Options in Projects/Investments/Acquisitions F One limitation of traditional investment analysis (NPV) is that it is static and does not adequately capture the options embedded in investment –Option to delay an investment, when a company has exclusive rights to it, until a later date –Taking one investment may allow taking advantage of other opportunities in the future –Option to abandon if the cash flows do not measure up F These options add value to projects and may make a “bad” investment into a good one.

Option to Delay F When a company has exclusive rights to a project, product, technology for a specific period, it can delay taking this project or product until a later date F A traditional NPV analysis just answers the question of whether the project is a “good” one if taken today F Thus, the fact that a project has negative NPV today does not mean that the rights to this project are not valuable

Valuing the Option to Delay a Project PV Expected Cash Flows PV Cash Flows From Project Initial Investment in Project - NPV range + NPV range

Insights for Investment Analyses F Having the exclusive rights to a product, project, or technology is valuable, even if it is not viable today. F The value of these rights increases with the volatility of the underlying business F The cost of acquiring these rights (by buying them or spending money on development, or by acquisition) has to be weighted against these benefits

Example 1: Valuing Product Patents as Options F A product patent provides the company with the right to develop the product and market it F It will do so only if the PV of the expected cash flows from the product sales > cost of development F If not, the company can shelve the patent and not incur any further costs F If I is the PV of the costs of developing the product, V is the PV of expected cash flows from development, the payoffs from owning a product patent are: Payoff = V - I if V > I = 0 if V < I

Payoff on Product Option PV Expected Cash Flows On product Net payoff to introducing product Cost of product introduction

6 Levers of Financial Options Uncertainty Stock Price Dividends Risk-Free Exercise Price Time to Expiry

6 Levers of Real Options Unpredictability of cash flows PV Cash Flows Value lost over duration of option Risk-Free PV fixed costs Period for which opportunity is valid

Inputs for Patent Valuation InputEstimation Process 1. Value of underlying asset - PV of cash flows from taking project now 2. Variance in value of underlying asset - Variance in cash flows of similar assets or firms - Variance in PV from simulation 3. Exercise Price on Option- Option is exercised when investment is made - Investment cost assumed to remain constant 4. Expiration of the Option- Life of the patent 5. Dividend Yield - Cost of delay. Each year of delay is one less year of value-creating cash flows - cost of delay/year = 1/n

NPV Simulation

Valuing a Product Patent: Avonex Biogen has a patent on Avonex, a drug to treat MS, for the next 17 years, that it plans to produce and sell by itself. Key input assumptions: PV Cash Flows from Introducing Drug Now = S = $3.422 billion PV Cost of Developing Drug for Commercial Use = K = $2.875 Patent life = t = 17 yrs R f = 6.7% (17-year T-Bond) Variance of E(PV) = (industry avg bio-tech firms) Expected Cost of Delay = y = 1/17 = 5.89% d 1 = N(d 1 ) = d 2 = N(d 2 ) = Call Value = 3.422e (-.0589)(17) (0.8720) – 2.875e (-0.067)(17) (0.2076) = $907

When is Managerial Flexibility Valuable? Moderate Flexibility Value High Flexibility Value Low Flexibility Value Moderate Flexibility Value High Low High Likelihood of Receiving New Information Uncertainty Room for Managerial Flexibility Ability to respond Flexibility Value Greatest When : 1. High uncertainty about the future Very likely to receive new information over time 2. High room for managerial flexibility Allows management to respond appropriately to this new information 1. High uncertainty about the future Very likely to receive new information over time 2. High room for managerial flexibility Allows management to respond appropriately to this new information + 3. NPV without flexibility near zero If a project is neither obviously good nor obviously bad, flexibility to change course is more likely to be used and therefore is more valuable 3. NPV without flexibility near zero If a project is neither obviously good nor obviously bad, flexibility to change course is more likely to be used and therefore is more valuable Under these conditions, the difference between ROA and other decision tools is substantial In every scenario flexibility value is greatest when the project’s value without flexibility is close to break even The flexibility value comes from the ability to respond to information that may be received in the future. The greater the likelihood that this new future information will elicit a managerial response and alter the course of a project, the more value the option will have

Valuing a Company with Patents F Value = Value of Commercial Products (DCF) + Value of existing patents (OPM) + Value of New Patents obtained in the future – Cost of Obtaining Patents F The last term measures the efficiency of the company in converting R&D into commercial products. If we assume R = K from research, this term is 0. Note: do not double count and allow for a high growth rate in cash flows in the DCF valuation.

