Lecture no44 real options analysis

Real Options Analysis Lecture No 44 Chapter 13 Contemporary Engineering Economics Copyright © 2016 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved What Is Real About “Real” Options? o Concept: Any corporate investment decision to invest and or divest real assets is simply an option, giving the option holder a right to make an investment decision without any obligation to act o At Issue: Can we apply the same logic used pricing financial options to value the real assets? • • Financial options analysis is mostly used in trading Real options analysis generally is used for valuing the real assets and strategic decision making th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Decision Tree vs Real Options d G oo new s d G oo est Inv Ba d Do n’t new s ne w ews Decision Tree Analysis th Contemporary Engineering Economics, edition Ba d s Don ’t n ew s d Goo Bad n Park est Inv ne ws st Inve Don ’t Real Options Analysis Copyright © 2016 by Pearson Education, Inc All Rights Reserved Real Option Premium th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Real Options: A New Math in Action  Step 1, evaluate each stage of the project separately  Step 2, understand your options  Step 3, reevaluate the project, using an options mind-set  Step 4, go figure From “Exploiting Uncertainty—The ‘Real-Options’ Revolution in Decision-Making,” BusinessWeek, June 7, 1999, p.119 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved The Analogy Between a Call Option on a Stock and a Real Option th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Types of Real Options In general, six real options exist in the decision-making process The option to postpone (or delay) the investment decision The growth option to scale up an initial project if events are favorable The option to abandon a project if events are unfavorable The option to scale back (or contract) an initial project if events become unfavorable The option to switch strategies once an initial strategy has been selected The option to invest contingently (i.e invest a little now; if events are favorable invest a little more, or if not abandon.) th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Delay Option o o The decision-maker (DM) does not always need to initiate a project immediately The DM has the option to postpone the investment decision due to: o o o o Uncertainty in market demand Uncertainty in market timing Uncertainty in market input/output prices Real options analysis (ROA) values the flexibility to postpone the investment decision th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example 13.9: Delaying Investment: Value of Waiting   o o Given: Financial data o o o o o Launch cost: $50M Expected sales: $12M per year (Random variable) Risk-adjusted discount rate: 12% Product life: years Launch cost after years: $60.5M Find: Is it worth waiting for years? By waiting, what you gain? How much would it worth if you were given the opportunity to delay the project for two years? Do not wait: conventional NPW $12 $12 $12 $12 $12 PW(12%) = $12(P/A,12%,5) - $50 =-$6.74 < $50 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Real-Options Approach  Given: V0 = $34.49, I = $60.5, T = years, r = 6%, and σ = 50%  Find: ROP  Conclusion: Since ROP > 0, it is worth retaining the delay option as long as the cost of this option does not exceed $11.5M th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Economic Interpretation The end result option value on the binomial tree represents the FNPV The value of the scale-up option itself is: ENPV = NPV + Option Value from Expansion Option = ENPV − NPV = 11.23 − 10 = $1.23 M Therefore, the option to expand the project in the future is worth $1.23M th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Scale-down Option • A firm has the right to scale-down an investment if the initial project is unfavorable • This is a scaled version of the abandonment option and will be valued on a binomial lattice th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example: Scale-down Option A project has been undertaken within a firm The firm has the option to sell some of its equipment and facilities and sublet out the same project workload Given:  o o The projects current value is V0 = $10 M Anytime over the next years, the firm can sell off $4 M in resources but receive an expected 30% decrease in net cash flows (and therefore, a 30% decrease in project value) Let the r = 6% and the σ = 30% A binomial lattice will be used with a one-year time increment  Find: Value of scale-down option th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Binomial Lattice with Scale-Down Option u=e 3(1) 24.60 0.94 ( 0.53 × 24.6 + 0.47 × 13.5 ) = $18.22 = 1.35 24.6 d = 1/1.35 = 0.74 Do not scale-down q = 0.53 w=e −.06(1) max(0.7*24.6 + 4, 24.6)= 18.23 = 0.94 max(18.23*0.7 + 4, 18.22)= 18.22 Do not scale-down 13.5 13.94 11 Do not scale-down max(0.7*13.5 + 4, 13.5)= 13.5 Do not scale-down max(13.5*0.7 + 4, 13.94)= 10 13.5 10 max(10*0.7 + 4, 10.78)= 11 7.4 Scale-down max(0.7*7.4 + 4, 7.4)= 7.4 9.18 Scale-down max(7.4*0.7 + 4, 8.94)= 9.18 Scale-down 5.48 max(5.48*0.7 + 4, 7.59)= 7.836 Scale-down 4.05 max(0.7*4.05 + 4, 4.05)= 6.835 Scale-down th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Economic Interpretation The end result option value on the binomial tree represents the FNPV The value of the scale-down option itself is: ENPV = NPV + Option Option = ENPV − NPV = $11 − $10 = $1 M Therefore, the option to scale-down the project in the future is worth $1 M th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Compound Options o The value of option depends on the value of another option o A sequential compound option exists when a project has a multiple phases and later phases depend on the success of earlier phases • Invest a little, observe results; the option to invest more • Phased investment Local, regional, national, international Research & development Growth opportunities th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example 13.13: “A Real-World Way to Manage Real Options” Given:  oIt requires $60 million cost of permits and preparation oAt the end of year 1, you have the right to invest $400 million on design phase oYou have the right to invest $800 million in building the plant over the following two years oThe firm’s risk adjusted discount rate (MARR) is 10.83% oIf the plant existed today, its value would be $1 billion oThe volatility of the value is 18.33% oThe risk-free interest rate is 8% Find: Is it worth initiating a new chemical plant?  th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Phases of Project th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Compound Option Framework o Investing in permit/preparation (or Phase 0) provides option to invest in design phase (Phase 1) o Investing in design phase provides the option to invest in plant construction (Phase 2) o Therefore, investing in Phase is contingent upon investing in Phase 1, which is contingent upon the results of Phase th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved How to Calculate the Combined Option Value Compound Real Options Phase Phase Phase Calculate the Phase option last Calculate the Phase option second Calculate the Phase option first th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved (a) Traditional NPV Analysis Given: Risk-adjusted discount rate = $1B 10.83% Find: NPW PW(10.83%)Investment 400 800 = 60 + + 1.1083 1.10833 = $1,008.56 M PW(10.83%)Value of investment = $1,000 M NPW = $1,000 − $1,008.56 $60M $400M = −$8.56M < (Reject) $800M th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved (b) Real Options Analysis: Step  The event tree that illustrates how the project’s value changes over time th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Step 2: Valuing Phase Options  At Issue: Is it worth keeping the option open at Year 2, assuming that you were at node B?  Keeping the option open  Exercise (committing $800M): $1,440M − $800M = $640M  Conclusion: Keep the option open th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Step 3: What to Do in Year At Issue: Is it worth investing $400M in design? Decision: At year 1, if you find yourself in node C, go ahead and invest $400M If not, don’t invest and get out of the project In that case, your loss is limited to $60M that were committed in year  th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Step 4: Standing at Year At Issue: Is it worth spending $60M today? The value of having the compound options is worth $71M (or exactly $71.039M) Since it requires only $60M now, it is desirable to proceed for now th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved ... used pricing financial options to value the real assets? • • Financial options analysis is mostly used in trading Real options analysis generally is used for valuing the real assets and strategic... Stock and a Real Option th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Types of Real Options In general, six real options exist... n ew s d Goo Bad n Park est Inv ne ws st Inve Don ’t Real Options Analysis Copyright © 2016 by Pearson Education, Inc All Rights Reserved Real Option Premium th Contemporary Engineering Economics,