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Valuing Flexibility

1
 Valuation Using Real Options

Slides 3-9 Decision Tree Analysis (DTA)

A simple method to evaluate uncertainty is to build a decision tree. Each branch
represents a critical uncertainty. To value the entire tree as of today, each branch
must be probability weighted and discounted to today’s value.

Slides 11-14
Real Option Valuation (ROV)
Part 2 If the project contains substantial market risk (i.e. beta greater than zero), decision
trees will be biased upwards because they underestimate the cost of capital.
Replicating portfolios allow us to value the option accurately.
Slide 16-23
An Exploration of Risk
Part 3 A number of factors, such as market risk, can affect the valuation process. We will
explore situations in which it may be more appropriate to use one of either the
Decision Tree Analysis or Real Option Valuation.

2
 Decision Tree Analysis (DTA)

• Your company has developed a new

serotonin stimulant which could potentially What is the expected ROIC
treat anxiety, depression, and obesity. and NPV of the new
Development of the product is expected to investment?
cost $350 million.
• Merck has offered to license the product
from our company. If the product can be
incorporated broadly, Merck has agreed to
pay $25 million in after-tax cash flows per
year every year forever. If it can only use
the compound in niche products, it will
generate $5 million in after-tax cash flows
per year forever.
• Assume the probability of wide use is 50%,
the risk free rate is 5%, and the cost of
capital for Merck is 15%.

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 Product Testing

• What if you had the ability to test the product’s potential over the
next year before making the investment? What would the net
present value be after the test is completed?

Value with Positive Results Value with Negative Results

4
 Building a Decision Tree

• What if you had the ability to test the product’s potential over the
next year before making the investment? What is the present
value of the test before the test is completed?

Good Results

 25 
max  0,  350 
 .05 
Value Today? Test
Bad Results

 5 
max  0,  350 
 .05 

5
 Valuing the Test Itself

• If this test costs $60 million and delays a full product launch by
a year, should we perform the test?

6
 Why the Difference in Values?

• Note that the ‘standard’ NPV is the maximum, decided today, of the
expected discounted cash flows or zero:

  Expected cash flowst  

Standard NPV  Max  ,0
time 0
 t 1 (1  WACC ) t


• The contingent NPV is the expected value of the maximums, decided

when information arrives, in each future state of nature, or zero:

   Cash flows contingent on information 

Contingent NPV  Expected  Max  ,0 
t 0   t 1 (1  WACC )t 

• Real options are most valuable whenever you face a decision that is costly
to reverse, such as a large initial investment (i.e. sunk cost).

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 A Slight Alteration: A Practice Example

• One of your scientists has a brilliant idea. With a slight alteration in the
compound, you can reduce research and development costs from $350
million to $275 million. Unfortunately, this makes any testing (of the
compound) more expensive. The cost of testing will rise from $60 to
$85 million.
• If both compounds are available, would you change your investment &
testing strategy?

8
 Valuation Using Real Options

Slides 3-9 Decision Tree Analysis (DTA)

A simple method to evaluate uncertainty is to build a decision tree. Each branch
Part 1 represents a critical uncertainty. To value the entire tree as of today, each branch
must be probability weighted and discounted to today’s value.

Slides 11-14
Real Option Valuation (ROV)
If the project contains substantial market risk (i.e. beta greater than zero), decision
trees will be biased upwards because they underestimate the cost of capital.
Replicating portfolios allow us to value the option accurately.
Slide 16-23
An Exploration of Risk
Part 3 A number of factors, such as market risk, can affect the valuation process. We will
explore situations in which it may be more appropriate to use one of either the
Decision Tree Analysis or Real Option Valuation.

9
 Using the Tools of Financial Options

• Our example looks quite

similar to a call option. What Real Options
Payoff Diagram
were the payout features of 500
this real option?

Project Payoff Using Real Options

400
• The most difficult part of real
options is distinguishing the 300

underlying asset from the 200

strike price. 100

– In the first example, what is

0
the underlying asset? 0 200 400 600 800

– What was the strike price? Project Value using Standard NPV

10
 Real Options Valuation (ROV)

• In our example, the “underlying asset” was the revenue stream.

Let’s value the underlying asset using standard probability and
the appropriate cost of capital.

Step 1: Value Underlying Asset Call Option Payoff

25  25 
p = 50%
Vu  max  0,  350 
.05  .05 
V0 

5  5 
1 - p = 50%
Vd  max  0,  350 
.05  .05 

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 Step 2: The Replicating Portfolio

• To value the call option, we can not use discounted cash flow, as we do not
know the appropriate cost of capital for the option. Therefore, we use
replicating portfolios.
• Since there are two states of the world, we need two assets to replicate the
payoff structure of the call option. As the second asset, we use a risk free
bond.

N(500)+B(1.05) = 150
Continuing
the same
example: N(100)+B(1.05) = 0
Value of Value of option
underlying payoff in down
asset in down state
state

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 Step 3: Valuing the Call Option

• Because both have identical payoffs, the value of the real option
equals the value of the replicating portfolio.
• Today’s value of the replicating portfolio equals N shares of the
underlying asset (S) financed by $b in risk free bonds.