Value of Biogen’s Existing Products F Biogen had 2 commercial products that it had licensed to other pharmaceutical firms (Hepatitis B, Intron). F The license fees on the two products were expected to generate $50m in after-tax cash flows each year for 12 years. F PV of License Fees = $50 [1 – (1.067) -12 ]/0.067 = $403.6m Note: Risk-free rate = 6.7%

Value of Biogen’sFuture R&D F Biogen continued to fund research into new products, spending $100m on R&D, expecting to grow 20% per year for 10 years, and 5% thereafter. F From past experience, every $ invested in R&D would create $1.25 in value in patents (valued using OPM described above) for 10 years, and breakeven after that F Cost of capital = 15%, given the risk

Value of Future R&D

Value of Biogen Value = Existing Products + Existing patents (Avonex option) + Value Future R&D = $ $907 + $318.3 = $1,628.9 M Biogen had 35.5m shares outstanding, no debt Value per share = $1,628.9/ 35.5 = $45.88 per share

Example 2: Valuing Natural Resource Options F In a natural resource investment, the underlying asset is the resource and the value of the asset is based on 2 variables: quantity and price of the resource available F There is a cost associated with developing the resource, and the difference between the value of the asset extracted and the cost of the development is the profit to the owner of the resource F If X is the cost of development, V is the estimated value of the resource, the potential payoffs on an natural resource option can be written as: F Payoff on natural resource investment = V - X if V > X = 0 if V < X

Payoff on Natural Resource Firms PV Expected Cash Flows from natural resource reserve Net payoff On extraction Cost of developing reserve

Inputs for Natural Resource Options InputEstimation Process 1. Value of available reserves of the resource - PV of cash flows from resource (expert estimates, geologists on oil, etc.) 2. Variance in value of underlying asset - Variability of price of the resources and variability of available resources 3. Cost of Developing reserve (exercise price) - Past costs and the specifics of the investment 4. Time to Expiration- Relinquishment period or time to exhaust inventory, based on inventory and capacity output 5. Net production revenue (Dividend Yield) - Net production revenue every year as a % of market value

Valuing an Oil Reserve F Consider an offshore oil property with an estimated oil reserve of 50 million barrels of oil, where the PV of the development cost is $12/barrel and the development lag is 2 years F The firms has the rights to exploit this reserve for the next 20 years and the marginal value/barrel is $12 (price/barrel – marginal cost/barrel F Once developed, the net production revenue each year will be 5% of the value of the reserves F The risk-free rate is 8% and the variance in ln(oil prices) is 0.03

Inputs to Option Pricing Model F Current value of the asset = S = Value of the developed reserve discounted back the length of the development lag at the dividend yield = $12 * 50/(1.05) 2 = $ F Note: If development is started today, the oil will not be available for sale until 2 years from now. The opportunity cost of this delay is the lost production revenue over the delay period, hence, the discounting of the reserve back at the dividend yield F Exercise Price = PV of development cost = $12 * 50 = $600 F Time to expiration the option = 20 years F Variance in the value of the underying asset = 0.03 F Risk-free rate = 8% F Dividend Yield = Net production revenue/Value of reserve = 5%

Valuing the Option F Based on these inputs, the Black-Scholes model provides the following value for the call: F d 1 = N(d 1 ) = F d 2 = N(d 2 ) = F Call Value = e (-.05)(20) (0.8498) – 600e (-0.08)(20) (0.6030) = $97.08 F This oil reserve, although not viable at current prices, still is a valuable property because of its potential to create value if oil prices go up.

Option to Expand/Follow-On Projects F Taking a project today may allow a company to consider and take other valuable projects in the future F Therefore, even though a project may have a negative NPV, it may be a project worth taking if the option it provides the company to take other projects in the future provides a compensatory value F These are the options that companies often call “strategic options” and use as a rationale for taking on “negative NPV” or even “negative return” projects

Option to Expand PV Expected Cash Flows on Expansion PV of Cash Flows From Expansion Additional Investment to Expand Company will not expand in this section Expansion becomes attractive in this section

