, by observing changes in the value of developed properties near your land. Second, you can update your estimates of the relative size of the hotel’s future cash flows versus the office building’s.
Figure 22.3 shows the conditions in which you would finally commit to build either the hotel or the office building. The horizontal axis shows the current cash flows that a hotel would generate. The vertical axis shows current cash flows for an office building. For simplicity, we assume that each investment would have an NPV of exactly zero at a current cash flow of 100. Thus, if you were forced to invest today, you would choose the building with the higher cash flow, assuming the cash flow is greater than 100. (What if you were forced to decide today and each building could generate the same cash flow, say, 150? You would flip a coin.)
FIGURE 22.3 Development option for vacant land, assuming two mutually exclusive uses, either hotel or office building. The developer should “wait and see” unless the hotel’s or office building’s cash flows end up in one of the shaded areas.
Source: Adapted from Figure 1 in P. D. Childs, T. J. Riddiough, and A. J. Triantis, “Mixed Uses and the Redevelopment Option,” Real Estate Economics 24 (Fall 1996), pp. 317–339.
If the two buildings’ cash flows plot in the colored area at the lower right of Figure 22.3, you build the hotel. To fall in this area, the hotel’s cash flows have to beat two hurdles. First, they must exceed a minimum level of about 240. Second, they must exceed the office building’s cash flows by a sufficient amount. If the situation is reversed, with office building cash flows above the minimum level of 240, and also sufficiently above the hotel’s, then you build the office building. In this case, the cash flows plot in the colored area at the top left of the figure.
Notice how the “wait and see” region extends upward along the 45-degree line in Figure 22.3. When the cash flows from the hotel and office building are nearly the same, you become very cautious before choosing one over the other.
You may be surprised at how high cash flows have to be in Figure 22.3 to justify investment. There are three reasons. First, building the office building means not building the hotel, and vice versa. Second, the calculations underlying Figure 22.3 assumed cash flows that were small, but growing; therefore, the costs of waiting to invest were small. Third, the calculations did not consider the threat that someone might build a competing hotel or office building right next door. In that case, the “relax and wait” area of Figure 22.3 would shrink dramatically.
22-3The Abandonment Option
Expansion value is important. When investments turn out well, the quicker and easier the business can be expanded, the better. But suppose bad news arrives, and cash flows are far below expectations. In that case, it is useful to have the option to bail out and recover the value of the project’s plant, equipment, or other assets. The option to abandon is equivalent to a put option. You exercise that abandonment option if the value recovered from the project’s assets is greater than the present value of continuing the project for at least one more period.
Bad News for the Perpetual Crusher
We introduced the perpetual crusher project in Chapter 19 to illustrate the use of the weighted-average cost of capital (WACC). The project cost $12.5 million and generated expected perpetual cash flows of $1.175 million per year. With WACC = .094, the project was worth PV = 1.175/.094 = $12.5 million. Subtracting the investment of $12.5 million gave NPV = 0.
Several years later, the crusher has not panned out. Cash flows are still expected to be perpetual but are now running at only $450,000 a year. The crusher is therefore worth only $450,000/.094 = $4.8 million. Is this bad news terminal?
Suppose the crusher project can be abandoned, with recovery of $5.2 million from the sale of machinery and real estate. Does abandonment make sense? The immediate gain from abandonment is of course $5.2 − 4.8 = $.4 million. But what if you can wait and reconsider abandonment later? In this case, you have an abandonment option that does not have to be exercised immediately.
We can value the abandonment option as a put. Assume for simplicity that the put lasts one year only (abandon now or at year 1) and that the one-year standard deviation of the crusher project is 30%. The risk-free interest rate is 4%. We value the one-year abandonment put using the Black–Scholes formula and put–call parity. The asset value is $4.8 million and the exercise price is $5.2 million. (See Section 21-3 if you need a refresher on using the Black–Scholes formula.)
Therefore, you decide not to abandon now. The project, if alive, is worth 4.8 + .690 = $5.49 million when the abandonment put is included but only $5.2 million if it is abandoned immediately.
You are keeping the project alive not out of stubbornness or loyalty to the crusher, but because there is a chance that cash flows will recover. The abandonment put still protects on the downside if the crusher project deals up further disappointments.
Of course, we have made simplifying assumptions. For example, the recovery value of the crusher is likely to decline as you wait to abandon. So perhaps we are using too high an exercise price. On the other hand, we have considered only a one-year European put. In fact, you have an American put with a potentially long maturity. A long-lived American put is worth more than a one-year European put because you can abandon in year 2, 3, or later if you wish.
Abandonment Value and Project Life
A project’s economic life can be just as hard to predict as its cash flows. Yet NPVs for capital-investment projects usually assume fixed economic lives. For example, in Chapter 6 we assumed that the guano project would operate for exactly seven years. Real-option techniques allow us to relax such fixed-life assumptions. Here is the procedure:7
1. Forecast cash flows well beyond the project’s expected economic life. For example, you might forecast guano production and sales out to year 15.
2. Value the project, including the value of your abandonment put, which allows, but does not require, abandonment before year 15. The actual timing of abandonment will depend on project performance. In the best upside scenarios, project life will be 15 years—it will make sense to continue in the guano business as long as possible. In the worst downside scenarios, project life will be much shorter than 7 years. In intermediate scenarios where actual cash flows match original expectations, abandonment will occur around year 7.
This procedure links project life to the performance of the project. It does not impose an arbitrary ending date, except in the far distant future.
Temporary Abandonment
Companies are often faced with complex options that allow them to abandon a project temporarily—that is, to mothball it until conditions improve. Suppose you own an oil tanker operating in the short-term spot market. (In other words, you charter the tanker voyage by voyage, at whatever short-term charter rates prevail at the start of the voyage.) The tanker costs $50 million a year to operate, and at current tanker rates, it produces charter revenues of $52.5 million per year. The tanker is therefore profitable but scarcely cause for celebration. Now tanker rates dip by 10%, forcing revenues down to $47.5 million. Do you immediately lay off the crew and mothball the tanker until prices recover? The answer is clearly yes if the tanker operation can be turned on and off like a faucet. But that is unrealistic. There is a fixed cost to mothballing the tanker. You don’t want to incur this cost only to regret your decision next month if rates rebound to their earlier level. The higher the costs of mothballing and the more variable the level of charter rates, the greater the loss that you will be prepared to bear before you call it quits and lay up the boat.
