V O L U M E 1 7 | N U M B E R 2 | SP R I N G 2005

Journal of

APPLIED CORPORATE FINANCE

A MO RG A N S TA N L E Y P U B L I C AT I O N

In This Issue: Real Options and Corporate Strategy

Realizing the Potential of Real Options: Does Theory Meet Practice? Real Options Analysis: Where Are the Emperors Clothes? Real Options: Meeting the Georgetown Challenge
8 17 32

Alexander Triantis, University of Maryland Adam Borison, Stratelytics Thomas E. Copeland and Vladimir Antikarov, Monitor Group

A Response to Real Options: Meeting the Georgetown Challenge Valuing Assets Using Real Options: An Application to Deregulated Electricity Markets

52 55

Adam Borison, Stratelytics Gregory P. Swinand, London Economics and Indecon, Carlos Run, Babson College, and Chetan Sharma, Cinergy Corporation

The Challenge of Valuing Patents and Early-Stage Technologies The Decline and Fall of Joint Ventures: How JVs Became Unpopular and Why That Could Change Managing Operational Flexibility in Investment Decisions: The Case of Intel

68 82

Martha Amram, Growth Options Insights Dieter Turowski, Morgan Stanley & Co. Limited

87

Peter Miller, London School of Economics and Political Science, and Ted OLeary, University of Manchester (UK) and University of Michigan

Taking Real Options Beyond the Black Box The Option Value of Acquiring Information in an Oileld Production Enhancement Project

94 99

Simon Woolley and Fabio Cannizzo, BP Margaret Armstrong, cole des Mines de Paris, and William Bailey and Benot Cout, Schlumberger-Doll Research

Value-Based Management in Biosciences Research and Development Valuing Pharma R&D: The Catch-22 of DCF

105 113

Gill Eapen, Decision Options, LLC Ralph Villiger and Boris Bogdan, Avance

A Response to Real Options: Meeting the Georgetown Challenge

by Adam Borison, Stratelytics

appreciate the attention that Copeland and Antikarov have given my article. However, their paper includes several misunderstandings that I want to correct.

Use of Undocumented Adjustments The primary purpose of my article is to provide practitioners with a critical review of well-established real options approaches that are extensively documented in the academic and professional literature. A key observation of my article is that these approaches make different assumptions, use different techniques, and produce different results. Copeland and Antikarov describe adjustments that could be made to these approaches to align their results. Given the contradictory assumptions underlying the different approaches, these adjustments are problematic. In addition, if the various approaches actually produce comparable results when used properly, it is unclear to me why one would choose a more complicated approach (such as their MAD approach) over a simple one (such as the classic approach). Most importantly, however, their use of undocumented adjustments misses my basic point: when applied in a straightforward manner as instructed by their proponents, the approaches are signicantly different. The simplest example involves the classic approach using a twin security and the Black-Scholes algorithm. This approach has been widely publicized and recommended by leading real options authors, including Martha Amram and Nalin Kulatilaka, Lenos Trigeorgis, and Copeland himself (in the second edition of his book Valuation). In my article, I follow the steps described by Amram and Kulatilaka in their Real Options book, but these are not substantially different from those outlined by other authors. The approach presumes the existence of a traded twin security or portfolio for the underlying asset, and a key step is specifying that security and using its market data. In this case, Copeland and Antikarov adjust my analysis by using the entity value of the twin security (with debt) instead of the equity value, and they imply strongly that I (and practitioners as well) should be aware of the need for such an adjustment. However, there is nothing in the assumptions of the classic approach that calls for this adjustment. Specically, the assumption is that there
52 Journal of Applied Corporate Finance Volume 17 Number 2