Option to Expand: Example F AmBev is considering introducing a soft drink to the U.S. market. The drink will initially be introduced only in the metropolitan areas of the U.S. and the cost of this limited introduction is $500m F A financial analysis of the cash flows from this investment suggest that the PV of the cash flows from this investment to AmBev will be only $400m. Thus, by itself, the new investment has a negative NPV of $100m F If the initial introduction works well, AmBev could go ahead with a full-scale introduction to the entire market with an additional investment of $1b any time over the next 5 years. While the current expectation is that the cash flows from having this investment is only $750m, there is considerable uncertainty about both the potential for the drink, leading to significant variance in this estimate

Valuing the Expansion Option F Value of Underlying Asset (S) = PV of Cash Flows from expansion to entire U.S. market, if done now = $750m F Exercise Price (K) = Cost of Expansion into entire U.S. market = $1,000m F σ of project value = annualized σ in value of publicly- traded companies in the beverage markets = 34.25% F Time to expiration = period for which expansion option applies = 5 years Call Value = $234 m

Project with Expansion Option F NPV of limited introduction = $400 - $500 = -$100 m F Value of Option to Expand to full market = $234m F NPV of project with option to expand = - $100 + $234 = $134 F Invest in Project !

NPV ’ = NPV passive + Option Value

Link to Strategy F In many investments, especially acquisitions, strategic options or considerations are used to take investments that otherwise do not meet financial standards F These strategic options or considerations are usually related to the expansion option described here. Key differences are: –Unlike “strategic options” which are usually qualitative and not valued, expansion options can be assigned a value and can be incorporated into the investment analysis –Not all “strategic considerations” have option value. For an expansion option to have value, the first investment (acquisition) must be necessary for the later expansion (investment). If not, there is no option value that can be added on to the first investment

The Determinants of Real Option Value F Does taking the 1 st investment/expenditure provide the firm with an exclusive advantage on taking on the 2 nd investment? –If yes, the firm is entitled to consider 100% of the value of the real option –If no, the firm is entitled to only a portion of the value of the real option with the proportion determined by the degree of exclusivity provided by the 1 st investment F Is there a possibility of earning significant and sustainable excess returns on the 2 nd investment? –If yes, the real option will have significant value –If no, the real option has no value

The Exclusivity Requirement in Option Value Is the 1 st investment necessary for the 2 nd investment? Not necessaryPre-Requisite Zero Competitive Advantage on 2 nd Investment Exclusive Right to 2 nd Investment No Option Value100% of Option Value

The Exclusivity Requirement in Option Value Zero Competitive Advantage on 2 nd Investment Exclusive Right to 2 nd Investment No Option Value100% of Option Value Increasing competitive advantage / Barriers to entry First-MoverTechnology EdgeBrand Name Pharmaceutical Patents

Internet Companies as Options F Some analysts have justified the valuation of Internet companies on the basis that you are buying the option to expand into a very large market. –Is there an option to expand embedded in these companies? –Is it a valuable option

NPV ’ = NPV passive + Option Value

Amazon.com: Building Value Through Options Start Success Failure BooksMusicVideo

Amazon.com: Building Value Through Options DCF books Option Value DCF books DCF Music Option Value DCF books DCF Music Option Value DCF Video Market Capitalization TIME

Value of whole strategy Product call 1 st expansion call (2 nd expansion Introduction value option value option) PV + +

Option to Abandon F A firm may sometimes have the option to abandon a project, if the cash flows do not meet expectations F If abandoning the project allows the firm to save itself from further losses, this option can make a project more valuable

Payoff on Put Option Price of underlying asset Net payoff on put Exercise price If asset value > exercise price, you lose what you paid for put

Option to Abandon PV Project Expected Cash Flows PV Cash Flows from Project Cost of Abandonment

Valuing the Option to Abandon F Airbus is considering a joint venture with Lear Aircraft to produce a small commercial passenger airplane on short haul flights –Airbus will have to invest $500m for a 50% share of the venture –Its share of the PV of Expected Cash Flows is $480m F Lear Aircraft offers to buy Airbus’ 50% share of the investment anytime over the next 5 years for $400m, if Airbus decides to get out of the venture F A simulation of the cash flows yields a variance of the PV of expected cash flow from the partnership of 0.16 F Project life is 30 years

Valuing the Option to Abandon F Value of Underlying Asset (S) = PV of Cash Flows from project = $480m F Exercise Price (K) = Salvage Value from Abandonment = $400m F σ 2 in Underlying Asset’s value = 0.16 F Time to expiration = Life of the Project= 5 yrs F Dividend Yield = 1/Life = 1/30 = F (i.e. PV will drop by 1/30 each year) F R f = 6% Put Value = $73 m

