Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 1 of 31 Richard de Neufville Professor of Engineering Systems and of Civil and Environmental Engineering MIT Real Options

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 2 of 31 Outline l Motivational Example: Garage Case l General Perspective

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 3 of 31 Garage Case Topics l Value at Risk l Analyzing flexibility using spreadsheet l Parking garage case

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 4 of 31 Value at Risk Concept l Value at Risk (VAR) recognizes fundamental reality: actual value of any design can only be known probabilistically l Because of inevitable uncertainty in –Future demands on system –Future performance of technology –Many other market, political factors

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 5 of 31 Value at Risk Definition l Value at Risk (VAR) definition: –A loss that will not be exceeded at some specified confidence level –“We are p percent certain that we will not lose more than V dollars for this project.” l VAR easy to see on cumulative probability distribution (see next figure)

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 6 of 31 l Look at distribution of NPV of designs A, B: –90% VAR for NPVA is -$91 –90% VAR for NPVB is $102

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 7 of 31 VAR and Flexibility l VAR is a common financial concept l It stresses downside losses, risks l However, designers also need to look at upside potential: “Value of Gain” l Flexible design provides value by both: –Decreasing downside risk –Increasing upside potential –See next figure

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 8 of 31 Sources of value for flexibility Cut downside ; Expand Upside

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 9 of 31 Excel Analysis Sequence to illustrate value of flexibility 1: Examine situation without flexibility –This is Base case design 2: Introduce variability (simulation)  a different design (in general) 3: Introduce flexibility => a even different and better design

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 10 of 31 Parking Garage Case l Garage in area where population expands l Actual demand is necessarily uncertain l Design Opportunity: Strengthened structure –enables future addition of floor(s) (flexibility) –costs more (flexibility costs) l Design issue: is extra cost worthwhile?

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 11 of 31 Parking Garage Case details l Demand –At start is for 750 spaces –Over next 10 years is expected to rise exponentially by another 750 spaces –After year 10 may be 250 more spaces –could be 50% off the projections, either way; –Annual volatility for growth is 10% l Average annual revenue/space used = $10,000 l The discount rate is taken to be 12%

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 12 of 31 Step 1: Set up base case Demand growth as predicted, no variability

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 13 of 31 Optimal design for base case (no uncertainty) is 6 floors

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 14 of 31 Step 2: Simulate uncertainty Lower demand => Loss Higher demand => Gain limited by garage size

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 15 of 31 NPV Cumulative Distributions Compare Actual (5 Fl) with unrealistic fixed 6 Fl design

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 16 of 31 Recognizing uncertainty => different design (5 floors)

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 17 of 31 Step 3: Introduce flexibility into design (expand when needed) Including Flexibility => Another, better design: 4 Floors with strengthened structure enabling expansion

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 18 of 31 Summary of design results from different perspectives Why is the optimal design much better when we design with flexibility?

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 19 of 31 Sources of value for flexibility: 1) Minimize exposure to downside risk

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 20 of 31 Sources of value for flexibility: 2) Maximize potential for upside gain

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 21 of 31 Comparison of designs with and without flexibility Wow! Everything is better! How did it happen? Root cause: change the framing of the problem recognize uncertainty ; add in flexibility thinking

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 22 of 31 Summary from Garage Case l Sources of value for flexibility –Cut downside risk –Expand upside potential l VAR chart is a neat way to represent the sources of value for flexibility l Spreadsheet with simulation is a powerful tool for estimating value of flexibility

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 23 of 31 “Options” Embody Idea of Flexibility l An “Option” provides a formal way of defining flexibility l An “Option” has a specific technical definition l Semantic Caution: –The technical meaning of an “option” is… much more specific and limited than … ordinary meaning of “option” in conversation... where “option” = “alternative” l Pay careful attention to definition that follows!

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 24 of 31 Technical definition of an Option An Option is... l A right, but not an obligation… –“Exercise”, that is “use” only if advantageous –Asymmetric returns -- “all gain, no pain” –Usually acquired at some cost or effort l to take some action… –to grow or change system, buy or sell something, etc, etc, l now, or in the future... –May be indefinite –But can be for a limited time after which option expires l for a pre-determined price (the “strike” price). –Cost of action separate from cost of option

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 25 of 31 Financial Options l Focus first on financial options because –Consequences easiest to present –This is where options and valuation developed l Financial Options –Are tradable assets (see quotes finance.yahoo.com) –Sold through exchanges similar to stock markets –Are on all kinds of goods (known as “underlying assets”) Stocks, that is, shares in companies Commodities (oil, meat, cotton, electricity...) Foreign exchange, etc., etc.

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 26 of 31 Real Options l “Real” because they refer to project and systems –Contrast with financial options that are contracts l Real Options are focus of interest for Design –They provide flexibility for evolution of system l Projects often contain option-like flexibilities –Rights, not obligations (example: to expand garage) –Exercise only if advantageous l These flexibilities are “real” options l Let’s develop idea by looking at possibilities…

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 27 of 31 Real Options are Everywhere l Examples: l Lease equipment with option to buy at end of lease –Action is to buy at end of lease (or to walk away) – Lease period defined up-front (typically 2-3 years) – Purchase price defined in lease contract l Flexible manufacturing processes – Ability to select mode of operation (e.g. thermal power by burning either gas or oil) – Switching between modes is action – Continuous opportunity (can switch at any time) – Switching often entails some cost (e.g.: set-up time)

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 28 of 31 Real Options “IN” and “ON” projects l Those “real” because, in contrast to financial options, they concern projects, they are “ON” projects –E.g.: the option to open a mine –These do not concern themselves with system design –Most common in literature l Those “real” because they concern the design elements of system, they are “IN” projects –EX: options for staging of system of communication satellites –These require detailed understanding of system –Most interesting to system designers Financial options Options ON projects Options IN projects Real Options These need knowledge of system

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 29 of 31 Real Options “ON” projects l These are financial options, but on technical things l They treat technology as a “black box” l Example: Antamina Copper –option to open the mine after a two-year exploration period –Uncertainty concerns: amount of ore and future price =>uncertainty in revenue and thus in value of mine –Option is a Financial Call Option (on Mine as asset) l Differs from normal Financial Option because –Much longer period -- financial option usually < 2 years –Special effort needed to model future value of asset, it can’t be projected simply from past data (as otherwise typical)

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 30 of 31 Real Options “IN” projects l These create options by design of technical system l They require understanding of technology l Example: Communications Satellites –Designers can create options for expansion of capacity by way they configure original satellites –Technical skill needed to create and exercise option l Differ from other “real” Options because –Special effort needed to model feasible flexibility within system itself (e.g.: modeling of ‘trade space” for design of communication satellites)

Engineering Systems Analysis for Design Massachusetts Institute of Technology Richard de Neufville  Real Options SDMSlide 31 of 31 Summary l Options embody formal concept of flexibility l Options are not “alternatives” l 4 step Mantra “right, but not obligation, to act…” l “Calls” for opportunities, “puts” for downside risks l OPTIONS MAY HAVE GREAT VALUE l Options are Financial and “Real” l Many “real” options available to system designers l “Real” Options “ON ” and “IN” systems