1. FINA 522: Project Finance and Risk Analysis Lecture 12 Updated: 19 May 2007

2. Real Options in Theory and Practice

3. Real Options Use of Net Present Value (NPV) rule Often does not capture management decisions to change and revise operations in response to new information or conditions. DCF approach assumes a commitment to an operating strategy to end of project’s useful life. In reality the realized cash flows will be different from what management expected at the beginning.

4. Managerial Operating Flexibility As new information becomes available and uncertainty is reduced, management may alter the operating strategy to: –Reduce loses –Take advantage of favorable opportunities as they arise

5. Managerial flexibility is similar to financial option –Call option on an asset (with current value v) gives the right, with no obligation to buy the underlying asset by paying the prescribed price- the exercise price. –Put Option gives the right to sell the underlying asset and receive the exercise price. –The asymmetry from having the right, but not the obligation to exercise the option gives the option its value. –To properly evaluate an investment opportunity need to combine the evaluating of NPV of distinct cash flows with option value of operating flexibility and strategic interactions.

6. Common Real Options 1.Options to defer –Firm has an option to buy land for future development of a mine. 2.Staged investments –Making a series of outlays creates the option to abandon the enterprise mid stream. 3.Options to alter scale, to expand, to shut down –If market conditions change then firm can adapt.

7. Common Real Options 4.Options to abandon −If market conditions decline badly then firm can abandon current operations. 5.Options to switch outputs or inputs −If prices or demand changes management can change the output mix or use different inputs. 6.Growth options −An early investment e.g. oil exploration, Research and Development project is a prerequisite or a link to future development and growth.

8. Comparison of Evaluation Techniques Discounted Cash Flow- –evaluates the net present value (NPV) of specific investment and operating strategies. –These techniques may under value investment opportunities. Real Options –Evaluates the value of having managerial flexibility to optimize the activity over time. –Japanese firms managed to incorporate real options into the manufacturing systems.

9. Example of Jyoti Spinning Mills Rup Jyoti decision in 1980s which choosing types of machines for making yarn 1.Could buy cheaper equipment that would produce lower quality yarn that could only be sold in Nepal. At that time, Nepal market was closed to international trade and very inactive. 2.Could buy more expensive equipment that would allow production of yarn of different qualities. This would allow Jyoti Mills to sell around the world if Nepal market was not good.

10. Example of Jyoti Spinning Mills Results –He purchased higher quality machines. –In early years after the firm opened, the government opened the Nepal market to imports of higher quality yarns at lower prices. –The market for low quality yarn in Nepal disappeared –Jyoti Mills was able to sell their yarn abroad in places like Hong Kong, Sri Lanka, and the UK. –They survived to change in market conditions while many of their competitors were closed down.

11. Real Options over time

12. Evaluation Techniques for Real Options 1.Those that approximate the underlying stochastic process directly Include: I.Monte Carlo Simulation II.Lattice methods III.Log transformation binomial approach 2.Techniques that approximate the underlying differential equations I.Numerical integration II.Implicitly or explicit finite-differential schemes

13. Real Option Approach to Project Decision Making Building manufacturing capacity to make computer chassis Feasibility study- cost US$ 800,000 –Options for size Major expansions- cost US$ 6 million Moderate expansion- cost US$ 4 million Minor expansion- cost US$2 million –Market opportunities High volume of sales US$ 6.5 million Lower volume sales US$ 2.5 million

14. Conventional Analysis Assume probabilities of each revenue is stream is 0.5 each. Assume probabilities of each expansions option are equally probable. Value of investments –Revenues = 0.5(6.5) + 0.5(2.5) = US$ 4.5 million –Costs = 0.33(6.0) + 0.33(4.0) + 0.33(2.0) = US$4.0 million –Net benefit = US$ 0.5 million US$0.5 million is less than US$ 0.8 million cost of feasibility study, so do not proceed.

15. Real Options Approach

16. We take a multi-step approach to decision making. During each step we incorporate newly gained information into the decision analysis. Beginning by estimating the profitability associated with each of the investment scenarios.

17. Scenario A: Major Expansion Expected Profit/major expansion =e (Revenue) – e Cost/Major Expansion =US$4.5 m – US$6.0 m = -US$1.5 m We will never carry out a major expansion because we would expect to lose money. Better to make zero profit.

18. Scenario B: Moderate Expansion Expected Profit/moderate expansion =e (Revenue) – e Cost/moderate Expansion =US$4.5 m – US$4.0 m = US$0.5 m Profit = US$0.5 million Scenario C: Minor Expansion Expected Profit/minor expansion =e (Revenue) – e Cost/Minor Expansion =US$4.5 m – US$2.0 m = US$2.5 m Profit = US$2.5 million

19. Overall Profitability E (profitability) = 0.33 (0 m) + 0.33(0.5 m) + 0.33(2.5 m) = US$1.0 million Expected profit is greater than cost of feasibility study of US$ 0.8 million. To see which scenario should be undertaken.

20. Second Round of Real Option Thinking Assume firm goes ahead with feasibility study. Recommends that the moderate facility be built. Marketing department starts to carry out a careful market research to determine which of the two revenue scenarios are most likely to arise. Question? Should company begin to build the new facilities or wait until better market information is available.

21. Traditional Approach Expected Profit/moderate expansion =e (Revenue) – e Cost/moderate Expansion =US$4.5 m – US$4.0 m = US$0.5 m Profit = US$0.5 million

22. Real Option Approach Scenario 1: High Revenue Expected Profit/moderate expansion and high revenue =e (Revenue/moderate) – e Cost/moderate Expansion =US$6.5 m – US$4.0 m = US$2.5 m Scenario 2: Low Revenue Expected Profit/moderate expansion and low revenue =e (Revenue/moderate) – e Cost/moderate Expansion =US$2.5 m – US$4.0 m = -US$1.5 m If this happens the lose US$1.5 m, if abandon idea of project then expected revenue = 0 million

23. Overall profitability If we assume that high revenue and low revenue scenarios are equal to probability = 0.5 each, Expected profit = e (profit) = 0.5(2.5m) + 0.5(0m) = US$1.25 m The profit of US$1.25 is larger than the US$0.5 computed using the tradition approach. Hence, worthwhile to wait until the marketing study is complete to determine anticipated revenue.

24. Other Considerations Every number used when employing real option approach is a guess. Need to use best information available. The probabilities of different payoffs or probabilities of costs will not be equal. Unlike financial options, real options are not traded. The timing of exercising the real option is uncertain. Some wait 2, 3, 4 months for marketing study - information improves over time. Note: More than 50% of the value of a real option analysis is thinking about them before making decisions on the initial investments. It is a guide to decision making.