NPV? Decision Trees? Real Options? EST581 F. Phillips

A running example An opportunity requires an investment of $10,000 now, with an assured first-year cash flow of $6,000. The second-year cash flow is uncertain with a chance of either a $15,000 gain or a $5,000 loss. The project can be abandoned at the end of the first year if new information uncovered during this period suggests that the second-year payoff will not be favorable. Dropping the project at that time involves no salvage value or penalty. The cost of capital is 10%.

Decision tree for the example

NPV for the example Negative NPV => Do not make this investment.

Traditional method of adding a “risk premium” to the discount rate: If risk premium = 5% Then Risk-adjusted NPV = -$10K + $6K/ $5K/(1.15) 2 = -$1, Much worse than before. Notice the formula applies the risk premium many times - thus overstating the project risk, and causing management to reject some good projects.

The NPV didn’t let us use the option of abandoning the project after we got the additional information. What if it did allow it? NPV(ABANDON) = -$10, ,000/1.10 NPV(KEEP) = -$10, ,000/ ,000/(1.10) 2 NPV(OPTION) = 0.5*NPV(KEEP) + 0.5*NPV(ABANDON) = $1,600. => Make the investment. Traditional DCF analyses may understate the attractiveness of new product market ventures which typically have high levels of uncertainty associated with early time periods.

Why decision trees are more flexible than NPV

NPV- Pro’s and Con’s Pros –Simple and understandable –Easily compare alternative projects/investments –Thus, easy to implement in companies Cons –Can’t allow for contingencies –Tends to overstate risks –Can’t address concerns of multiple constituents

Decision Trees: Pro’s and Con’s Pros –Allows for contingent actions –More realistic choice of projects or investments –Adaptable to concerns of (small # of) constituents. Cons –Only good for discrete choices –More complex than NPV –Requires more organizational buy-in than NPV. –Thus, most uses are personal or entrepreneurial.

Options. Hmm, they sound good. Let’s learn more about them.

Option - A right to make a decision in the future Elements of an option –An underlying asset –Exercise price (strike price) –Expiration date –European or American form Basic options –Call option –Put option Financial options Real options Complex options –Contingencies - Option created by some earlier action –Interdependencies - Options with interdependent values ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 An Introduction to Options

Example of a financial option

Value of Asset Value of Underlying Asset Underlying Asset E Expiration Value Call before Expiration ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 The Structure of a Call Option

Buy a Call Write a Call Loss Gain Loss ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Realized Returns on Options

Simple (Financial) Options: Features A bet on the rise or fall of a single stock. The option may be: To buy a certain number of shares at a certain price and certain date (“put”) To sell a certain number of shares at a certain price and certain date (“call”) The bet is made by one investor or fund manager. I.e., rather simple.

Simple Financial Options Put Call Complex Options (Rainbow Options) A single option linked to two or more underlying assets. In order for the option to pay off, all the underlying assets must move in the intended direction. ( Real Options Adapted from ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Kinds of Continuous Options

The Black-Scholes Option Pricing Model This will not be on the exam.

Terminology “Real option” refers to treating a contingent operations management decision using the same reasoning as for a financial option. (Kind of implies that finance isn’t real, ha ha.) Some people call decision trees a real option technique. However, In this class we reserve the term “real options” for analysis of situations where choice variables (time, money, etc.) are continuous rather than discrete. –Analyzed with variations of the Black-Scholes formula. –Can give some good approximate solutions, but... –... Assumptions of B-S model do not always hold in operational situations.

Opportunities to alter input sourcing, change output mix, or redirect exports to new markets are common in settings of multiple markets with fluctuating currency values. Example: With the devaluation of SE Asian currencies in 1997, Japanese automakers shifted subsidiaries in Thailand and Indonesia from production of autos for the local markets to production of parts for developed-country markets. This flexibility is a major rationale for value creation via the “multinational corporation” model. Complex Enterprise Decisions

Defer - Investing now eliminates the option to defer (learning). Expand - An option to defer part of the scale of investment. Contract - The flexibility to reduce the rate of output. Abandon - Stop investing, and liquidate existing assets. Staging - Substitute a series of small investments for one large. Switching - Re-deploy resources or change inputs (terminate). Change Scope - Expand or contract scope. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Real Options - Some Examples

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 4 Extending brand names to new products or marketing through existing distribution channels Defer Expand or contract Abandon Switch inputs or outputs Grow To wait before taking an action until more is known or timing is expected to be more favorable To increase or decrease the scale of a operation in response to demand To discontinue an operation and liquidate the assets To commit investment in stages giving rise to a series of valuations and abandonment options To alter the mix of inputs or outputs of a production process in response to market prices Stage investment To expand the scope of activities to capitalize on new perceived opportunities ExamplesDescriptionOption Adding or subtracting to the daily flights on an airline route or adding memory to a computer When to harvest a stand of trees, introduce a new product, or replace an existing piece of equipment Discontinuing a research project, closing a store, or resigning from current employment Staging of research and development projects or financial commitments to a new venture The output mix of refined crude oil products or substituting coal for natural gas to produce electricity Examples: More Detail

So, why is NPV still so widely (and exclusively) used?

Survey of High Tech Execs

Discuss The acquisition of a fleet of buses (for example) has one value to the acquiring company if later decisions about maintenance are made in a certain way, e.g., if the oil is changed at certain intervals, and a different lifetime value if the oil is changed less frequently or not at all. If the return on fleet acquisition is allowed to depend on reliable mechanics changing the oil regularly, why are other kinds of project selections made without depending on reliable executives to make the subsequent decisions that maximize the project’s value?

Sources for this lecture

FDI and New Venture Strategy: Real Option / Strategic Decision Trees Analysis Compiled by Ted Fu July 1, 2002 Adapted from Luenberger: Investment Science Smith: Entrepreneurial Finance Click: International Financial Management Ted Fu

The Evolution of Decision Analysis By Ali Abbas Lecturer Department of Management Science and Engineering Stanford University

F. Phillips, Market-Oriented Technology Management Springer, 2001.