Real Options1 Real Options Back To Reality Stefan Bary

Real Options2 Topics Static Value: Standard DCF Risk Neutral Valuation Simulation When to Exercise Real Project

Real Options3 Static Value: Standard DCF Prognosis of Cash Flow Statement Continuing Value after Planning Period Discount Free Cash Flows Discount at WACC

Real Options4 Static Value: Standard DCF

Real Options5 Static Value: Standard DCF Static Value: or

Real Options6 Static Value: Standard DCF WACC: Beta adjusts only for systematic risk

Real Options7 Risk Neutral Valuation - financial options - Option Valuation uses Delta Hedging Portfolio of Option and Δ · Shares Discount at Risk free Rate

Real Options8 Risk Neutral Valuation - real projects - Use Certainty-equivalent: How to estimate C(FCF t ): –Assume only revenues to be stochastic –Use Solver in Excel (menu Tools) to estimate risk neutral growth of revenues No options implemented yet

Real Options9 Risk Neutral Valuation - real projects - Problem with real options: –WACC changes in different states by implementing options due to skewed distribution –Risk neutral growth of revenues changes in different states Solution: –Strong assumption of twin security for option pay-offs

Real Options10 Risk Neutral Valuation - real projects -

Real Options11 Simulation Monte Carlo Simulation We want to use Cash Flow Statement Not value is stochastic variable Revenues are stochastic (geometric Brownian motion) Other variables fixed or linked to revenues Use risk neutral growth of revenues to discount at risk free rate

Real Options12 Simulation

Real Options13 Simulation Run simulation a large amount of times Define C(FCF t ) for each run Calculate average of C(FCF t ) and discount at r f Present Value of simulation should approximate Static Present Value (no options incorporated yet)

Real Options14 Simulation Incorporate the options Call will be exercised in certain states in the top of the distribution Put will be exercised in certain states in the bottom of the distribution Calculate average of C(FCF t ) and discount at risk free rate to obtain strategic present value

Real Options15 When to Exercise - in case of simulation - In the past: –trial and error –select one level of revenues: test –select second level of revenues: test –continue until satisfied –complicated in case of interactions SiS (Simulation in Simulation) method: –corporate finance: value of future free cash flows –exercise should be based on value

Real Options16 When to Exercise - in case of simulation -

Real Options17 When to Exercise - solution of newly developed SiS - 1.Compose two CF Statements: A.without option B.with certain exercise of option 2.Simulate one path until moment of exercise 3.Fix revenues at moment of exercise 4.Simulate large no. of paths after exercise 5.Define NPV after exercise corresponding to level of revenues for both CFS A. and B. 6.Repeat steps 2. to 5. 7.Define optimal level of revenues to exercise

Real Options18 When to Exercise - solution of newly developed SiS -

Real Options19 Real Project JNJ Technology: Start-up venture Start-up in Netherlands Uncertain market: Technology Estimate of revenues (2001 EUR 2.96 mio), etc. Static DCF Value: EUR 5.2 mio

Real Options20 Real Project - Identify the Options - Different types of options –Option to shut-down (end 2002): Quit –Option to expand (end 2003): Roll-out in Europe Interactions (probability of joint exercise): –First order interaction –Second order interaction

Real Options21 Real Project - Identify the Options -

Real Options22 Real Project - Only option to expand - Compose two cashflow statements Run SiS Exercise option when revenues 2003 are at least EUR 3.92 mio Compose cashflow statement with exercise level of revenues Run Simulation Strategic value: EUR 7.8 mio Value of option: EUR 2.6 mio (exercise in 41%)

Real Options23 Real Project - Only option to shut-down - Compose two cashflow statements Run SiS Exercise option when revenues 2002 are max EUR 2.07 mio Compose cashflow statement with exercise level of revenues Run Simulation Strategic value: EUR 5.4 mio Value of option: EUR 0.2 mio (exercise in 33%)

Real Options24 Real Project - Both options - Compose four cashflow statements Exercise option to expand when revenues 2003 are at least EUR 3.68 mio Exercise option to shut-down when revenues 2002 are max EUR 2.09 mio Strategic value: EUR 8.0 mio Value of options: EUR 2.8 mio Exercise option to shut-down in 25% Exercise option to expand in 42%

Real Options25 Real Project - Both options - Value of option to expandEUR 2.6 mio Value of option to shut-downEUR 0.2 mio Value of both optionsEUR 2.8 mio Options approximately additive = low interaction Explanation: –time of exercise close to each other –put vs call

Real Options26 Real Project - Compare chance to exercise both options -

Real Options27 Real Project - Compare chance to exercise both options -

Real Options28 Real Project - Compare chance to exercise both options -

Real Options29 Real Options Back To Reality Stefan Bary