Should Airbus Enter the Joint Venture? F Value of Put = Ke -rt [1 – N(d 2 )] – Se -yt [1 – N(d 1 )] = 400 e (-.06)(5) [ ] – 480e (-0.033)(5) [ ] = $73m F Value of abandonment option has to be added to the NPV of the project of -$20m, yielding a total NPV with the abandonment option of $53m

Implications for Investment Analysis F Having an option to abandon a project can make otherwise unacceptable projects acceptable F Actions that increase the value of the abandonment option: –More cost flexibility, i.e., make more of the costs of the projects into variable vs fixed costs –Fewer long-term contracts/obligations with employees and customers because these add to the cost of abandoning a project –Find partners in the investment who are willing to acquire your share of the investment in the future F These actions will cost the firm some value, but this has to be weighted off against the increase in the value of the abandonment option

Option Analysis at Merck F Project Gamma - new line of business that required the acquisition of appropriate technologies from a small biotech company called Gamma F Merck would make a $2 million payment to Gamma over a period of three years F Merck would pay royalties to Gamma should the product ever come to market F Merck had the option to terminate the agreement at any time if dissatisfied with the research

Option Analysis at Merck F Merck’s finance group used the Black-Scholes option-pricing model –Exercise price = capital investment to be made 2 years hence –Stock price = present value of cash flows from the project –Time to expiration = varied over two, three and four years (with market entry unfeasible after four years) –Volatility = standard deviation of returns for typical biotech stocks –Risk-free interest rate = U.S. Treasury rate over the two to four year period

Example: Business Plan: Option to Launch New Product

Business Plan Spend $12M on Market Launch If Launch, obtain value of established participant Year 1 Year 2 Year 3 Raise $4M X spend $0.5M/quarter on product development fixed cash flow optional cash flow

But there is no obligation to launch the product, only an option F NPV has 2 parts u “hardwired” investment schedule u single roll of the dice on revenue F Recognizing the option to launch u multitude of outcomes u optimal response to each outcome, including the no launch decision

Valuing the option to launch F Black-Scholes formula was a Nobel Prize winning breakthrough F When applicable, the Black-Scholes formula is an easy-to-use and quick “option calculator” F Beauty of formula u No-arbitrage pricing u only 5 inputs u no forecasting

A Generic Example

Types of Option Flexibility F Option to Defer F Option to Default F Option to Expand F Option to Contract F Option to Shut Down F Option to Abandon F Option to Switch Use F Corporate Growth Options

An Oil Extraction and Refinery Project F 1-yr lease on undeveloped land with potential oil reserves F Initial exploration costs I 1 F Processing facility I 2 F Extraction can begin only after construction is complete F Management can choose to reduce scale of operation by c%, saving a portion of the last outlay I C or F Processing can be expanded by x% with a follow-up outlay of I E F At any time management can salvage a portion of its investment or switch them to an alternative use A.

The Option to Defer Investment F The lease enables management to defer investment and benefit from resolution of uncertainty about oil prices F Early investment sacrifices the option to wait and the option value loss is like an additional opportunity cost F Investment is justified only if the value of cash benefits actually exceeds the inital outlay by a substantial premium F The option to wait is extremely valuable in resource extraction industries due to high uncertainties and long investment horizons

The Option to Default During Construction F The staging of capital investment outlays over time create options to “default” at any given stage F Thus each stage can be viewed as an option on the value of subsequent stages F This option is valuable in highly uncertain, long- development capital intensive industries and R&D industries

The Option to Expand F If oil prices are more favorable than expected, management can expand the scale of production by x% by incurring a follow-up outlay of I E F This is similar to a call option to acquire and additional part (x%) of the base project, paying I E as exercise price F Management may deliberately favor a more expensive technology for the built-in flexibility to expand production if and when it becomes desirable - allows management to capitalize on future growth opportunities F Can make a seemingly unprofitable NPV project worth undertaking

The Option to Contract F If market conditions are weaker than expected, management can reduce the scale of operations by c% and save part of investment outlays I C F This is analogous to a put option on part (c%) of the base project with exercise price equal to I C savings F May be valuable for new product introductions in uncertain markets F May be preferable to build a plant with lower initial construction costs and higher maintenance expenditures in order to acquire flexibility to contract by cutting maintenance

