Investment decision techniques for long-term network planning: Real Options Valuation Sofie Verbrugge Didier Colle, Mario Pickavet

GBOUGhent University – IMEC – IBBT 2 Network planning process network planning physical constraints equipment cost existing network technical constraints network deployment plan customer demand time equipment cost old technology new technology time total traffic demand Which investments should be made at which points in time ?

GBOUGhent University – IMEC – IBBT 3Outline Classical investment decision rules Real options valuation Network planning problems to be seen as investment decision problems Conclusions

GBOUGhent University – IMEC – IBBT 4 Present value of future cash flows Positive time value of money: –prefer receiving now –prefer spending later Discount future expenses to present values where C = current value F = future expense i = interest rate n = years into the future nowyear 1year 2year 3year 4year 5 Current value of 100 euro to be spent in the future

GBOUGhent University – IMEC – IBBT 5 Investment decisions “Should the investment be made or not?” Consider all cash flows CF for the project –Initial investment (-) –Additional revenues (+) Cash flows used: –Incremental, operational, after taxes, economical lifetime time Initial investment: buy a machine Annual revenue: sell produced goods End of the project: resell the machine

GBOUGhent University – IMEC – IBBT 6 Net Present Value Definition –Present value of all cash flows in the investment project, discounted using the minimum required return on investment –r = minimum required return for considered project, grows with project risk (riskless project: interest earned on bank account) Objective –NPV >= 0 Advantages –Takes into account all CFs –Takes into account timing –Takes into account size of the project

GBOUGhent University – IMEC – IBBT 7Outline Classical investment decision rules Real options valuation Network planning problems to be seen as investment decision problems Conclusions

GBOUGhent University – IMEC – IBBT 8 Real Options compared to NPV Net Present Value (NPV) –Discounts CFs using fixed discount rate –Evaluates now-or-newer investment decisions –For risky project: difficult to determine appropriate discount rate Real Options Valuation (ROV) –Includes the options that may be present in an investment project with uncertain parameters –Includes flexibility in decision process –Uses risk-free discount rate ROV is extension of NPV technique –Value of a project = NPV + value of the options

GBOUGhent University – IMEC – IBBT 9 Origin: financial options An option gives the buyer the right to buy or sell an asset for a predetermined exercise price over a limited time period. –Right, not obligation –Asset: Asset for which the option holds, can be anything: stocks, real estate, precious metals, … –Exercise price = strike price: Price for which option holder can exercise the option, fixed over exercise time –Exercise date: option is no longer valid after this date (remaining time = Time To Maturity)

GBOUGhent University – IMEC – IBBT 10Terminology European option –can only be exercised on the exercise date American option –can be exercised till the exercise data Option price = option premium –Price to acquire the option, price to acquire to right Exercise price = strike price –Price for which option holder can exercise the option (fixed) Call option –option holder has right to buy the asset Put option –option holder has right to sell the asset

GBOUGhent University – IMEC – IBBT 11 Value of call option on exercise date Call option = right to buy (a stock) –Predetermined exercise price: X –Market value of the stock on exercise date: S On exercise date –S < X the option is useless everyone buys on the market –S > X the option is valuable Value of the option: S - X Option always has a positive value Value call option at exercise date = MAX(0,S-X)

GBOUGhent University – IMEC – IBBT 12 Value of option before exercise date Value of option = end value + time value End value –Value the option would have if today was the exercise date Time value –Grows with a growing time to maturity Over longer time chance is bigger that good changes will occur –Grows with volatility of share value Big volatility, big chance the value will change a lot before exercise date, bigger option value Remark: traditional valuation vs. option valuation –Small when difference between S and X is big Big |S-X|: value of the option (+ or -) not likely to change, small time value Small |S-X|: big chance the option value will change, big time value

GBOUGhent University – IMEC – IBBT 13 Option valuation Binomial method –for European call option –assumes 2 possible end values for the stock value –can be expanded for more time periods: software needed Black-Scholes –formula –assumes arbitrage-free pricing, stock prices follow Brownian motion Simulations –Monte Carlo simulation –Tools available: e.g. Crystal Ball S U D

GBOUGhent University – IMEC – IBBT 14 Financial versus real options Stock optionReal option Xexercise price of the option investments required to carry out the project Svalue of the underlying stock NPV of the cash flows generated by the investment project  volatility of the stockrisk grade of the project rthe risk-free interest raterisk-free interest rate tlife time of the optiontime period where company has the opportunity to invest in the project

GBOUGhent University – IMEC – IBBT 15Outline Classical investment decision rules Real options valuation Network planning problems to be seen as investment decision problems Conclusions

GBOUGhent University – IMEC – IBBT 16 Apply ROV for long-term planning ROV especially useful for –two-phase investment decisions –with an optional second phase (e.g. only performed if market situation is favourable) OXC introduction in an existing network with growing traffic demand –can be seen as two-phase decision –phase 1: introduction of the OXC itself (only including interface cards needed to switch the current traffic) –phase 2: option to expand the OXC with extra interface cards if needed –Actual decision whether or not to really expand only taken in phase 1 (uncertainty reduced by then)!!

