Chapter 22 Principles of Corporate Finance Tenth Edition Real Options Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

22-2 Topics Covered  The Value of Follow-On Investment Opportunities  The Timing Option  The Abandonment Option  Flexible Production  Aircraft Purchase Options  A Conceptual Problem

22-3 Corporate Options 4 types of “Real Options” 1 - The opportunity to expand and make follow-up investments. 2 - The opportunity to “wait” and invest later. 3 - The opportunity to shrink or abandon a project. 4 - The opportunity to vary the mix of the firm’s output or production methods. Value “Real Option” = NPV with option - NPV w/o option

22-4 Microcomputer Forecasts Example – Mark I Microcomputer ($ millions)

22-5 Microcomputer Forecasts Example – Mark II Microcomputer Option

22-6 Microcomputer Forecasts Example – Mark II Microcomputer ($ millions) Forecasted cash flows from 1982 NPV(1982) =PV(inflows) -PV(investment) = 467 – 676 = - $209 million

22-7 Microcomputer Forecasts Example – Mark II Microcomputer (1985) Distribution of possible Present Values Expected value ($807) Required investment ($900) Present value in 1985 Probability

22-8 Option to Wait Intrinsic Value Option Price Stock Price

22-9 Option to Wait Intrinsic Value + Time Premium = Option Value Time Premium = Vale of being able to wait Option Price Stock Price

22-10 Option to Wait More time = More value Option Price Stock Price

22-11 Timing Option Example Possible cash flows and end-of-period values for the malted herring project are shown. The project costs $180 million, either now or later. The figures in parentheses show payoffs from the option to wait and to invest later if the project is positive-NPV at year 1. Waiting means loss of the first year’s cash flows. The problem is to figure out the current value of the option.

22-12 Timing Option Example High demand generates $25 million and a value of $250 million at the end of the year. Low demand generates $16 million and no value. High DemandLow Demand Risk neutral return = 5%

22-13 Timing Option Example The next step requires the calculation of the probability of there being a high demand for the malted herring project. The option value is now determined as follows.

22-14 Option to Wait Example – Development option Wait NPV< Hotel NPV>0 Cash flow from hotel Cash flow Office Bldg Office Bldg NPV>

22-15 Option to Abandon

22-16 Option to Abandon Simple Example - Abandon Mrs. Mulla gives you a non-retractable offer to buy your company for $150 mil at anytime within the next year. Given the following decision tree of possible outcomes, what is the value of the offer (i.e. the put option) and what is the most Mrs. Mulla could charge for the option? Use a discount rate of 10%

22-17 Option to Abandon Simple Example - Abandon Mrs. Mulla gives you a non-retractable offer to buy your company for $150 mil at anytime within the next year. Given the following decision tree of possible outcomes, what is the value of the offer (i.e. the put option) and what is the most Mrs. Mulla could charge for the option? Year 0Year 1Year (.6) 100 (.6) 90 (.4) NPV = (.6) 50 (.4) 40 (.4)

22-18 Option to Abandon Simple Example - Abandon Mrs. Mulla gives you a non-retractable offer to buy your company for $150 mil at anytime within the next year. Given the following decision tree of possible outcomes, what is the value of the offer (i.e. the put option) and what is the most Mrs. Mulla could charge for the option? Year 0Year 1Year (.6) 100 (.6) 90 (.4) NPV = (.4) Option Value = = $17 mil

22-19 Option to Abandon Example – Ms. East - Revenues

22-20 Option to Abandon Example – Ms. East – Cash Flows

22-21 Option to Abandon Example – Ms. East – Value

22-22 Tanker Example Mothballing costs Value if mothballed Cost of reactivating Value in operation Tanker Rates Value of Tanker

22-23 Aircraft Purchase Option The option to purchase an aircraft provides the holder both the ability to obtain a lower price as well as receive the aircraft sooner. Both have value to the aircraft buyer, thus the option has value.

22-24 Aircraft Purchase Option Value of aircraft purchase option—the extra value of the option versus waiting and possibly negotiating a purchase later. The purchase option is worth most when NPV of purchase now is about zero and the forecasted wait for delivery is long.

22-25 Real Option Barriers  Practical reasons exist why real options are not always feasible to use. 1.Valuation of real options can be complex and sometimes it is impossible to arrive at the “perfect” answer. 2.Real options do not always have a clear structure their path and cash flows. 3.Competitors also have real options, which an alter the value of your options by altering the underlying assumptions and environment that serves as the basis of your valuation. Given these limitations, real options are not always the best approach when valuing projects.

22-26 Web Resources Click to access web sites Internet connection required