MBA201a: Real Options

Professor WolframMBA201a - Fall 2009 Page 1 The value of information and real options –We’ve seen that acquiring information early can be valuable. Said another way: –It can be valuable to delay decisions until you have more information.  REAL OPTIONS.

Professor WolframMBA201a - Fall 2009 Page 2 Real options – an example Consider the following situation: –September 2009: Anadarko is given the opportunity to buy mineral rights for a tract in the Gulf of Mexico. They believe that there’s a: 10% chance that it will yield 25 million barrels of oil (great site), 50% chance that it will yield 15mm barrels (OK site), and 40% chance that it will yield 10mm barrels (mediocre site). –October 2009: If they win the site, Anadarko’s geologists can assess the site and determine whether it’s a great, OK or mediocre site. –Spring 2010: The company can start developing the site for drilling. If it chooses a cheap extraction technology, it will spend $100mm but it will only get 1/5th of the oil. Extracting all the oil costs $1,000mm. The company can sell the oil for $70/bbl.

Professor WolframMBA201a - Fall 2009 Page 3 NPV analysis –Assuming the numbers are already discounted, the NPV of investing in the expensive extraction technology at this site is (in millions): $70  (.4    25) - $1000 = -$20 –Similarly, the NPV of investing in the cheap technology at this site is (in millions): $70  (.4    5) - $100 = $96 –This is a naïve NPV calculation, however. price med site OK site great site extraction profits per barrel probability x yield (in millions) cost

Professor WolframMBA201a - Fall 2009 Page 4 Other real option examples –Companies are choosing to reverse choice and chance nodes: Hewlett Packard’s printer production decision. Old power plants with high running costs are kept around in case prices spike.

Professor WolframMBA201a - Fall 2009 Page 5 Winglets –Besides the price of oil, and the resulting price of jet fuel, what other factors would go into Southwest’s decision analysis for installing winglets on a particular plane? –As the price of oil has climbed, what do you think has happened to the price an airline pays for installing winglets? –Compare what the article implies about Southwest’s and Alaska’s analyses about whether or not to install winglets on their planes.

Professor WolframMBA201a - Fall 2009 Page 6 Real options –“Real” and “financial” options are the same animal. A financial put option on the S&P500 gives you (for some cost) the right to sell the S&P500 at some strike price X at some point in the future after you’ve acquired information about where the stock market is going. –The value of an option depends on: the likelihood you will exercise it, and the expected profit when you do exercise it. –The higher the variance in possible returns, the higher the value of the option.

Professor WolframMBA201a - Fall 2009 Page 7 Ask yourself: –Do I need to commit to a decision now, or would waiting provide me with more information? –What would this new information be worth? Would it be worth more than the cost, if any, of waiting? –If I commit to a decision now, to what extent can I back out of it?