2. Real Options: The Via Dutra Case Luiz Brandao The University of Texas at Austin luiz.brandao@mccombs.utexas.edu Class Web Site www.mccombs.utexas.edu/faculty/luiz.brandao www.mccombs.utexas.edu/faculty/luiz.brandao Austin, Texas

3. Via Dutra Case

4. MSIS 383N University of Texas at Austin 3 Via Dutra  Brazil is about the size of the USA.  Roadways account for over 60% of total freight transportation, compared to 26% in the USA.  Quality of roads is poor.

5. MSIS 383N University of Texas at Austin 4 Federal Highway Network of Brazil

6. MSIS 383N University of Texas at Austin 5 Privatization Program  In the 90’s Brazil privatized state owned steel mills, phone and public utility firms and part of the federal and state highways.  The privatized highways were to be operated and maintained through a concession contract  The President Dutra highway was the most important one of the federal network, linking Brazil’s two largest cities, Rio and Sao Paulo.  Highway was 400km (250 miles) long.

7. MSIS 383N University of Texas at Austin 6 Rio de Janeiro, Brazil

8. MSIS 383N University of Texas at Austin 7 Rio de Janeiro, Brazil

9. MSIS 383N University of Texas at Austin 8 Rio de Janeiro, Brazil

10. MSIS 383N University of Texas at Austin 9 Sao Paulo, Brazil

11. MSIS 383N University of Texas at Austin 10 The Project  Twenty five year concession  Obligation to invest over US$ 500 million in repairs, upgrading and maintenance.  Bi-directional toll collection at four toll plazas  Bidders were the largest construction firms in Brazil.  Very few roads in Brazil were toll roads at the time.

12. MSIS 383N University of Texas at Austin 11 Via Dutra, Inauguration, 1948.

13. MSIS 383N University of Texas at Austin 12 Via Dutra, Inauguration, 1948.

14. MSIS 383N University of Texas at Austin 13 Via Dutra, 2003

15. MSIS 383N University of Texas at Austin 14 Via Dutra: Before and After

16. MSIS 383N University of Texas at Austin 15 Via Dutra: Before and After

17. MSIS 383N University of Texas at Austin 16 Via Dutra: Before and After

18. MSIS 383N University of Texas at Austin 17 Via Dutra: Before and After

19. MSIS 383N University of Texas at Austin 18 Project Risks and Options Risks  Traffic risk  Foreign exchange risk  Political risk  Interest rate risk  Inflation risk  Implementation risk  Operational risk Options  Option to Abandon  Option to Expand

20. MSIS 383N University of Texas at Austin 19 -2% -1% 0% 1% 2% 3% 4% 5% 6% 7% 8% 19841985198619871988198919901991199219931994199519961997 Ano % de mudança Traffic GDP Correlation between Traffic and GDP - USA

21. MSIS 383N University of Texas at Austin 20 Real Options Model  Create DCF spreadsheet  Model the stochastic process of each uncertainty  Use Monte Carlo simulation to estimate the project volatility  Model project GBM diffusion process with a binomial lattice  Insert options as decision nodes in tree.  Solve using risk neutral probabilities.

22. MSIS 383N University of Texas at Austin 21 Binomial Approximation  A lognormal stochastic process can be modeled with a binomial lattice.  This allows us to use a simpler, discrete model

23. MSIS 383N University of Texas at Austin 22  The binomial parameters are:  Note that volatility is the annualized standard deviation of the project returns. The Δt factor adjusts for time intervals different than a year. Binomial Model

24. MSIS 383N University of Texas at Austin 23 Risk Neutral Probabilities  Risk Neutral Probabilities are the probabilities that provide us the same PV as before, when we discount at the risk free rate.  They can easily be derived from the relationship that exists between the project cash flows, the discount rate, the probabilities and the Present Value.  This way we can discount the cash flows with the risk free rate and arrive at the same PV, as long as we use the risk neutral probabilities

25. MSIS 383N University of Texas at Austin 24 How can we adjust for risk?

26. MSIS 383N University of Texas at Austin 25 Discount the outcomes at the Risk Adjusted Rate? The discount rate is 10%

27. MSIS 383N University of Texas at Austin 26 Discount the outcomes at the Risk Free Rate? I f we discount the cash flows at the Risk Free rate instead of the Risk Adjusted rate, we arrive at an incorrect PV.

28. MSIS 383N University of Texas at Austin 27 Discount the outcomes at the risk free rate and adjust the probabilities? We can correct this by “adjusting” the probability to 0.477

29. Real Option Valuation Class Website www.mccombs.utexas.edu/faculty/luiz.brandao