is a traded twin security for the underlying asset, not an adjusted security or a portion of a security. Furthermore, there is nothing in the documentation by Amram and Kulatilaka or other authors that calls for this adjustment. In their Real Options book, Copeland and Antikarov note the difculty in the classic twin security approach of nding a priced security that is perfectly correlated with the investment. There is no reference to any adjustments to this security. The documentation is quite clear that a key step is to identify a traded security or portfolio that most closely resembles the underlying asset, and then to use its unadjusted price and volatility. Amram and Kulatilaka discuss adjustments to the cash ows of the real asset for leakage and sizing the asset relative to the security. I considered these adjustments in my review. However, they do not propose any adjustment to the security for debt, or for any other assets or liabilities, along the lines mentioned by Copeland and Antikarov. Their examples rely on the prices of traded securities, and none includes an adjustment for equity rather than an entity value. The MAD approach provides another example. In my review, I followed the steps described by Copeland and Antikarov in their Real Options book. A key step is the development of a cash ow NPV model of the underlying asset based on subjective data, perhaps supported by history. As instructed, I developed a simple model of revenues, xed costs, and variable costs using reasonable, subjective data. In this case, Copeland and Antikarov adjust my analysis by developing their own more detailed cash ow model. This model produces a different (lower) valuation that is more in line with the other approaches. While my model is simple, there is no reason to believe that it is biased and no rationale for rejecting it in favor of the cash ow model proposed by Copeland and Antikarov. There is nothing in the assumptions or documentation of the MAD approach that argues for the use of a particular NPV cash ow model or a particular piece of data for that model. The bottom line is that the ve approaches I reviewed reect different assumptions about capital markets, different ways of calculating the value of the underlying asset, different ways of treating uncertainty, different sources of data, and more. These differences in approach produce
A Morgan Stanley Publication Spring 2005

differences in results, which in turn create a dilemma for the practitioner: whom to believe, what to believe, and what to do. These differences need to be pointed out and analyzed, rather than papered over and dismissed. Comparison of Option Pricing and Decision Analysis Copeland and Antikarov purport to demonstrate that real options analysis is superior to decision analysis for evaluating real options problems. However, their comparison actually involves the application of option pricing and decision analysis to a pure option pricing problem in which all the standard option pricing conditions hold. These include an objective of maximizing shareholder value, the existence of a twin security, and a GBM price process. It is not surprising that option pricing is a superior tool for evaluating a problem where all the conditions underlying option pricing hold, just as it is not surprising that decision analysis is a superior tool for evaluating a problem where all the conditions underlying decision analysis hold. The latter include the objective of maximizing expected utility, the absence of markets in the assets under consideration, and limited relevant historical data on the risks. No academic or practitioner I am aware of advocates the use of standard decision analysis to address an investment problem involving a twin security. Certainly, none of the ve approaches I reviewed takes such a position. Where decision analysis is used in these approaches, it is used only when the standard conditions underlying option pricing do not hold. The important question, and the one that my article is attempting to address, is what to do when the truth underlying a real option problem lies somewhere in the middlethat is, when the objective is maximizing shareholder value, markets are incomplete so twin securities are largely absent, relevant market data is only partially available, and inputs move according to non-GBM processes. This is the case with most real investments. The comparison by Copeland and Antikarov does not really address this fundamental issue. Application of No-Arbitrage Conditions to the MAD Approach In reviewing the MAD approach, I relied on the description in Copeland and Antikarovs Real Options book. A key step is the development of a cash ow NPV model of the underlying asset. The data for the variables in this model, both base estimates and volatilities, come from subjective assessment and history: In most cases, we use either historical data and assume that the future is like the past; or we use subjective, but forward-looking, estimates made by management. There is no reference to the use of capital market data for the model variables; the only data taken directly from capital markets is the models discount rate.
Journal of Applied Corporate Finance Volume 17 Number 2

