1. Corporate Valuation 2001-5 Institut for Regnskab, IC Pontoppidan Options Last session: The 5 steps This lecture: Options workshop –presentation 12.4 Midstage reports and exam form Next

2. Corporate Valuation 2001-5 Institut for Regnskab, IC Pontoppidan CMK.20 Options If investors were riskneutral we could discount risky cashflow using the riskfree rate, but they are not ! Hence risky inflows minus certain outflows (=NPV) does not work if you use risk-adjusted probabilities you can discount using the risk free rate, alternatively discount using a risk adjusted interest rate, but NPV assumes constant risk i.e. a passive management in a static world !

3. Corporate Valuation 2001-5 Institut for Regnskab, IC Pontoppidan CMK.20 Options Decision Tree Analysis decides AFTER information is received (ctr. event tree) but what discount rate to use ? there is no single, constant discount rate because it changes with time (info) and underlying conditions (risk) Options are truely dymanic and “find” their discount rate in a comparable security the risk on an option on an underlying risky asset is always greater than the risk on the asset hence DTA uses too low an interest rate giving too high value estimates

4. Corporate Valuation 2001-5 Institut for Regnskab, IC Pontoppidan CMK.20 Options Options “takes care” of flexibility and of uncertainty that is gradually solved over time. They presume decisiontaking in the future, contingent on the arrival of new information and learning, not now - based on expectations of future informations operating real option is the value of flexibility growth option is the value of sequential interdependency there are asset options and liability options e.g.

5. Corporate Valuation 2001-5 Institut for Regnskab, IC Pontoppidan CMK.20 Options Options to: abandon (put)resale /liquidation value defer(call)development costs expand(call)expansion costs contract(put)contraction costs switch(putts and calls) restruc+ Shutdown c. non ordinary equity lease Of value when uncertainty is high adaptiveness is highsee exh.20.1

6. Corporate Valuation 2001-5 Institut for Regnskab, IC Pontoppidan CMK.20 Options Exhibit 20.4 –NPV -6,5 $ - without flexibility –DTA23,4 $ - with flexibility the value of the option can be approximated to the diff. = 29,6$ –the true optionvalue calculated on a twinn security gives an option value of 20,9$ + 6,5$ = 27,4$

7. Corporate Valuation 2001-5 Institut for Regnskab, IC Pontoppidan 6 optionvalue drivers

8. Corporate Valuation 2001-5 Institut for Regnskab, IC Pontoppidan CMK.20 Options Event tree (no flexibility) models the evolution of uncertainty in the different possible NPV events over time. Use expected values + risk adjusted interest rates OR risk adjusted probabilities + risk free rate Decision tree (with flexibility) have decision nodes added and hence improves the “positive” value path in the event tree 4 steps in option evaluation(exh.20.10) –base case without uncertainty and flexibility, using DCF –event tree with uncertainty, but still no flex. (use objective probabilities and WACC) –use flexibility in a decision tree analysis –calculate option value (evt.using option risk rate)

9. Corporate Valuation 2001-5 Institut for Regnskab, IC Pontoppidan Luehrman: Investment opportunities The correspondance between project characteristics and the option value drivers shows us, that deferral has two value elements to be included earning the timevalue of money on the postponed exercise price X, = (X-PV(X)) the world may change/ is uncertain ad1. NPV= S-X where S is stock value modifiedNPV = S-X+(X-PV(X))=S-PV(X) converted to a ratio to handle it easier NPVq=S/PV(X) ad2. Measure uncertainty by assessing probability and let the option-pricing model quantify the value. The measure is cumulative variance in returns but we utilize the square root of this called cumulative volatility

10. Corporate Valuation 2001-5 Institut for Regnskab, IC Pontoppidan Luehrman: Investment opportunities These two metrics combine the 5 option variables into two dimensions (see p.55) called Option space Option space is priced via a table (see p.56) “How to do” in 7 steps (p.58)

11. Corporate Valuation 2001-5 Institut for Regnskab, IC Pontoppidan Luehrman: Strategy as options Use the two option value metrics ( NPV q and cumulative volatility) to locate the project in the “option space” to obtain the effect of uncertainty and active decision making The tomato garden metaphor divides the garden in 6 regions, giving us 6 possible actions instead of just two (invest/ not invest) - also taking the likelihood of the projekcts future attraction into consideration. Never (6) and Now (1) combined with sure, maybe, and probable. (se p.94). This is a dynamic approach where time moves the opportunity upwarrd and to the left, and active management can move it back

12. Corporate Valuation 2001-5 Institut for Regnskab, IC Pontoppidan Kasanen & Trigeorgis Strategic investment planning how to design proper controls consistent with the value-max strategy to create and manage a collection of opportunities giving a growth path (strategic investment mix)- controlled via ROA and growth. 3 strategic sources of value –flexibility (operating real options) –synergy between projects –sequential project interdependencies (growth options)