1. Yale School of Management 1 Emerging Market Finance: Lecture 10: The Real-Option Approach to Valuation in Emerging Markets

2. Yale School of Management 2 The Limitations of Simple NPV Simple NPV-Analysis: Treat investment as one-off decision:  Project stays constant; cannot be adapted. Treat uncertainty as an exogenous factor Decision Trees and real options Managers respond to risk-factors: Integrate strategy and capital budgeting: What is the value of flexibility and responsiveness?

3. Yale School of Management 3 Investment under Uncertainty: The Simple NPV Rule 012...T Period Initial Investment I 120 80 120 80... Revenue if Demand is high Revenue if Demand is low 50% Cost of Capital = 10% NPV = - I + 100/0.1 = 1000 - I Invest if I < 1000

4. Yale School of Management 4 Investment under Uncertainty: Delay 012...T Period - I 0 120 00... Revenue if Demand is high Revenue if Demand is low 50% Strategy: Wait one Period Case 1: I > 800, do not invest if demand is low NPV = 0.5 1.1 (- I + 120 1.1 + 120 1.1 2 +... ) = 1200 - I 2.2 0 0 Demand

5. Yale School of Management 5 Investment under Uncertainty: Delay (2) 012...T Period - I 120 80... Revenue if Demand is high Revenue if Demand is low 50% Strategy: Wait one Period Case 2: I < 800, always invest NPV = 1 1.1 (- I + 100 1.1 + 100 1.1 2 +... )= 1000 - I 1.1 Demand 0 0

6. Yale School of Management 6 Summary of Strategies Decision ruleNPV (1)Simple NPV1000 - I (2)Delay if I > 800 (3)Delay if I < 800 Delay is never optimal if I < 800 Delay is better than investing now if I > 833 Investment is never optimal if I > 1200

7. Yale School of Management 7 Comparison of both Strategies 1000 - I NPV I 1000 909 0 083310001200 I > 1200: 833 < I < 1200: I < 833: Never invest Wait; invest if demand is high Invest now (1000 - I)/1.1 800 181 (1200-I)/2.2 Vertical distance =value of flexibility

8. Yale School of Management 8 1If 833 < I < 1000 Investment now has positive NPV = 1000 - I However:Waiting is optimal in order to see how uncertainty over demand resolves. Benefits from waiting: receive information to avoid loss. Costs of waiting: delay of receiving cash flows. Investment in positive NPV projects is not always optimal: the flexibility gained from waiting has a positive value. Note:Critical point is 833, not 800, why? Results of Comparison (1)

9. Yale School of Management 9 2.If 1000 < I < 1200 Investment now has negative NPV. However:The project should not be abandoned: if demand turns out high later, it has a positive NPV. Negative NPV-projects should be delayed, but not always be dismissed. Results of Comparison (2)

10. Yale School of Management 10 The project can be broken down into two components:  The investment possibility itself Has a Simple NPV of 1000-I  The flexibility of the project from the option to delay investment Value of Flexibility is: =Max (Value of investment later - Value of investing now, 0) Total NPV is the value of the whole project: Total NPV = Simple NPV + Value of Flexibility  Investing immediately ignores that option of delay is valuable  Decisions must be based on total NPV The value of flexibility is never negative Total NPV leads always to the correct decision Total NPV and Simple NPV Incorporating the Value of Flexibility

11. Yale School of Management 11 If I<833, invest now, hence option to delay has no value. If 1000>I>833, then:  Value of investing now = 1000 - I  Expected value of investing later is (1200-I)/2.2  Value of flexibility is then: So, with I=833, the value of flexibility is zero, with I=1000 it increases to 91. If 1200> I>1000, the value of flexibility is simply (1200-I)/2.2.  How does this change if the investment becomes more risky? Compute the Value of Flexibility

12. Yale School of Management 12 How to Use Total NPV Assume I=900>833, hence value of flexibility positive.  Value of following optimal strategy = Total NPV  Value of investing now = Simple NPV  Value of flexibility = 80/2.2=36.4  Should you invest now? Investing now gives 1000-900=100,  Simple NPV =100>0 Investing later gives:  Total NPV= Simple NPV+ Value of Flexibility = 100 + 36.4= 136.4 Total NPV > Simple NPV, therefore delay!  Deciding on the basis of Simple NPV ignores that investing now “kills the option”;

13. Yale School of Management 13 The Impact of Volatility How does the value of flexibility depend on uncertainty? Compare previous case with situation of more volatile prices: Revenue (High Demand) = 150 Revenue (Low Demand) = 50 Expected revenue is unchanged ( = 100). Volatility is higher.

14. Yale School of Management 14 Flexibility in a Volatile Environment Value of Flexibility I 0 833100012001500 250 0 Prices 150/50 Prices 120/80 583 Flexibility has a higher value in a more volatile environment

15. Yale School of Management 15 The Option to Abandon Assume same scenario as before, but no option to delay Revenue (High Demand)= 120 Revenue (Low Demand)= 80 Investment outlay I=1010 If there is no option to delay, NPV=1000-I = -10  Do not invest! Assume assets have a scrap value:  At the end of the period:scrap value = 910  After the first period:scrap value = 0

16. Yale School of Management 16 High revenue state (120):  PV (Cash Flow) = 1200 > 910  Continue after period 1!  Receive: 1200 + 120 in period 1 Low revenue state (80):  PV (Cash Flows) = 800 < 910  Divest and abandon project in period 1!  Receive: 910 + 80 in period 1 With option to abandon, NPV=40 Invest: Option to abandon makes the project viable. The Option to Abandon

17. Yale School of Management 17 Flexibility and Project Design Many projects have built-in flexibility:  Options to contract or expand.  Possibility to abandon if the assets have values outside the project (secondary market).  Development opportunities: Sequence of models of the same product. Oil fields. In many cases the project can be designed to be more flexible:  Leasing contracts.  Make or buy decisions.  Scale versus adaptability.