The Option to Shut Down (and Restart) Operations F If the costs of switching between operating and idle modes are small, it may be better to suspend operations temporarily when revenues do not cover variable costs F Operations in each year are a call option to acquire that year’s cash revenues by paying the variable costs of operation as the exercise price F The options are typical in the natural resource industries, cyclical industries and consumer good industries

The Option to Abandon F Abandoning the project permanently in exchange for its salvage value F Can be valued as a put option on the current project value with the exercise price the salvage value or best alternative use value F Found in capital intensive industries, financial services and in new product introductions in uncertain markets

The Option to Switch Use F Suppose the oil refinery can be designed to use alternative forms of energy inputs (oil, gas, electricity) to process oil F The firm should be willing to pay a premium for such a flexible technology F Can gain this flexibility through technology, relationships with suppliers, subcontracting, locating production facilities in other countries F Valuable option in feedstock-dependent facilities F Product flexibility (alternative outputs) is valuable for auto and pharmaceutical manufacturers

Corporate Growth Options F Many early investments can be seen as links in a chain of interrelated projects F The value of these projects can not be derived from directly measurable cash flows, but from unlocking future growth opportunities F For example, investment in a first generation high-tech product is an option on options F Despite its negative NPV, the infrastructure, experience and potential by-products act as springboards for future generations of that product or new applications into other areas

Examples of Options Embedded in Strategic Acquisitions

Examples of Growth Options F A computer firm purchases another software start-up company rather than developing its own competing software. F An international airline acquires a U.S. airline to break into the U.S. market and increase traffic on existing or potential future routes. F A large publishing firm buys a smaller niche periodical firm enabling launches into related specialized periodicals in the future.

Examples of Flexibility Options F A firm in the aggregates business buys undeveloped quarry sites which have future potential for municipal waste disposal. F A diversified retailer switches use of shopping mall leased space in response to varying market conditions for each business. F A newsprint maker with virgin fiber mills acquires a mill capable of using recycled fiber.

Examples of Divestiture Options F An acquirer can divest real estate with a more valuable alternative use. F An acquiring airline can sell off selected routes or airport gates after purchasing another airline. F An acquirer sells companies that have not met growth targets, thereby truncating downside risk

You cannot analyze everything using Black-Scholes! F American and exotic option features F Path dependency F Compound options F Multiple underlyings F Logical inconsistency

Important nuances F Mapping the project back to a traded asset. If not, may need to calculate a risk premium. F Returns to ownership. What is analogue to the dividend received by a stock? F Multiple risk factors.

Current Industry Applications of the Real Options Approach Ž Valuing R&D and patents Ž Drug development Ž Value of vacant land Ž Venture capital investments Ž Flexible capacity expansion Ž Oil exploration and development Ž Flexible manufacturing Ž Value of electricity generation capacity Ž Intellectual property Ž Value of growth options in M&As

Conclusion: The Real Value of Real Options F Reshaping our thinking about strategic investments under uncertainty F Communicating value internally and to the financial markets F Making strategic decisions that increase shareholder value

Conclusion: The Real Value of Real Options F Growth related options significantly undervalued by traditional tools F Need to change the frame of reference : u Face the uncertainty u Identify the options u Is the value of the option > cost of acquiring or maintaining it? u What does it take to keep the option alive and valuable? F Option-based decision-making links strategy and valuation

Strategic Planning and Financial Theory Strategic Investments Options Analysis Managing a Portfolio of Options

Strategic Planning Options Management F Acquiring Options –Investing in R&D –Product Design –Loss-Leaders F Abandoning Options –Abandon options far “out of the money” F Exercise valuable options at the right time

Valuation Problems: A Taxonomy Balance Sheet Sources Debt Claims 3. Equity Claims Uses 1.Operations (Assets in place) 2. Opportunities (Real options) Financial Asset Markets Real Asset Markets Investors 1. Operations (Assets in place) 2. Opportunities (real options) Debt claims 3. Equity Claims

Range of Valuation Methodologies Problem TypeRecommended Valuation Method Alternative Methods 1. Operations (Assets in place) APV NPV, Multiples 2. Opportunities (real options) Option Pricing Multiples, Decision Trees 3. Equity ClaimsFlows-to-Equity All-Entity (E=V-D) Multiples

THE END Ready for questions!