Suppose that eventually you do decide to take the boat off the market. You lay up the tanker temporarily.8 Two years later, your faith is rewarded; charter rates rise, and the revenues from operating the tanker creep above the operating cost of $50 million. Do you reactivate immediately? Not if there are costs to doing so. It makes more sense to wait until the project is well in the black and you can be fairly confident that you will not regret the cost of bringing the tanker back into operation.
These choices are illustrated in Figure 22.4. The teal line shows how the value of an operating tanker varies with the level of charter rates. The black line shows the value of the tanker when mothballed.9 The level of rates at which it pays to mothball is given by M and the level at which it pays to reactivate is given by R. The higher the costs of mothballing and reactivating and the greater the variability in tanker rates, the farther apart these points will be. You can see that it will pay for you to mothball as soon as the value of a mothballed tanker reaches the value of an operating tanker plus the costs of mothballing. It will pay to reactivate as soon as the value of a tanker that is operating in the spot market reaches the value of a mothballed tanker plus the costs of reactivating. If the level of rates falls below M, the value of the tanker is given by the black line; if the level is greater than R, value is given by the teal line. If rates lie between M and R, the tanker’s value depends on whether it happens to be mothballed or operating.
FIGURE 22.4 An oil tanker should be mothballed when tanker rates fall to M, where the tanker’s value if mothballed is enough above its value in operation to cover mothballing costs. The tanker is reactivated when rates recover to R.
22-4Flexible Production and Procurement
Flexible production means the ability to vary production inputs or outputs in response to fluctuating demand or prices. Take the case of CT (combustion-turbine) generating plants, which are designed to deliver short bursts of peak-load electrical power. CTs can’t match the thermal efficiency of coal or nuclear power plants, but CTs can be turned on or off on short notice. The coal plants and “nukes” are efficient only if operated on “base load” for long periods.
The profits from operating a CT depend on the spark spread—that is, on the difference between the price of electricity and the cost of the natural gas used as fuel. CTs are money-losers at average spark spreads, but the spreads are volatile and can spike to very high levels when demand is high and generating capacity tight. Thus, a CT delivers a series of call options that can be exercised day by day (even hour by hour) when spark spreads are sufficiently high. The call options are normally out-of-the-money (CTs typically operate only about 5% of the time), but the money made at peak prices makes investment in the CTs worthwhile.10
The volatility of spark spreads depends on the correlation between the price of electricity and the price of natural gas used as fuel. If the correlation were 1.0, so that electricity and natural gas prices moved together dollar for dollar, the spark spread would barely move from its average value, and the options to operate the gas turbine would be worthless. But, in fact, the correlation is less than 1.0, so the options are valuable. In addition, some CTs are set up to give a further option because they can be run on oil as well as natural gas.11
The top panel of Figure 22.5 shows a histogram of electricity prices for the U.K. between March 2001 and August 2017. Prices are set every half hour, so there are nearly 300,000 prices plotted. Prices are quoted as pounds per megawatt-hour (£/MWH). Notice how strongly the histogram is skewed to the right. Although the average price was only £45 per MWH, prices above £100/MWH crop up regularly when electricity demand peaks. The highest price was £5,003/MWH. The occasional high prices are hardly visible in the top panel of Figure 22.5. The bottom panel plots only the prices above £60/MWH.
FIGURE 22.5 In the U.K., electricity prices are set every half hour. The top panel is a histogram of prices (£/MWH) for March 2001 through August 2017. Note how the histogram is skewed to the right. Many prices exceeded £100/MWH and a few (not visible in the plot) exceeded £500/ MWH. The bottom panel shows the payoff to a plant that costs £60/MWH to run. The plant operator has an option to produce with an exercise price of £60.
Suppose you have a CT generating plant in the U.K. that is profitable only at prices above £60/MWH. If the plant was in continuous operation, the profit per MWH would be negative at £45.33 – 60 = –£14.67. But it would be better to leave the plant idle when prices are low and to exercise your option to operate only when prices are above £60. Although the plant would have been idle for nearly three-quarters of the time, it would have reaped an average profit of 95.41 – 60 = £35.41 per MWH when it was producing. The possible payoffs are plotted in the bottom panel of Figure 22.5. The payoff line exactly matches the payoff diagrams for call options with an exercise price of £60. The only difference is that your plant has about 17,500 options every year, one for each half hour in the year.
The payoff line in Figure 22.5 assumes that the plant’s operating cost is constant at £60. This is accurate only if the cost of natural gas is constant. Otherwise, the payoff to the option to operate depends on the spark spread. Often, the cost of gas is locked in by contract between the generator and the gas supplier. But if the cost of gas is sufficiently volatile, you would replot Figure 22.5 in spark spreads rather than electricity prices. You would operate when the spark spread is positive.
In this example, the output is the same (electricity); option value comes from the ability to vary the level of output. In other cases, option value comes from the flexibility to switch from product to product using the same production facilities. For example, textile firms have invested heavily in computer-controlled knitting machines, which allow production to shift from product to product, or from design to design, as demand and fashion dictate.
Flexibility in procurement can also have option value. For example, a computer manufacturer planning next year’s production must also plan to buy components, such as disk drives and microprocessors, in large quantities. Should it strike a deal today with the component manufacturer? This locks in the quantity, price, and delivery dates. But it also gives up flexibility—for example, the ability to switch suppliers next year or buy at a “spot” price if next year’s prices are lower.
