Lecture 3

Real Options Approach

NRU HSE 2023

 Real Option Valuation

• Real options is the term used to denote the

opportunities associated with changing
decisions in response to the resolution of
relevant uncertainty.
• Real options analysis provide explicit valuation
of these opportunities

Investment decisions in innovation projects are:

• Irreversible (sunk cost)
• Uncertain future
• Timing of investment

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 Real Option Valuation

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 Real Option Valuation

A real option is the right, but not the obligation,

to take an action (e.g. deferring, expanding,
menunda / menangguhkan

contracting or abandoning) at a predetermined

cost (exercise price), for a predetermined
period (the life of the option)

Stewart Myers

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 Real Option Valuation

Spotting Real (Strategic) Options

Real options are a central in valuing new ventures
• Option to expand
• Option to delay
• Option to abandon
• Option to get into related businesses
Different approaches to valuing real options
• Decision analytic approach
• Binomial method
• Black-Scholes model
• Monte-Carlo simulation

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 Example

Example 1 (Auto Plant). Scenarios (50 / 50 chance in one year):

 Optimistic – high demand on auto, average demand on auto parts.
 Pessimistic – low demand on auto, lack of demand on auto parts.
Scenario Cash Flow, mil USD a year
Start 1-th 2-th 3-th 4-th
Opt. -5206 2078 3233 3556 5533
Pes. -5206 88 456 669 703
WACC = 20%. Decision tree
E (V)= (Vo Po +Vp PP )/1.2= 4909.58,
NPV=E(V)-IC=-296.42 Po Vo=10443.58

Don’t invest. V
Vp=1339.41
Pp

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 NPV Drawbacks.

Example 1. Conclusions:
 High volatility of scenarios.
 Doesn’t consider the role of management flexibility:
• Adjust or alter production schedules as price changes
mengubah

(contraction)
• Delay or defer making the investment (delay)
• Expand into new markets or products at later stages in
the process, based upon observing favorable outcomes
at the early stages (expansion)
• Stop production or abandon investments if the outcomes
are unfavorable at early stages (abandonment)

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 Option to contract.

In case of pessimistic scenario – contract production (PUT).

Example 1 (contd).
Partly loaded equipment (80%).
Cost of equipment adjustment- 82 mil USD.
Vсp = 88+ (1339.41 - 88)*0.8 – 82=1007.12 mil USD.
(1339.41-88)*0.8 is PV in 1 year (pessimistic scenario PS)
Contraction decrease value. Option has no value!
If CF are negative in PS
V-p = -1339.41 mil USD.
Vсp = -1171.13 mil USD. > -1339.41 mil USD.
Option has a positive value!
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 Option to abandon (PUT).

Example 1 (contd).
Option to sell equipment at 1500 mil USD. in a year.
Vdp = 88 +1500 = 1588 mil USD. > 1399.41 mil USD. = Vp
E(Vd)= (Vo Po + Vdp PP )/1.2= 5013.16,
NPVd=E(Vd)-IC=-192.84 mil USD.
Option has value:
CPUT= NPVd – NPV = 103.58 mil USD.
But still don’t invest!

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 Option to abandon .

We can look at decision tree of the option itself:

Po COput = 0
CPUT
CPput = 1588 -1339.41= 248.59
Pp

CPUT= (1/1.2)x(0 + 248.59*0.5) = 103.58

Same as before.
DTA is not good because of the discount rate!

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 Option to grow (CALL)

Example 1 (contd).
We have option to grow (CALL).
Opt. scenario (OS): invest 1225 mil USD increase CF by 20%.
VEo= 2078 + (10443.58 – 2078)*1.2 – 1225 = 10891.69 mil USD >
10443.58 mil USD = Vo
Option has value.
CCALL= NPVE – NPV = 186.71 mil USD .
But still don’t invest!
E(VE)= (VEo Po + Vdp PP ) /1.2= 5199.87 mil USD,
NPVE=E(VE)-IC= - 6.13 mil USD

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 Option to grow

Types:
• Buy excessive equipment .
• Reservation.
• R&D
• Ventures
perusahaan

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 Option to expand or scale(CALL)

Example 1 (contd). Duplicate project.

