Professional Documents
Culture Documents
Lect 6 Real Options PART 1 PDF
Lect 6 Real Options PART 1 PDF
Real Options
2
• Book by Johnathan Mun
• Other material available on
internet
3
Lecture Outline
• DCF advantages and Disadvantages
• Real Options Introduction
• Types of Real Options
• Example
4
Advantages of DCF
5
6
7
Comparison Between DCF and Real
Options
Value of flexibility = 10.6‐4.3 = $6.3 8
Comparison Between DCF and Real
Options
9
Developing the Lattice Structure
10
What is Real Options
As per Investopedia
• A real option is a choice made available with business investment
opportunities, referred to as “real” because it typically references a
tangible asset instead of financial instrument.
• Real options are choices a company’s management makes to
expand, change or curtail projects based on changing economic,
technological or market conditions.
• Factoring in real options impacts the valuation of potential
investments, although commonly used valuations, such as net
present value (NPV), fail to account for potential benefits provided
by real options
• In other words it could be said that during decision making
anything that has flexibility and has some value can be considered
as “real options”.
11
But what is an Option?
Options
• Options are rights to exercise but not an
obligation
• The main element of an option is that the cost
of exercising the option
• Because of flexibility, an option has value.
12
More about Real Options
• These give us tools for calculating the value of
“real options” that provide flexibility.
• Enables us to estimate the expected value the
possible outcomes associated with options.
• The Real Options analysis gives us the “value”
of an option.
13
Types of Options in Real Life
• Input Mix Options or Process Flexibility
– The option to use different inputs to produce the same
output is known as an input mix option or process
flexibility.
• Examples:
– Agriculture: An farmer will value the option to switch
between various crops, preferring to use the best available
alternatives
14
Types of Options in Real Life
• Input Mix Options or Process Flexibility
• Examples:
– Utility industry. An electric utility may have the option
to switch between various fuel sources to produce
electricity. In particular, consider an electric utility
that has the choice of building a coal‐fired plant or a
plant that burns either coal or gas.
15
Types of Options in Real Life
• Output Mix Options or Product Flexibility
– The option to produce different outputs from the same
facility is known as an output mix option or product
flexibility.
• Examples:
– Toy industry. A manufacturer's ability to vary producing a
style of toy that has become unfashionable and quickly
begin producing a popular new style of toy.
16
Types of Options in Real Life
• Abandonment or Termination Options
– Whereas traditional capital budgeting analysis assumes
that a project will operate in each year of its lifetime, the
firm may have the option to cease a project during its life.
This option is known as an abandonment or termination
option.
– Abandonment options, which are the right to sell the
cash flows over the remainder of the project's life for
some salvage value, are like American put options. When
the present value of the remaining cash flows falls below
the liquidation value, the asset may be sold.
17
Types of Options in Real Life
Abandonment or Termination Options
• Examples
– These options are particularly important for large
capital intensive projects such as nuclear plants,
airlines, and railroads.
– They are also important for projects involving new
products where their acceptance in the market is
uncertain.
18
Types of Options in Real Life
Temporary‐Stop or Shutdown Options
– For projects with production facilities, it may not be
optimal to operate a plant for a given period if revenues
will not cover variable costs.
• Examples:
– If the price of oil falls below the cost of extraction, for
example, it may be optimal to temporarily shut down the
oil well until the oil price recovers.
19
Types of Options in Real Life
Temporary‐Stop or Shutdown Options
• Examples:
– Farming: May be exercised if the cost of fertilizing,
watering and harvesting exceeds the sale price of
the product.
– Real‐estate development: May be exercised if the
cost of construction exceeds rent revenues.
20
Types of Options in Real Life
Intensity or Operating Scale Options
– Intensity or operating scale options involve the
flexibility to expand or contract the scale of the
project. Management may have the option to
change the output rate per unit of time or to
change the total length of production run time.
21
Types of Options in Real Life
Option to Expand
– Build production capacity or the infrastructure for the
capacity in excess of expected level of output (so it can
produce at higher rate if needed).
– Management has the right (not the obligation to expand).
If project conditions turn out to be favorable,
management will exercise this option.
• Example
– Mozal Project
22
Types of Options in Real Life
Option to Contract
– This is the equivalent to a put option. Many
projects can be engineered in such a way that
output can be contracted in future. Forgoing
future expenditures is equivalent to exercising
the put option.
• Example:
– Modularization of project.
23
Types of Options in Real Life
Option to Expand or Contract (Switching
Option)
– It is equivalent to the firm having a portfolio of
call and put options. Restarting operations when
project currently shut down is a call option.
Shutting down is a put option.
24
Types of Options in Real Life
• Initiation or Deferment Options
– The option to choose when to start a project is
an initiation or deferment option.
• Examples:
– The purchaser of an off‐shore lease can choose
when, if at all, to develop property.
25
What need to be done
Identifying Real Options
– Why are there empty lots in prime commercial
real estate areas in all major cities?
– Multipurpose real estate (hotel/apartment)
26
CSUF Example
• Trigen plant at CSUF with solar panels and
other development
27