For example, Hewlett-Packard used to customize printers for foreign markets and then ship the finished printers. If it did not correctly forecast demand, it was liable to end up with too many printers designed for the German market (say) and too few for the French market. The company’s solution was to ship printers that were only partially assembled and then to customize them once it had firm orders. The change made for higher manufacturing costs, but these costs were more than compensated by the extra flexibility. In effect, Hewlett-Packard gained a valuable option to delay the cost of configuring the printers.12
Aircraft Purchase Options
For our final example, we turn to the problem confronting airlines that order new airplanes for future use. In this industry, lead times between an order and delivery can extend to several years. Long lead times mean that airlines that order planes today may end up not needing them. You can see why an airline might negotiate an aircraft purchase option.
In Section 10-4, we used aircraft purchase options to illustrate the option to expand. What we said there was the truth, but not the whole truth. Let’s take another look. Suppose an airline forecasts a need for a new Airbus A320 four years hence.13 It has at least three choices.
· Commit now. It can commit now to buy the plane, in exchange for Airbus’s offer of locked-in price and delivery date.
· Acquire option. It can seek a purchase option from Airbus, allowing the airline to decide later whether to buy. A purchase option fixes the price and delivery date if the option is exercised.
· Wait and decide later. Airbus will be happy to sell another A320 at any time in the future if the airline wants to buy one. However, the airline may have to pay a higher price and wait longer for delivery, especially if the airline industry is flying high and many planes are on order.
The top half of Figure 22.6 shows the terms of a typical purchase option for an Airbus A320. The option must be exercised at year 3, when final assembly of the plane will begin. The option fixes the purchase price and the delivery date in year 4. The bottom half of the figure shows the consequences of “wait and decide later.” We assume that the decision will come at year 3. If the decision is “buy,” the airline pays the year-3 price and joins the queue for delivery in year 5 or later.
FIGURE 22.6 This aircraft purchase option, if exercised at year 3, guarantees delivery at year 4 at a fixed price. Without the option, the airline can still order the plane at year 3, but the price is uncertain and the wait for delivery longer.
Source: Adapted from Figure 17–17 in J. Stonier, “What Is an Aircraft Purchase Option Worth? Quantifying Asset Flexibility Created through Manufacturer Lead-Time Reductions and Product Commonality,” Handbook of Airline Finance, G. F. Butler and M. R. Keller, eds.
The payoffs from “wait and decide later” can never be better than the payoffs from an aircraft purchase option since the airline can discard the option and negotiate afresh with Airbus if it wishes. In most cases, however, the airline will be better off in the future with the option than without it; the airline is at least guaranteed a place in the production line, and it may have locked in a favorable purchase price. But how much are these advantages worth today, compared to the wait-and-see strategy?
Figure 22.7 illustrates Airbus’s answers to this problem. It assumes a three-year purchase option with an exercise price equal to an A320 price of $45 million. The present value of the purchase option depends on both the NPV of purchasing an A320 at that price and on the fore-casted wait for delivery if the airline does not have a purchase option but nevertheless decides to place an order in year 3. The longer the wait in year 3, the more valuable it is to have the purchase option today. (Remember that the purchase option holds a place in the A320 production line and guarantees delivery in year 4.)
FIGURE 22.7 Value of aircraft purchase option—the extra value of the option versus waiting and possibly negotiating a purchase later. (See Figure 22.6.) The purchase option is worth most when NPV of purchase now is about zero and the forecasted wait for delivery is long.
Source: Adapted from Figure 17–20 in J. Stonier, “What Is an Aircraft Purchase Option Worth? Quantifying Asset Flexibility Created Through Manufacturer Lead-Time Reductions and Product Commonality,” in Handbook of Aviation Finance, G. F. Butler and M. R. Keller, eds.
If the NPV of buying an A320 today is very high (the right-hand side of Figure 22.7), future NPV will probably be high as well, and the airline will want to buy regardless of whether it has a purchase option. In this case, the value of the purchase option comes mostly from the value of guaranteed delivery in year 4.14 If the NPV is very low, then the option has low value because the airline is unlikely to exercise it. (Low NPV today probably means low NPV in year 3.) The purchase option is worth the most, compared to the wait-and-decide-later strategy, when NPV is around zero. In this case, the airline can exercise the option, getting a good price and early delivery, if future NPV is higher than expected; alternatively, it can walk away from the option if NPV disappoints. Of course, if it walks away, it may still wish to negotiate with Airbus for delivery at a price lower than the option’s exercise price.
We have cruised by many of the technical details of Airbus’s valuation model for purchase options. But the example does illustrate how real-options models are being built and used. By the way, Airbus offers more than just plain-vanilla purchase options. Airlines can negotiate “rolling options,” which lock in price but do not guarantee a place on the production line. (Exercise of the rolling option means that the airline joins the end of the queue.) Airbus also offers a purchase option that includes the right to switch from delivery of an A320 to an A319, a somewhat smaller plane.
22-5Investment in Pharmaceutical R&D
An investment in research and development (R&D) is really an investment in real options. When your research engineers invent a better mousetrap, they hand you an option to manufacture and sell it. New and improved mousetraps can be engineering triumphs but commercial failures. You will make the investment to manufacture and launch the better mousetrap only if the PV of expected cash inflows is greater than the required investment.
The pharmaceutical industry spends massive amounts for R&D to develop options to produce and sell new drugs. We described pharmaceutical R&D in Example 10.2 and in Figure 10.4, which is a simplified decision tree. After you have reviewed that example and figure, take a look at Figure 22.8, which recasts the decision tree as a real option.
FIGURE 22.8 The decision tree from Figure 10.4 recast as a real option. If phase II trials are successful, the company has a real call option to invest $130 million. If the option is exercised, the company gets an 80% chance of launching an approved drug. The PV of the drug, which is forecasted at $350 million in year 5, is the underlying asset for the call option.
The drug candidate in Figure 22.8 requires an immediate investment of $18 million. That investment buys a real option to invest $130 million at year 2 to pay for phase III trials and costs incurred during the prelaunch period. Of course the real option exists only if phase II trials are successful. There is a 56% probability of failure. So after we value the real option, we will have to multiply its value by the 44% probability of success.