IC = 5206 + 1225 = 6431.
V1o= 10891.69
NPVo2= 10443.58*1.2/(1+0.2) – 6431 = 4012.58 > 0
PS – sell equipment and obtain 1588 mil USD
OS – expand
V1,2o= V1o + NPV2= 14 904.1 mil USD
NPV1,2= (14 904.1 *.5+ 1588*.5)/1.2 =1665.66
Finally invest!
Project 1 is the first step. It provides info about future projects.
Value of option СCALL = 1665.66 – (-6.13) = 1671.79

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 Option to switch

Conversion is adaptation to changing market conditions.

Example 1 (contd).
Our project
Technology Х
NPV= 1665.66 mil USD. Po 14 904.1
In case of PO we replace 6302.13
1588
the auto production Pp

with plastic storage production. Technology Y

Po 11 000
Costs are 500 mil USD
5500
Pp 2200

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 Option to switch

In case of OS
VXo = 14 904.1 – 2078 = 12 826.1 > 10 500 = VYo (subtracting cost
of switch) – No value!
In case of PS: VYр = 88 + 2200 – 500 = 1788 > 1588 = VXp
Value increased.
E(V)= (0.5* VXo + 0.5* Vyр) /1.2 = 6955.04 mil USD
NPV = 1749.46
Option value is:
СS= 1749.46 – 1665.66 + Po 14 904.1
103.58 = 187.41 6385.46
We switch, don’t abandon! Pp 1788

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 Complex Option

Several options but one source of uncertainty (CF)

Example 1 (contd). Options premiums:

Option Option premium

Contract 0
Abandon 103.58
Grow 186.71
Expand 1671.79
Switch 187.41
TOTAL 2148.68

But the value of the complex option is:

С = NPVC- NPV = 1749.46 – (-296.42) = 2045.91
Because we switch instead of abandoning (option interaction)

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 Option to defer

Example 2. Consider the NPV to the following simple investment.

The NPV is $600 and the decision is to invest.
However . . .
Facts:
• Investment outlay = $1,600
• Once made, the investment is irreversible
• Replacement expense equals depreciation
• Perpetual level cash inflows
• Price level = $200 now
• 50 / 50 chance of price changing to $300 or $100 in one year
• The price will stay at its new level forever
• Cost of capital = 10%
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 Option to defer

NPV =-1600+ (200/0.1 )= 400

• We do not have to invest immediately, we can
defer.
• If the project is deferred one year, it is
possible to take advantage of price
information.
• We would invest only if the price goes up.

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 Option to defer

• Regardless of whether it goes up or down, the

NPV with deferral is
NPVD= -1600/1.1 +(300/.1)/1.1 +0= 1273
• Since the NPV of deferring (option price) is
$1273- $400-$200=$673 higher than investing
immediately,
• we would choose to defer, even though the
NPV of investing immediately is large and
positive

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 Option to defer

Higher volatility
• Suppose the price in the previous example is
equally likely to go to $400 or $100 (rather
than $300 or $100)
NPVD= -1600/1.1 +(400/.1)/1.1 +0= 2182
• The value of the deferral option goes up as
there is greater uncertainty
• Greater uncertainty in the economy can cut
investment because the deferral option
penangguhan

becomes more valuable

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Option to defer and financial option.

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 Real options thinking.

Under these conditions, the difference between ROA and other decision tools
is substantial.
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Real options progress.

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 Other Types of Real Options.
• Staged (or multi-phase) investment
options
• Complex and derivative options
– Multiple interacting options
– Rainbow options
– Compound options
– Compound rainbow options

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Risk Analysis Techniques.

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 Thank you
for your attention!

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