Call Option Value = NS + B

• When valuing financial options, this relation MUST hold,

otherwise arbitrage is available. For instance, let’s say C > NS
+ B, what could an investor do?
• What if a real option was mispriced? Is arbitrage available?

13
 Valuation Using Real Options

Slides 3-9 Decision Tree Analysis (DTA)

A simple method to evaluate uncertainty is to build a decision tree. Each branch
Part 1 represents a critical uncertainty. To value the entire tree as of today, each branch
must be probability weighted and discounted to today’s value.

Slides 11-14
Real Option Valuation (ROV)
Part 2 If the project contains substantial market risk (i.e. beta greater than zero), decision
trees will be biased upwards because they underestimate the cost of capital.
Replicating portfolios allow us to value the option accurately.
Slide 16-23
An Exploration of Risk
A number of factors, such as market risk, can affect the valuation process. We will
explore situations in which it may be more appropriate to use one of either the
Decision Tree Analysis or Real Option Valuation.

14
 Modeling Market Based Risk

• Through this point, we have assumed all risk was technological,

i.e.
– the primary driver of volatility was technological feasibility – the
outcome of research is likely uncorrelated with the economy.
– Even long-term cash flows were also uncorrelated to the market, as
Cisco was absorbing all market-based risk by paying a level cash
flow stream.
• But what if your company decides to “play the market.” Then
the company takes on both market based risk and technology
risk. This change will render decision tree analysis (DTA) as
theoretically flawed.

15
 Analyzing Market Risk vs. Technological Risk

• Your company has developed a new

serotonin stimulant which could potentially What is the expected ROIC
treat anxiety, depression, and obesity. and NPV of the new
Development of the product is expected to
investment?
cost $350 million.
• You have decided to market the product
yourself. If the economy rebounds, you
expect to generate $75 million in after-tax
cash flows per year every year forever. If
it can only use the compound in niche
products, it will generate $15 million in
after-tax cash flows per year forever.
• Assume the probability of wide use is
50%, the risk free rate is 5%, and the cost
of capital for your company is 15%.

16
 Using DTA to Solve for Option Value

• What if you had the ability to test the product’s potential over the
next year before making the investment? What is the net
present value after the test is completed?

Good Results

 75 
max  0,  350   150
 .15 

Value Today? Test

Bad Results

 75 
max  0, 15  350   0
 .15 

17
 Using ROV to Solve for Option Value

• To value the call option, we can not use discounted cash flow, as we do not
know the appropriate cost of capital. Therefore, we use replicating portfolios.
• Since there are two states of the world, we need two assets to replicate the
payoff structure of the call option. As the second asset, we use a risk free
bond.

If the hedge ratio

doesn’t change,
then why does the
Continuing N(500)+B(1.05) = 150 option value
along the change?
same
example:
N(100)+B(1.05) = 0

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 Valuing the Call Option

• Because they have identical payoffs, the value of the real option
equals the value of the replicating portfolio.
• Today’s value of the replicating portfolio equals N shares of the
underlying asset (S) financed by $B in risk free bonds.

Call Option Value = NS + B

• How does this value differ from DTA?

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 The Intuition Behind the Valuation Difference

• In the first example, when the

A call option is identical to
only risk was technological,
a levered stock portfolio
DTA and ROV both led to a
value of $71.4 million •
Example 2:
Do it ourselves

• When the risk is both market

based and technological, then •
DTA will overstate the valuation
of real options that mimic calls. Rf • • • Example 1:
Merck license
In this case, DTA led to $65.2 Underlying Call
asset Option
million, while ROV was
approximately 5% lower at
$62.1. Standard Deviation

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 When to Use DTAs versus ROV Models

• When risk is nondiversifiable

and the cost of capital for the
Underlying risk
underlying asset is greater
Diversifiable Nondiversifiable
than the risk free rate, only Nontrade
d assets
ROV models provide the
Decision tree Decision tree
correct value. analysis analysis, real
options
• The real options model, Available valuation
data
however, requires that the
underlying asset be traded, in Decision tree Real options
analysis valuation
order to prevent arbitrage. Traded
assets
• DTAs have the added benefit
of simplicity.

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 Complex Real Option Models

Research phase Testing phase Marketing

Value up PV (Drug) 7,254

q= 86% Invest (150)
Technological risk event Success
p= 40%
Commercial risk event Value up PV (Drug) 4,314
PV (drug) 5,594 1–q= 14%
q= 86% Invest (150)
Invest (250) Value
1–p= 60% down
Stop
Failure

Success

p= 15% Value up PV (Drug) 4,314

q= 86% Invest (150)
Success
p= 40%
PV (Drug) 4,314 1–q= 14% PV (drug) 3,327 1–q= 14% PV (Drug) 2,566
Invest (100) Invest (250) Invest (150)
Value Value
down 1–p= 60% down
Stop
Failure

1–p= 85%
Stop

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