The exercise price of the real option is $130 million. The underlying asset is the PV of the drug, assuming that it passes phase III successfully. Figure 10.4 forecasts the expected PV of the drug at launch at $350 million in year 5. We multiply this value by .8 because the decision whether to exercise the option must be taken in year 2, before the company knows whether the drug will succeed or fail in phase III and prelaunch. Then we must discount this value back to year 0, because the Black–Scholes formula calls for the value of the underlying asset on the date when the option is valued. The cost of capital is 9.6%, so the PV today is
PV at year 0, assuming success in phase II = .8 × 350 / (1.096)5 = 177, or $177 million
To value the real option, we need a risk-free rate (assume 4%) and a volatility of the value of the drug once launched (assume 20%). With these inputs, the Black–Scholes value of a two-year call on an asset worth $177 million with an exercise price of $130 million is $58.4 million. (Refer to Section 21.3 if you need a refresher on how to use the Black– Scholes formula.)
But there’s only a 44% chance that the drug will pass phase II trials. So the company must compare an initial investment of $18 million with a 44% chance of receiving an option worth $58.4 million. The NPV of the drug at year 0 is
NPV = −18 + (.44 × 58.4) = $7.7 million
This NPV is less than the $19 million NPV computed from Figure 10.4.15 Nevertheless, the R&D project is still a “go.”
Of course Figure 22.8 assumes only one decision point, and only one real option, between the start of phase II and the product launch. In practice, there would be other decision points, including a Go/No Go decision after phase III trials but before prelaunch investment. In this case, the payoff to the first option at the end of phase II is the value at that date of the second option. This is an example of a compound call.
With two sequential options, you could look up the formula for a compound call in an option pricing manual, or you could build a binomial tree for the R&D project. Suppose you take the binomial route. Once you set up the tree, using risk-neutral probabilities for changes in the value of the underlying asset, you solve the tree as you would solve any decision tree. You work back from the end of the tree, always choosing the decision that gives the highest value at each decision point. NPV is positive if the PV at the start of the tree is higher than the $18 million initial investment.
Despite its simplifying assumptions, our example explains why investors demand higher expected returns from R&D investments than from the products that the R&D may generate. R&D invests in real call options.16 A call option is always riskier (higher beta) than the underlying asset that is acquired when the option is exercised. Thus, the opportunity cost of capital for R&D is higher than for a new product after the product is launched successfully.17
R&D is also risky because it may fail. But the risk of failure is not usually a market or macroeconomic risk. The drug’s beta or cost of capital does not depend on the probabilities that a drug will fail in phase II or III. If the drug fails, it will be because of medical or clinical problems, not because the stock market is down. We take account of medical or clinical risks by multiplying future outcomes by the probability of success, not by adding a fudge factor to the discount rate.
22-6Valuing Real Options
In this chapter, we have presented several examples of important real options. In each case, we used the option-pricing methods developed in Chapter 21, as if the real options were traded calls or puts. Was it right to value the real options as if they were traded? Also we said next to nothing about taxes. Shouldn’t the risk-free rate be after-tax? What about the practical problems that managers face when they try to value real options in real life? We now address these questions.
A Conceptual Problem?
When we introduced option pricing models in Chapter 21, we showed that the trick is to construct a package of the underlying asset and a loan that would give exactly the same payoffs as the option. If the two investments do not sell for the same price, then there are arbitrage possibilities. But most real assets are not freely traded. This means that we can no longer rely on arbitrage arguments to justify the use of Black–Scholes or binomial option valuation methods.
The risk-neutral method still makes practical sense for real options, however. It’s really just an application of the certainty-equivalent method introduced in Chapter 9.18 The key assumption—implicit until now—is that the company’s shareholders have access to assets with the same risk characteristics (e.g., the same beta) as the capital investments being evaluated by the firm.
Think of each real investment opportunity as having a “double,” a security or portfolio with identical risk. Then the expected rate of return offered by the double is also the cost of capital for the real investment and the discount rate for a DCF valuation of the investment project. Now what would investors pay for a real option based on the project? The same as for an identical traded option written on the double. This traded option does not have to exist; it is enough to know how it would be valued by investors, who could employ either the arbitrage or the risk-neutral method. The two methods give the same answer, of course.
When we value a real option by the risk-neutral method, we are calculating the option’s value if it could be traded. This exactly parallels standard capital budgeting. Shareholders would vote unanimously to accept any capital investment whose market value if traded exceeds its cost, as long as they can buy traded securities with the same risk characteristics as the project. This key assumption supports the use of both DCF and real-option valuation methods.
What about Taxes?
So far, this chapter has mostly ignored taxes, but just for simplicity. Taxes have to be accounted for when valuing real options. Take the Mark II microcomputer in Table 22.2 as an example. The Mark II’s forecasted PV of $807 million should be calculated from after-tax cash flows generated by the product. The required investment of $900 million should likewise be calculated after-tax.19
What about the risk-free discount rate used in the risk-neutral method? It should also be after-tax. Look back to the Chapter 19 Appendix, which demonstrates that the proper discount rate for safe cash flows is the after-tax interest rate. The same logic applies here because projected cash flows in the risk-neutral method are valued as if they were safe.
Recall that the value of a real call option can be expressed as a position in the underlying asset minus a loan. Thus, the call behaves like a claim on the underlying asset partly financed with borrowed money. The borrowing does not show up on the corporation’s balance sheet, but it is nevertheless really there. The implicit borrowing is a debt-equivalent obligation that must be valued using an after-tax interest rate.20
The implicit borrowing creates off-balance-sheet financial leverage. The resulting financial risk is the reason why the real call option’s value is more volatile than the value of the underlying asset. (The real option would have a higher beta than the underlying asset if both were traded in financial markets.)
In Chapter 18, we pointed out that highly profitable growth companies like Alphabet and Amazon use mostly equity finance. These companies’ real growth options are one explanation. The options contain implicit debt. If the CFOs of these growth firms recognize the implicit debt, or at least the extra financial risk attached to the options, they should reduce ordinary borrowing to compensate. Option leverage therefore displaces ordinary financial leverage. The displacement means that if you forget to count both the debt that is on and off the balance sheet, a growth firm will appear to be less leveraged than it actually is.