GBOUGhent University – IMEC – IBBT 17 Case study European backbone network –16 nodes and 22 links –initially WDM point-to-point systems are used on all links –if an OXC is introduced: transit traffic passes the node optically –time frame 2002 – 2008 –initial traffic: IP traffic from Lion-Cost266 model –afterwards: 70% annual growth –links filled to 60% of there capacity –network equipment costs: relative to the cost of a WDM mux/demux –linear price model –price is changing (in a random way) In which nodes is OXC introduction beneficial? When?

GBOUGhent University – IMEC – IBBT 18 OXC introduction in Brussels NPV phase 1 NPV phase 2 NPV project ROV phase 2 ROV project ,17-94,44-97,607,344, ,17-87,51-90,6717,2214, ,17-87,08-90,2522,1819, ,17-95,8-98,9620,3717, ,17-117,69-120,8610,807,64 installation OXC + needed interface cards 2002 installation of extra line cards in considered years optional installation of extra line cards in considered years all > 0: OXC introduction should definitely be considered in Brussels best timing for upgrade : 2004

GBOUGhent University – IMEC – IBBT 19 OXC introduction in all nodes NPV: no OXC introduced in the entire network ROV: OXC introduction beneficial in half of the nodes Negative ROV project value: OXC not beneficial –Prague, Vienna and Zagreb: overall traffic too low –Berlin, Munich, London, Lyon and Rome: too little transit traffic Positive ROV project value: OXC introduction beneficial –Hamburg, Brussels, Frankfurt, Paris, Strasbourg, Zurich, Milan, Amsterdam –overall traffic big enough (exceeds router capacity within 2 years), transit traffic fraction > 60%

GBOUGhent University – IMEC – IBBT 20 Case study results Net Present Value –unable to correctly evaluate projects that comprise an optional follow-up investment –project value for OXC introduction < 0 Real Options Valuation –aimed to valuate projects where uncertainty is involved –project value for OXC introduction > 0 –optional character of second phase leads to bigger project value (postponing decision reduces uncertainty) –disadvantages: often very difficult to detect a real option correctly estimating the option value difficult (estimating CF) Black and Scholes assumptions should be tested carefully

GBOUGhent University – IMEC – IBBT 21Outline Classical investment decision rules Real options valuation Network planning problems to be seen as investment decision problems Conclusions

GBOUGhent University – IMEC – IBBT 22Conclusions Time value of money –Discount future expenses to present values –Always when comparing/ adding CFs for different time points Classical investment decision rules –Net Present Value (NPV) best of classical investment rules –Need to estimate CFs –Need to estimate required interested rate (related to risk) Real options valuation –Extension of NPV, to include optional future investments –Originates from world of stock options –Need to estimate CFs –Use of risk free discount rate –Several valuation techniques, best-known: Black and Scholes

GBOUGhent University – IMEC – IBBT 23Conclusions Network planning problems seen as investment decision problems –ROV can be used for two phase investment problems with optional second phase –disadvantages: Correct estimation of needed parameters not always easy Black and Scholes assumptions should be tested carefully OXC introduction seen as real option –ROV leads to bigger project value in case of optional follow-up investment –According to ROV: OXC introduction beneficial if expected traffic demand exceeds router capacity within next 2 years and the transit traffic fraction surpasses 60% –Introduction in half of the nodes in considered European backbone Future work: use simulations, to avoid B-S constraints

GBOUGhent University – IMEC – IBBT 24 Thanks for your attention!

GBOUGhent University – IMEC – IBBT 25 Backup slides

GBOUGhent University – IMEC – IBBT 26 Payback time Definition: –Payback time = time needed to pay back initial investment e.g. Objective: –Payback time <= Maximum accepted payback time Advantages –Indicates risk: shorter payback time = smaller risk –Easy to use Disadvantages –Does not take into account CFs after payback period –Does not take into account timing of CFs (time value) time Payback time = 4.66 years

GBOUGhent University – IMEC – IBBT 27 Return on investment Definition: –Return on investment = ROI = average future annual cash flow initial investment (average over econom. lifetime of project) Objective: –ROI >= minimum required ROI Advantages –Takes into account CFs after payback time Disadvantages –Does not take into account timing of CFs

GBOUGhent University – IMEC – IBBT 28 Internal rate of return Definition –Internal rate of return = discount ratio for which present value of expenses equals present value of revenues Objective –IRR >= required minimum Advantages –Takes into account all CFs –Takes into account timing of CFs (time value)

GBOUGhent University – IMEC – IBBT 29 NPV compared to IRR Similarities –Use discounting to present value: take into account timing of CFs –In most cases: both methods lead to the same decision Differences –Marginal cash flows have more than 1 change of sign: multiple IRRs possible –Mutual exclusive projects: different results NPV takes into account size of the project, IRR does not NPV best of ‘classical’ investment rules