Lecture note 6

Real Options

Value of Flexibility

Many real investment projects allow decisions

to expand or contract over the life-time of the
project.
Example:
Opportunity to expand and make follow-up
investments.
Opportunity to wait and invest later.
Opportunity to shrink or abandon a project.
Opportunity to vary the mix of the firms
output or production methods.

The Case of Boeing

In the mid-1990s, Boeing undertook a strategic
plan to create a viable corporate vision in the
21st century.
In January 1996, Boeing decided that it should
initiate preliminary design of a new 800-seat
super-jumbo jet, with the objective to build and
sell the new product to airlines in January 2001.
The preliminary R&D of the super-jumbo jet
would cost Boeing $500m.
There is an investment cost of $20b to take on
the super-jumbo jet project in January 2001.

 Expected 2001 value of super-jumbo-jet

business conditional on information in 1996

Expected 2001 static NPV

1996 static NPV given a WACC of 13%

Probability

Present value in 2001

Expected value

Required investment

($18.5b)

($20b)

1996 value of underlying

 The expected return on underlying over 5 years

Compounded annual growth rate

The variance in returns on underlying over 5

years

Annual standard derivation in returns

 By 1998, the global economy weakened

considerably and Airbus offered the A380
double-decked plane.
Boeing decided that there would be limited
demand for a super-jumbo jet.

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 Valuation using the Black-Scholes Model

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Estimating Volatility
Search for a range of volatility that makes the
binominal model consistent with managements
intuition about the real-world future.
Determine the break-even volatility parameter.
See what it implies about the future of the
world.
See where it falls relative to the range.
Ask the manager Is this reasonable? or Is
the world really this uncertain?

Example
In June 2000, a US server and router company
determined that a particular part of its
proprietary operating system software could be
scaled down and applied to a new type of
consumer electronics product.
The launch of the first-generation product
produces the opportunity to later launch
subsequent generation products that might
create value.
=> Platform investments for follow-on
opportunities.

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13

Probability

Present value on
Expected value

Development costs

($62.8 m)

($65.5m)

December 31, 2001

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 Start with an arbitrary volatility = 100%

Build a 6-step binominal tree:

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 True NPV of the first generation product

= $8.6m + $17.6m = $9m

A way to calibrate the volatility parameter.

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 The probability that the 2nd generation will not be

undertaken

Many managers think more in terms of how

likely it is that we exceed certain extreme values.

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Break-even Volatility
True NPV of the first generation product
= $8.6m + $8.6m = $0 when = 60%.

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Valuing the Option to Delay

Delay is beneficial in deciding whether to adopt
a project.
When a firm accepts a project, it exercises the
strategic option to delay and, hence, loses the
value from waiting.
It is often better to delay accepting a project
even when the project currently has positive net
present value, as computed by discounting its
direct cash flows.

Example:
Acme industries is considering building a plant.
After an initial investment of $100 million, the
plant will be completed in one year and then
have the series of annual cash flows. After a
year of start-up procedures, next years cash
flow will be $10 million, but a perpetual annual
cash flow stream of either $15 million or $2.5
million will occur each year thereafter,
depending on whether the economy is good or
bad one year from now.

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 Example (cont)
Acmes managers can decide to immediately
invest the $100 million, or they can wait until
next year to decide whether to build or not.
Assume that the risk-free interest rate is 5% per
year and that $1 invested in the market portfolio
today will be worth either $1.3 (if the economy is
good) or $0.8 (if the economy does poorly).
Compute the NPV of the project and decide
whether or not it pays to wait.

Solution:
Dont wait

Year 0

1
10

2
15

3
15

10

2.5

2.5

100 15

15

100 2.5

2.5

100

Wait one year

0

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 Risk neutral probability

$1 = [$1.3 x + $0.8 x (1 )] / 1.05
=> = 0.5
If the manager does not wait, the payoff would
be
$10m + $15m/0.05 = $310m in good state
$10m + $2.5m/0.05 = $60m in bad state
PV = (0.5 x $310m + 0.5 x $60m) /1.05
= $176.19m > $100m
NPV = $176.19m $100m = $76.19m

Alternatively, if the manager waits for a year

NPV
= [0.5 x 0 + 0.5 x ($15m/0.05 $100m)] /1.05
= $95.24m > $76.19m
Thus, the firm should wait for one year.