Practical Challenges
The challenges in applying real-options analysis are not conceptual but practical. It isn’t always easy. We can tick off some of the reasons why.
First, real options can be complex, and valuing them can absorb a lot of analytical and computational horsepower. Whether you want to invest in that horsepower is a matter for business judgment. Sometimes an approximate answer now is more useful than a “perfect” answer later, particularly if the perfect answer comes from a complicated model that other managers will regard as a black box. One advantage of real-options analysis, if you keep it simple, is that it’s relatively easy to explain. Complex decision trees can often be described as the payoffs to one or two simple call or put options.
The second problem is lack of structure. To quantify the value of a real option, you have to specify its possible payoffs, which depend on the range of possible values of the underlying asset, exercise prices, timing of exercise, etc. In this chapter, we have taken well-structured examples where it is easy to see the road map of possible outcomes. For example, investments in pharmaceutical R&D are well-structured because all new drugs have to go through the same series of clinical trials to get approved by the U.S. Food and Drug Administration. Outcomes are uncertain, but the road map is clear. In other cases, you may not have a road map. For example, reading this book can enhance your personal call option to work in financial management, yet we suspect that you would find it hard to write down how that option would change the binomial tree of your entire future career.
A third problem can arise when your competitors have real options. This is not a problem in industries where products are standardized and no single competitor can shift demand and prices. But when you face just a few key competitors, all with real options, then the options can interact. If so, you can’t value your options without thinking of your competitors’ moves. Your competitors will be thinking in the same fashion.
An analysis of competitive interactions would take us into other branches of economics, including game theory. But you can see the danger of assuming passive competitors. Think of the timing option. A simple real-options analysis will often tell you to wait and learn before investing in a new market. Be careful that you don’t wait and learn that a competitor has moved first.21
Given these hurdles, you can understand why systematic, quantitative valuation of real options is restricted mostly to well-structured problems like the examples in this chapter. The qualitative implications of real options are widely appreciated, however. Real options give the financial manager a conceptual framework for strategic planning and thinking about capital investments. If you can identify and understand real options, you will be a more sophisticated consumer of DCF analysis and better equipped to invest your company’s money wisely.
Understanding real options also pays off when you can create real options, adding value by adding flexibility to the company’s investments and operations. For example, it may be better to design and build a series of modular production plants, each with capacity of 50,000 tons per year of magnoosium alloy, than to commit to one large plant with capacity of 150,000 tons per year. The larger plant will probably be more efficient because of economies of scale. But with the smaller plants, you retain the flexibility to expand in step with demand and to defer investment when demand growth is disappointing.
Sometimes valuable options can be created simply by “overbuilding” in the initial round of investment. For example, oil-production platforms are typically built with vacant deck space to reduce the cost of adding equipment later. Undersea oil pipelines from the platforms to shore are often built with larger diameters and capacity than production from the platform will require. The additional capacity is then available at low cost if additional oil is found nearby. The extra cost of a larger-diameter pipeline is much less than the cost of building a second pipeline later.
SUMMARY
In Chapter 21, you learned the basics of option valuation. In this chapter, we described four important real options:
1. The option to make follow-on investments. Companies often cite “strategic” value when taking on negative-NPV projects. A close look at the projects’ payoffs reveals call options on follow-on projects in addition to the immediate projects’ cash flows. Today’s investments can generate tomorrow’s opportunities.
2. The option to wait (and learn) before investing. This is equivalent to owning a call option on the investment project. The call is exercised when the firm commits to the project. But rather than exercising the call immediately, it’s often better to defer a positive-NPV project in order to keep the call alive. Deferral is most attractive when uncertainty is great and immediate project cash flows—which are lost or postponed by waiting—are small.
3. The option to abandon. The option to abandon a project provides partial insurance against failure. This is a put option; the put’s exercise price is the value of the project’s assets if sold or shifted to a more valuable use.
4. The option to vary the firm’s output or its production methods. Firms often build flexibility into their production facilities so that they can use the cheapest raw materials or produce the most valuable set of outputs. In this case they effectively acquire the option to exchange one asset for another.
We should offer here a healthy warning: The real options encountered in practice are often complex. Each real option brings its own issues and trade-offs. Nevertheless, the tools that you have learned in this and previous chapters can be used in practice. The Black–Scholes formula often suffices to value one-time expansion and abandonment options. For more complex options, it’s sometimes easier to switch to binomial trees.
Binomial trees are cousins of decision trees. You work back through binomial trees from future payoffs to present value. Whenever a future decision needs to be made, you figure out the valuemaximizing choice, using the principles of option pricing theory, and record the resulting value at the appropriate node of the tree.
Don’t jump to the conclusion that real-option valuation methods can replace discounted cash flow (DCF). First, DCF works fine for safe cash flows. It also works for “cash cow” assets—that is, for assets or businesses whose value depends primarily on forecasted cash flows, not on real options. Second, the starting point in most real-option analyses is the present value of an underlying asset. To value the underlying asset, you typically have to use DCF.
Real options are rarely traded assets. When we value a real option, we are estimating its value if it could be traded. This is the standard approach in corporate finance, the same approach taken in DCF valuations. The key assumption is that shareholders can buy traded securities or portfolios with the same risk characteristics as the real investments being evaluated by the firm. If so, they would vote unanimously for any real investment whose market value if traded would exceed the investment required. This key assumption supports the use of both DCF and real-option valuation methods.
Taxes are not tracked specifically in the several real-options examples presented in this chapter. But remember that all cash flows from real options should be projected after corporate tax. The discount rate in the risk-neutral method should also be after-tax.
FURTHER READING
The Further Reading for Chapter 10 lists several introductory articles on real options. The Spring 2005 and 2007 issues of the Journal of Applied Corporate Finance contain additional articles.
