1. Introducing Real Options
WEMBA Real Options
Introducing Real Options
What are Real Options?
Expansion Options:
Starsoft Inc. is considering expanding its internet software product lines to include web page
design software. If it does so, this will open up further expansion opportunities in the future,
since the infrastructure requirements for developing web design software will undoubtedly be
applicable to other web-based applications.
Timing Options:
Maxwell Corp. has a 3-year contract that gives it the right to develop a silver mine. However,
the current price of silver is too low for the project to have a positive NPV. Maxwell has the
choice between selling the contract today for a known price, or retaining it and waiting to see
whether the price of silver increases sufficiently to make the mining project worthwhile.
Learning Options
Pharmacure is evaluating whether to begin R&D on a newdrug for treating certain types of cancer.
Throughout the R&D process, the company will learn more about the drug's potential, the likely
market demand, and any negative side-effects. As they gain new information, they can use it
to adjust their level of spending on development, testing, and marketing costs.

2. Introducing Real Options
WEMBA Real Options
Introducing Real Options
How do Real Options differ from a standard Discounted Cash Flow/Decision Tree analysis?
Project 1: High-risk
Project 2: Low-risk
180
0.5
0.5
135
PV?
PV?
0.5
0.5 50 95
Risk-adjusted PV @ 20% = 1* ( )
(1.20)
= 95.8
Risk-adjusted PV @ 8% = 1* ( )
2 (1.08) =
Both projects have the same expected rate of return: ( )/2 = (135+95)/2 = 115
But…the variance in Project 1 is higher, hence we discount it at a higher rate.
Now…suppose we have an option to exit either project in the "bad" scenario, in which
case we would earn a salvage value of How much would we pay for this option
in either case?

3. Introducing Real Options
WEMBA Real Options
Introducing Real Options
Assume we have an option to exit the project, with a salvage value of What is the new PV
using standard Discounted Cash Flow analysis?
Project 1
Project 2
180
0.5
135
0.5
PV?
PV?
0.5
0.5
110
110
Risk-adjusted PV @ 20% = 1* ( )
(1.20)
= 120.8
Risk-adjusted PV @ 8% = 1* ( )
2 (1.08)
= 113.4
Now Project 1 has a higher PV: = 7.4
What is wrong with this analysis?
Should we still be using 20% as the discount rate for Project 1?
If not, what discount rate should we use?

4. Flashback to Binomial Pricing Methodology 2
WEMBA Real Options
Flashback to Binomial Pricing Methodology 2
Remember in Binomial Pricing Method 2 we calculated the “risk-neutral probability” as follows:
Option Value
Stock Price 1 22 q q
0.59 20
1-q
1-q 18
Call price = 0.59
= [1 * q * (1 - q)]/1.02
q = 0.6
Stock price = 20
= [22 * q * (1 - q)]/1.02
q = 0.6
We can use this technique to price real options very quickly!
Step 1: calculate the risk-neutral probability from the stock price tree
Step 2: calculate the option price using the risk-neutral probability

5. WEMBA Real Options
Using the Risk-Neutral Probability to price the Salvage Option in Project 1
Project 1 without the salvage option
Valuing the salvage option in Project 1
Stock Price
Option Value
180 q
max[0,K-S] = 0 q
95.8
?PV
1-q
1-q 50
max[0, K-S] =60
Step 1: Solve for q (the “risk-neutral”
probability)
Step 2: Calculate the salvage option value using
the risk-neutral probability
Stock Price = 95.8
= [180*q *(1 - q)]/1.05
q = 0.39
Put option = [0*q + 60*(1-q)]/(1.05)
= [ 0* *0.61]/(1.05)
= 34.9
put = 34.9
Project Value = Project without the option + value of the option = = 130.7

6. WEMBA Real Options
Using the Risk-Neutral Probability to price the Salvage Option in Project 2
Project 2 without the salvage option
Valuing the salvage option in Project 2
Stock Price
Option Value
135 q
max[0,K-S] = 0 q
106.50
?PV
1-q
1-q 95
max[0, K-S] =15
Step 1: Solve for q (the “risk-neutral”
probability)
Step 2: Calculate the salvage option value using
the risk-neutral probability
Stock Price =
= [135*q *(1 - q)]/1.05
q = 0.42
Put option = [0*q + 60*(1-q)]/(1.05)
= [ 0* *0.58]/(1.05)
= 34.9
put = 8.3
Project Value = Project without the option + value of the option = = 114.8

7. Introducing Real Options
WEMBA Real Options
Introducing Real Options
Project Project 2 Difference
PV using DCF analysis
PV using real options analysis:
Project value without put
Put value
TOTAL
Using Discounted Cash Flow analysis, Project 1 is worth 7.4 more than Project 2
Using Binomial Option Pricing, Project 1 is worth 15.9 more than Project 2
Why is this the case?
Options account for differing levels of risk at different times/scenarios (DCF uses
the same discount rate throughout--which implies the same level of risk throughout)
When can we use option pricing models for real options?
When we can create a replicating portfolio of traded assets to neutralize the risk from the project

8. Case Study 1: Martha's Brewery, a micro-brewery startup
WEMBA Real Options
Case Study 1: Martha's Brewery, a micro-brewery startup
Discounted Cash Flow analysis:
Startup investment requirement: $4 million today
Market launch: $12 million in two years time
Today's NPV (based on projected cash flows) = MM Reject
Contingency plan:
Market launch in two years only if market conditions are favorable
Complication:
How to evaluate the "option to expand"?
Solution:
Use option analysis to calculate present value of option to expand
If present value of option less today's $4MM investment is positive: Accept!

9. Case Study 1: Martha's Brewery, a micro-brewery startup
WEMBA Real Options
Case Study 1: Martha's Brewery, a micro-brewery startup
Discounted cash flow analysis:
NPV = =
(1.21) (1.21)(0.21) 6
3.5
Sales
earnings
Time (years) 4
Cost of Capital Calculation:
CAPM: E[r] = rf + (E[rm] - rf)
= 5% + 2 * 8%
= 21% 12

10. Case Study 1: Martha's Brewery, a micro-brewery startup
WEMBA Real Options
Case Study 1: Martha's Brewery, a micro-brewery startup
Option analysis:
Spot Price:
Strike Price:
Volatility:
Expiration
(years):
Riskless rate:
Call Value
Option-adjusted
Present value:
[Market-value-to-sales ratio for established micro-breweries = 3.66
Projected annual sales = 6
Spot price = 6 * 3.66 = 22
PV(Spot) = 15]
[Cost of follow-on investment if market conditions are favorable]
45% [from comparables]
[time at which $12 investment will be made if conditions are favorable] 5%
4.55
[ ]

11. Case Study 1: Martha's Brewery, a micro-brewery startup
WEMBA Real Options
Case Study 1: Martha's Brewery, a micro-brewery startup
Critical Assumptions for Option analysis:
1. Is spot price calculation realistic?
Confidence in the sales estimate
Use of market-value-to-sales ratio
Alternative comparable analysis? (e.g. P/E ratio)
2. Is the current estimate of follow-on investment subject to change?
3. How was the implied volatility calculated?
-- using historic volatility
-- using existing options on publicly-traded micro-brewery companies
4. Riskless rate: which rate was used?
5. How confident are we about the timing of the follow-on investment?