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Valuing Vacant Land

Vacant land has value because it has an option
to turn the vacant land into developed land.
For example, a plot of land may have potential
use for an office building or a shopping mall. The
developer has an incentive to develop the
property for the use that maximizes the
difference between the value of the projects
future revenues and its construction costs. The
best possible future use for the land, however,
may not be known at the present time.

Example:
An investor owns a lot that is suitable for either 6
or 9 condominium units. The per unit
construction costs of the building with 6 units are
$80,000 and with 9 units $90,000. Construction
costs are the same whether construction takes
place this year or next. The current market price
of each unit is $100,000.

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 Example (cont)
The per year rental rate is $8,000 per unit (net of
expenses), and the risk-free rate of interest is
12% per year. If market conditions are favorable
next year, each condominium will sell for
$120,000; if conditions are unfavorable, each
will sell for only $90,000. What is the value of the
lot?

Solution:
Building 9 condo units
Profit = ($100,000 $90,000) x 9 = $90,000
Building 6 condo units
Profit = ($100,000 $80,000) x 6 = $120,000
Therefore, building 6-unit condo is the best
choice if building now.

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 If the investor waits,

Build 9 unit in favorable state

9 x ($120,000 $90,000) = $270,000

Build 6 unit in unfavorable state
6 x ($90,000 $80,000) = $60,000

If the investor builds 6 (9) unit in the favorable

(unfavorable) state, the profit is only $240,000
($0).

Risk neutral probability

Invest $100,000 in a condo this year,
in next year,
=> $120,000 + $8,000
with prob.
Value
Rent
=> $90,000 + $8,000
with prob. 1
$100,000
= [ x $128,000 + (1 ) x $98,000] / 1.12
=> = 7/15

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 The value of vacant land in the next year

$270,000 x 7/15 + $60,000 x 8/15
1.12
= $141,071 > $120,000
It is better to keep the land vacant till next year.

Valuing the Option to Expand Capacity

Flexibility such as the ability to take a project
already initiated to expand it, reduce its scale, or
completely abandon it is an option, and each
option available enhances the projects value.
Example:
Acam Industries is considering building a plant
that will have a value after two years. The cash
flows from the plant will be $200 million following
two good years, $150 million following one good
and one bad year, and $100 million following
two bad years.

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 Example (Cont)
The initial cost of the plant is $140 million. After
one year, however, if the state of the economy
looks good, the firm has the option to double the
plants capacity by investing another $140
million. Assume a risk-free rate of 5% per year
and that $1 invested in the market portfolio today
yields future values, depending on the state of
the economy. Compute the value of building the
plant.

Market portfolio payoffs

u = 1.3 = 0.5
= 0.5
$1.3
1 = 0.5
$1
d = 0.8 = 0.5
1 = 0.5 $0.8
1 = 0.5

$1.69

u = 1.3

$1.04

d = 0.8

$1.04

u = 1.3

$0.64

d = 0.8

rf = 5%

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 Solution
Year 0

Year 1

Year 2
D 200 (2 good years)

Good
A
140

Bad

B
C

E 150 (1 good and

1bad year)
F 100 (2 bad years)

CF if Plant Capacity is doubled at node B

400
B
140
300
A
140
150
C
Not double
100
investment

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 Without the expansion, the value of the plant at

node B
(0.5 x $200m + 0.5 x $150m) / 1.05
= $166.67m
at node C
(0.5 x $150m + 0.5 x $100m) / 1.05
= $119.05m
at node A
(0.5 x $166.67m + 0.5 x $119.05m) / 1.05
= $136.06m
NPV = $136.06m $140m = $3.94m

With the expansion,

At node B
$140m + (0.5 x $400m + 0.5 x $300m) / 1.05
= $193.33m > $166.67m
At node C
$140m + (0.5 x $300m + 0.5 x $200m) / 1.05
= $98.09m < $119.05m
Thus, no expansion at node C.

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At node A
(0.5 x $193.33m + 0.5 x $119.05m) / 1.05
= $148.75m
NPV = $148.75m $140m = $8.75m
Option value of expansion
= $8.75m ( $3.94m) = $12.69m

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