The Spring 2006 issue contains two further articles:
R. L. McDonald, “The Role of Real Options in Capital Budgeting: Theory and Practice,” Journal of Applied Corporate Finance 18 (Spring 2006), pp. 28–39.
M. Amram, F. Li, and C. A. Perkins, “How Kimberly-Clark Uses Real Options,” Journal of Applied Corporate Finance 18 (Spring 2006), pp. 40–47.
The standard texts on real options include:
M. Amram and N. Kulatilaka, Real Options: Managing Strategic Investments in an Uncertain World (Boston: Harvard Business School Press, 1999).
T. Copeland and V. Antikarov, Real Options: A Practitioner’s Guide (New York: Texere, 2003).
A. K. Dixit and R. S. Pindyck, Investment under Uncertainty (Princeton, NJ: Princeton University Press, 1994).
H. Smit and L. Trigeorgis, Strategic Investment, Real Options and Games (Princeton, NJ: Princeton University Press, 2004).
L. Trigeorgis, Real Options (Cambridge, MA: MIT Press, 1996).
Mason and Merton review a range of option applications to corporate finance:
S. P. Mason and R. C. Merton, “The Role of Contingent Claims Analysis in Corporate Finance,” in E. I. Altman and M. G. Subrahmanyam, eds., Recent Advances in Corporate Finance (Homewood, IL: Richard D. Irwin, Inc., 1985).
Brennan and Schwartz have worked out an interesting application to natural resource investments:
M. J. Brennan and E. S. Schwartz, “Evaluating Natural Resource Investments,” Journal of Business 58 (April 1985), pp. 135–157.
PROBLEM SETS
Select problems are available in McGraw-Hill’s Connect. Please see the preface for more information.
1. Real options Respond to the following comments.
a. “You don’t need option pricing theories to value flexibility. Just use a decision tree. Discount the cash flows in the tree at the company cost of capital.”
b. “These option pricing methods are just plain nutty. They say that real options on risky assets are worth more than options on safe assets.”
c. “Real-options methods eliminate the need for DCF valuation of investment projects.”
2. Real options Why is quantitative valuation of real options often difficult in practice? List the reasons briefly.
3. Real options True or false?
a. Real-options analysis sometimes tells firms to make negative-NPV investments to secure future growth opportunities.
b. Using the Black–Scholes formula to value options to invest is dangerous when the underlying investment project would generate significant immediate cash flows.
c. Binomial trees can be used to evaluate options to acquire or abandon an asset. It’s OK to use risk-neutral probabilities in the trees even when the asset beta is 1.0 or higher.
d. It’s OK to use the Black–Scholes formula or binomial trees to value real options, even though the options are not traded.
e. A real-options valuation will sometimes reveal that it’s better to invest in a series of smaller plants rather than a single large plant.
4. Real options Alert financial managers can create real options. Give three or four possible examples.
5. Real options Describe each of the following situations in the language of options:
a. Drilling rights to undeveloped heavy crude oil in Northern Alberta. Development and production of the oil is a negative-NPV endeavor. (Assume a break-even oil price is C$90 per barrel, versus a spot price of C$80.) However, the decision to develop can be put off for up to five years. Development costs are expected to increase by 5% per year.
b. A restaurant is producing net cash flows, after all out-of-pocket expenses, of $700,000 per year. There is no upward or downward trend in the cash flows, but they fluctuate as a random walk, with an annual standard deviation of 15%. The real estate occupied by the restaurant is owned, not leased, and could be sold for $5 million. Ignore taxes.
c. A variation on part (b): Assume the restaurant faces known fixed costs of $300,000 per year, incurred as long as the restaurant is operating. Thus,
The annual standard deviation of the forecast error of revenue less variable costs is 10.5%. The interest rate is 10%. Ignore taxes.
d. A paper mill can be shut down in periods of low demand and restarted if demand improves sufficiently. The costs of closing and reopening the mill are fixed.
e. A real estate developer uses a parcel of urban land as a parking lot, although construction of either a hotel or an apartment building on the land would be a positive-NPV investment.
f. Air France negotiates a purchase option for 10 Boeing 787s. Air France must confirm the order by 2021. Otherwise Boeing will be free to sell the aircraft to other airlines.
6. Expansion options* Look again at the valuation in Table 22.2 of the option to invest in the Mark II project. Consider a change in each of the following inputs. Would the change increase or decrease the value of the expansion option?
a. Increased uncertainty (higher standard deviation).
b. More optimistic forecast (higher expected value) of the Mark II in 1985.
c. Increase in the required investment in 1985.
7. Expansion options Look again at Table 22.2. How does the value in 1982 of the option to invest in the Mark II change if
a. The investment required for the Mark II is $800 million (vs. $900 million)?
b. The present value of the Mark II in 1982 is $500 million (vs. $467 million)?
c. The standard deviation of the Mark II’s present value is only 20% (vs. 35%)?
8. Timing options* You own a parcel of vacant land. You can develop it now, or wait.
a. What is the advantage of waiting?
b. Why might you decide to develop the property immediately?
9. Timing options Look back at the Malted Herring option in Section 22-2. How did the company’s analysts estimate the present value of the project? It turns out that they assumed that the probability of low demand was about 45%. They then estimated the expected payoff as (.45 × 176) + (.55 × 275) = 230. Discounting at the company’s 15% cost of capital gave a present value for the project of 230/1.15 = 200.
a. How would this present value change if the probability of low demand was 55%? How would it change if the project’s cost of capital was higher than the company cost of capital at, say, 20%?
b. Now estimate how these changes in assumptions would affect the value of the option to delay.
10. Abandonment options A start-up company is moving into its first offices and needs desks, chairs, filing cabinets, and other furniture. It can buy the furniture for $25,000 or rent it for $1,500 per month. The founders are of course confident in their new venture, but nevertheless they rent. Why? What’s the option?
11. Abandonment options Flip back to Tables 6.2 and 6.3, where we assumed an economic life of seven years for IM&C’s guano plant. What’s wrong with that assumption? How would you undertake a more complete analysis?