Copeland and Antikarov state in their paper, We cannot accept any solution for real options that is not arbitrage free. I agree. My biggest concern with the MAD approach is that the use of an NPV model in this manner encourages, or at least allows, just such arbitrage opportunities. Many authors distinguish between investment risks that can be duplicated or hedged in the capital markets (public risks) and those that cannot (private risks). Amram and Kulatilaka refer to private risks and the tracking error they cause when looking for a twin security. James Smith and Robert Nau refer to market and private risks, and treat them differently. This distinction is critical because public risks have already been priced by capital markets. If investments are evaluated using subjective, non-market assessments of these risks, the possibility of arbitrage is introduced. It is not possible to avoid this simply by comparing subjective assessments to current and historical market prices. It requires analyzing relevant spot, future, and option prices to determine the prices that capital markets have already established for an investments public risks. The assumptions and documentation of the MAD approach do not make this distinction between public and private risks, and thus do nothing to prevent this form of arbitrage. Copeland and Antikarov refer to the use of current and historical data to support subjective assessments, but they do not discuss market-priced risks. If the investment involves any public risks (commodity prices, exchange rates, stock prices), the evaluation of the underlying asset and the option will not be arbitrage free. In my example, my NPV model relies on a subjective assessment that gas prices will grow on average at 2% a year. This is based on examining historical and current prices, but not futures or options. Nothing in the assumptions and documentation of the MAD approach indicated that this was necessary or recommended. As it turns out, capital markets reect an expectation of a 4% annual decline. Copeland and Antikarov view the 2% increase versus 4% decrease difference as my inconsistency. Instead, it reects the arbitrage opportunity created by the use of subjective estimates of market-priced risks in the MAD approach. Conclusions Regarding the Integrated Approach The integrated approach relies in large part on the distinction between public risk and private risk. In their discussion of the integrated approach, Copeland and Antikarov appear to misunderstand these two terms. They indicate that I dene a public risk as one that is correlated with the economy and a private risk as one that is uncorrelated with the economy. This is incorrect. As noted above, a public risk is one that can be hedged in the capital markets; it may or may not be correlated with the economy as a whole. In practice, most public risks have some market correlation, but it is quite possible to have a zero-beta public risk. A private
A Morgan Stanley Publication Spring 2005 53

risk is one that cannot be hedged in the capital markets; that is, there is no single security or portfolio of securities that duplicates the risk. In practice, private riskswhich are effectively uncorrelated with any and all securitiesare treated as uncorrelated with the overall market. The integrated approach decomposes the uncertainty (or volatility) of the underlying asset into individual components. It does not, as Copeland and Antikarov contend, make the mistake of assuming that the volatility of the asset is the volatility of any one component or that the replicating portfolio for the entire asset is the replicating portfolio for any one component. Instead, the volatility of the entire asset is a function of the volatility of the components. Components that involve public risks are evaluated using capital markets, thereby eliminating arbitrage. Components that involve private risks are evaluated using subjective assessments. Because the integrated approach relies in part on a cash ow NPV model, Copeland and Antikarov mistakenly state that it also relies on the MAD assumption. This is not the case. The MAD approach presumes that the best estimate of value is based on managements subjective assessments of all risks. The integrated approach presumes that the best estimate of value must reect market prices, not subjective assessments, of public risks. Copeland and Antikarov also state incorrectly that, because of its use of decision trees, the integrated approach is limited to a few, sequential uncertainties. First, the ordering of uncertainties in a decision tree reects conditionality,

not (necessarily) sequence. Thus, the integrated approach can include uncertainties that are resolved simultaneously or sequentially. Second, there is no (arbitrary) limit on the number of risks, public or private, or on the number and timing of decisions. Finally, Copeland and Antikarov also indicate that the integrated approach is essentially a simplied version of their own keeping uncertainties separate variation of the MAD approach. While there are similarities, as I mention in my article, there are important differences. First, while Copeland and Antikarov discuss various stochastic processes for individual uncertainties, they assume that the value of the underlying asset must evolve according to a random walk. They cite Samuelsons article to justify this. However, his article is devoted entirely to properly anticipated pricesthat is, prices of assets that are actively traded. There is no reason why a subjective assessment of asset value must follow a random walk. Because it allows for a greater range of stochastic processes, the integrated approach is more general. Second and more important, the integrated approach treats uncertainties differently. In the integrated approach, there are public and private risks, dened in terms of the ability to hedge in the capital markets. Public risks are evaluated using capital market data, and private risks are evaluated using subjective data. In the keeping uncertainties separate approach, the two types of uncertainties are market/economy-correlated and market/economy-uncorrelated. Both are evaluated using subjective data. This leads to the arbitrage problems noted above.