12. Abandonment options In Section 10-4, we considered two production technologies for a new Wankel-engined outboard motor. Technology A was the most efficient but had no salvage value if the new outboards failed to sell. Technology B was less efficient but offered a salvage value of $17 million.
Figure 10.3 shows the present value of the project as either $24 or $16 million in year 1 if Technology A is used. Assume that the present value of these payoffs is $18 million at year 0.
a. With Technology B, the payoffs at year 1 are $22.5 or $15 million. What is the present value of these payoffs in year 0 if Technology B is used? (Hint: The payoffs with Technology B are 93.75% of the payoffs from Technology A.)
b. Technology B allows abandonment in year 1 for $17 million salvage value. You also get cash flow of $1.5 million, for a total of $18.5 million. Calculate abandonment value, assuming a risk-free rate of 7%.
13. Abandonment options Take another look at the perpetual crusher example in Section 22-3. Construct a sensitivity analysis showing how the value of the abandonment put changes depending on the standard deviation of the project and the exercise price.
14. Flexible production and procurement* Gas turbines are among the least efficient ways to produce electricity, much less thermally efficient than coal or nuclear plants. Why do gas-turbine generating stations exist? What’s the option?
15. R&D Construct a sensitivity analysis of the value of the pharmaceutical R&D project described in Figure 22.8. What input assumptions are most critical for the NPV of the project? Be sure to check the inputs to valuing the real option to invest at year 2.
BEYOND THE PAGE
Try it! The Black-Scholes model
mhhe.com/brealey13e
16. Real option valuation* You own a one-year call option to buy one acre of Los Angeles real estate. The exercise price is $2 million, and the current, appraised market value of the land is $1.7 million. The land is currently used as a parking lot, generating just enough money to cover real estate taxes. The annual standard deviation is 15% and the interest rate 12%. How much is your call worth? Use the Black–Scholes formula. You may find it helpful to go to the spreadsheet for Chapter 21, which calculates Black–Scholes values (see the Beyond the Page feature).
17. Real option valuation A variation on Problem 16: Suppose the land is occupied by a warehouse generating rents of $150,000 after real estate taxes and all other out-of-pocket costs. The present value of the land plus warehouse is again $1.7 million. Other facts are as in Problem 16. You have a European call option. What is it worth?
18. Real option valuation You have an option to purchase all of the assets of the Overland Railroad for $2.5 billion. The option expires in nine months. You estimate Overland’s current (month 0) present value (PV) as $2.7 billion. Overland generates after-tax free cash flow (FCF) of $50 million at the end of each quarter (i.e., at the end of each three-month period). If you exercise your option at the start of the quarter, that quarter’s cash flow is paid out to you. If you do not exercise, the cash flow goes to Overland’s current owners.
In each quarter, Overland’s PV either increases by 10% or decreases by 9.09%. This PV includes the quarterly FCF of $50 million. After the $50 million is paid out, PV drops by $50 million. Thus, the binomial tree for the first quarter is (figures in millions):
The risk-free interest rate is 2% per quarter.
a. Build a binomial tree for Overland, with one up or down change for each three-month period (three steps to cover your nine-month option).
b. Suppose you can only exercise your option now, or after nine months (not at month 3 or 6). Would you exercise now?
c. Suppose you can exercise now, or at month 3, 6, or 9. What is your option worth today? Should you exercise today, or wait?
19. Real option valuation Josh Kidding, who has only read part of Chapter 10, decides to value a real option by (1) setting out a decision tree, with cash flows and probabilities forecasted for each future outcome; (2) deciding what to do at each decision point in the tree; and (3) discounting the resulting expected cash flows at the company cost of capital. Will this procedure give the right answer? Why or why not?
20. Real option valuation In binomial trees, risk-neutral probabilities are set to generate an expected rate of return equal to the risk-free interest rate in each branch of the tree. What do you think of the following statement: “The value of an option to acquire an asset increases with the difference between the risk-free rate of interest and the weighted-average cost of capital for the asset”?
21. Real options and put-call parity Redo the example in Figure 22.8, assuming that the real option is a put option allowing the company to abandon the R&D program if commercial prospects are sufficiently poor at year 2. Use put-call parity. The NPV of the drug at date 0 should again be +$7.7 million.
CHALLENGE
22. Complex real options Suppose you expect to need a new plant that will be ready to produce turbo-encabulators in 36 months. If design A is chosen, construction must begin immediately. Design B is more expensive, but you can wait 12 months before breaking ground. Figure 22.9 shows the cumulative present value of construction costs for the two designs up to the 36-month deadline. Assume that the designs, once built, will be equally efficient and have equal production capacity.
A standard DCF analysis ranks design A ahead of design B. But suppose the demand for turbo-encabulators falls and the new factory is not needed; then, as Figure 22.9 shows, the firm is better off with design B, provided the project is abandoned before month 24.
Describe this situation as the choice between two (complex) call options. Then describe the same situation in terms of (complex) abandonment options. The two descriptions should imply identical payoffs, given optimal exercise strategies.
23. Options and growth In Chapter 4, we expressed the value of a share of stock as
where EPS1 is earnings per share from existing assets, r is the expected rate of return required by investors, and PVGO is the present value of growth opportunities. PVGO really consists of a portfolio of expansion options.22
a. What is the effect of an increase in PVGO on the standard deviation or beta of the stock’s rate of return?
b. Suppose the CAPM is used to calculate the cost of capital for a growth (high-PVGO) firm. Assume all-equity financing. Will this cost of capital be the correct hurdle rate for investments to expand the firm’s plant and equipment, or to introduce new products?
FIGURE 22.9 Cumulative construction cost of the two plant designs. Plant A takes 36 months to build; plant B, only 24. But plant B costs more.
1You could also use scenario analysis, which we described in Chapter 10. Work out “best” and “worst” scenarios to establish a range of possible future values. Then find the annual standard deviation that would generate this range over the life of the option. For the Mark II, a range from $300 million to $2 billion would cover about 90% of the possible outcomes. This range, shown in Figure 22.1, is consistent with an annual standard deviation of 35%.
2Be sure to “unlever” the standard deviations, thereby eliminating volatility created by debt financing. Chapters 17 and 19 covered unlevering procedures for beta. The same principles apply for standard deviation: You want the standard deviation of a portfolio of all the debt and equity securities issued by the comparable firm.
3If the required investment is uncertain, you have, in effect, an option to exchange one risky asset (the future value of the exercise price) for another (the future value of the Mark II’s cash inflows). See W. Margrabe, “The Value of an Option to Exchange One Asset for Another,” Journal of Finance 33 (March 1978), pp. 177–186.
4We have drawn the future values of the Mark II as a lognormal distribution, consistent with the assumptions of the Black–Scholes formula. Lognormal distributions are skewed to the right, so the average outcome is greater than the most likely outcome. The most likely outcome is the highest point on the probability distribution.
5We have been a bit vague about forecasted project cash flows. If competitors can enter and take away cash that you could have earned, the meaning is clear. But what about the decision to, say, develop an oil well? Here delay doesn’t waste barrels of oil in the ground; it simply postpones production and the associated cash flow. The cost of waiting is the decline in today’s present value of revenues from production. Present value declines if the cash flow from production increases more slowly than the cost of capital.
6The following example is based on P. D. Childs, T. J. Riddiough, and A. J. Triantis, “Mixed Uses and the Redevelopment Option,” Real Estate Economics 24 (Fall 1996), pp. 317–339.
7See S. C. Myers and S. Majd, “Abandonment Value and Project Life,” in Advances in Futures and Options Research, F. J. Fabozzi, ed. (Greenwich, CT: JAI Press, 1990).
8We assume it makes sense to keep the tanker in mothballs. If rates fall sufficiently, it will pay to scrap the tanker.
9Dixit and Pindyck estimate these thresholds for a medium-sized tanker and show how they depend on costs and the volatility of freight rates. See A. K. Dixit and R. S. Pindyck, Investment under Uncertainty (Princeton, NJ: Princeton University Press, 1994), Chapter 7. Brennan and Schwartz provide an analysis of a mining investment that also includes an option to shut down temporarily. See M. Brennan and E. Schwartz, “Evaluating Natural Resource Investments,” Journal of Business 58 (April 1985), pp. 135–157.
10Here we refer to simple CTs, which are just large gas turbines connected to generators. Combined-cycle CTs add a steam generator to capture exhaust heat from the turbine. The steam is used to generate additional electricity. Combined-cycle units are much more efficient than simple CTs.
11Industrial steam and heating systems can also be designed to switch between fuels, depending on relative fuel costs. See N. Kulatilaka, “The Value of Flexibility: The Case of a Dual-Fuel Industrial Steam Boiler,” Financial Management 22 (Autumn 1993), pp. 271–280.
12Hewlett-Packard’s decision is described in P. Coy, “Exploiting Uncertainty,” BusinessWeek, June 7, 1999, pp. 118–122.
13The following example is based on J. E. Stonier, “What Is an Aircraft Purchase Option Worth? Quantifying Asset Flexibility Created through Manufacturer Lead-Time Reductions and Product Commonality,” in Handbook of Airline Finance, G. F. Butler and M. R. Keller, eds. © 1999 Aviation Week Books.
14The Airbus real-options model assumes that future A320 prices will be increased when demand is high, but only to an upper bound. Thus the airline that waits and decides later may still have a positive-NPV investment opportunity if future demand and NPV are high. Figure 22.7 plots the difference between the value of the purchase option and this wait-and-see opportunity. This difference can shrink when NPV is high, especially if forecasted waiting times are short.
15Note that the Black–Scholes formula treats the exercise price of $130 million as a fixed amount and calculates its PV at a risk-free rate. In Chapter 10, we assumed this investment was just as risky as the drug’s postlaunch cash flows. We discounted the investment at the 9.6% overall cost of capital, reducing its PV and thus increasing NPV overall. This is one reason the Black–Scholes formula gives a lower NPV than we calculated in Chapter 10. Of course, the $130 million is only an estimate, so discounting at the risk-free rate may not be correct. You could move from Black–Scholes to the valuation formula for an exchange option, which allows for uncertain exercise prices (see footnote 3). On the other hand, the R&D investment is probably close to a fixed cost because it is not exposed to the risks of the drug’s operating cash flows postlaunch. There is a good case for discounting R&D investment at a low rate, even in a decision tree analysis.
16You could also value the R&D example as (1) the PV of making all future investments, given success in clinical trials, plus (2) the value of an abandonment put, which will be exercised if clinical trials are successful but the PV of postlaunch cash flows is sufficiently low. NPV is identical because of put–call parity.
17The higher cost of capital for R&D is not revealed by the Black–Scholes formula, which discounts certainty-equivalent payoffs at the risk-free interest rate.
18Use of risk-neutral probabilities converts future cash flows to certainty equivalents, which are then discounted to present value at a risk-free rate.
19If the capital investment cannot be deducted immediately for tax, you should subtract the PV of any depreciation tax shields from the pre-tax capital investment, thus converting the investment to a net after-tax outlay.
20The interest on the option debt is also implicit and therefore not tax-deductible. The proof that the discount rate for real options should be after-tax is in S. C. Myers and J. A. Read, Jr., “Real Options, Taxes and Leverage,” Critical Finance Review, forthcoming.
21Being the first mover into a new market is not always the best strategy, of course. Sometimes later movers win. For a survey of real options and product-market competition, see H. Smit and L. Trigeorgis, Strategic Investment, Real Options and Games (Princeton, NJ: Princeton University Press, 2004).
22If this challenge problem intrigues you, check out two articles by Eduardo Schwartz and Mark Moon, who attempt to use real-options theory to value Internet companies: “Rational Valuation of Internet Companies,” Financial Analysts Journal 56 (May/June 2000), pp. 62–65; and “Rational Pricing of Internet Companies Revisited,” The Financial Review 36 (November 2001), pp. 7–25.