54

Journal of Applied Corporate Finance Volume 17 Number 2

A Morgan Stanley Publication Spring 2005

Journal of Applied Corporate Finance (ISSN 1078-1196 [print], ISSN 1745-6622 [online]) is published quarterly on behalf of Morgan Stanley by Blackwell Publishing, with ofces at 350 Main Street, Malden, MA 02148, USA, and PO Box 1354, 9600 Garsington Road, Oxford OX4 2XG, UK. Call US: (800) 835-6770, UK: +44 1865 778315; fax US: (781) 388-8232, UK: +44 1865 471775. Information for Subscribers For new orders, renewals, sample copy requests, claims, changes of address, and all other subscription correspondence, please contact the Customer Service Department at your nearest Blackwell ofce (see above) or e-mail subscrip@bos.blackwellpublishing.com. Subscription Rates for Volume 17 (four issues) Institutional Premium Rate* The Americas $330, Rest of World 201; Commercial Company Premium Rate, The Americas $440, Rest of World 268; Individual Rate, The Americas $95, Rest of World 53, 80; Students**, The Americas $50, Rest of World 28, 42. *Includes print plus premium online access to the current and all available backles. Print and online-only rates are also available (see below).

Journal of Applied Corporate Finance is available online through Synergy, Blackwells online journal service, which allows you to: Browse tables of contents and abstracts from over 290 professional, science, social science, and medical journals Create your own Personal Homepage from which you can access your personal subscriptions, set up e-mail table of contents alerts, and run saved searches Perform detailed searches across our database of titles and save the search criteria for future use Link to and from bibliographic databases such as ISI. Sign up for free today at http://www.blackwell-synergy.com. Disclaimer The Publisher, Morgan Stanley, its afliates, and the Editor cannot be held responsible for errors or any consequences arising from the use of information contained in this journal. The views and opinions expressed in this journal do not necessarily represent those of the Publisher, Morgan Stanley, its afliates, and Editor, neither does the publication of advertisements constitute any endorsement by the Publisher, Morgan Stanley, its afliates, and Editor of the products advertised. No person should purchase or sell any security or asset in reliance on any information in this journal. Morgan Stanley is a full service nancial services company active in the securities, investment management, and credit services businesses. Morgan Stanley may have and may seek to have business relationships with any person or company named in this journal. Copyright 2005 Morgan Stanley. All rights reserved. No part of this publication may be reproduced, stored, or transmitted in whole or part in any form or by any means without the prior permission in writing from the copyright holder. Authorization to photocopy items for internal or personal use or for the internal or personal use of specic clients is granted by the copyright holder for libraries and other users of the Copyright Clearance Center (CCC), 222 Rosewood Drive, Danvers, MA 01923, USA (www.copyright.com), provided the appropriate fee is paid directly to the CCC. This consent does not extend to other kinds of copying, such as copying for general distribution for advertising or promotional purposes, for creating new collective works, or for resale. Institutions with a paid subscription to this journal may make photocopies for teaching purposes and academic course-packs free of charge provided such copies are not resold. For all other permissions inquiries, including requests to republish material in another work, please contact the Journals Rights and Permissions Coordinator, Blackwell Publishing, 9600 Garsington Road, Oxford OX4 2DQ. E-mail: journalsrights@oxon.blackwellpublishing.com.

Customers in Canada should add 7% GST or provide evidence of entitlement to exemption.

Customers in the UK should add VAT at 5%; customers in the EU should also add VAT at 5%, or provide a VAT registration number or evidence of entitlement to exemption. **Students must present a copy of their student ID card to receive this rate. For more information about Blackwell Publishing journals, including online access information, terms and conditions, and other pricing options, please visit www.blackwellpublishing.com or contact our Customer Service Department, tel: (800) 835-6770 or +44 1865 778315 (UK ofce). Back Issues Back issues are available from the publisher at the current singleissue rate. Mailing Journal of Applied Corporate Finance is mailed Standard Rate. Mailing to rest of world by DHL Smart & Global Mail. Canadian mail is sent by Canadian publications mail agreement number 40573520. Postmaster Send all address changes to Journal of Applied Corporate Finance, Blackwell Publishing Inc., Journals Subscription Department, 350 Main St., Malden, MA 02148-5020.