Finance 2 (6012B0457Y)

Prof. Arnoud Boot

University of Amsterdam – Finance Group
MARCH 15, 2024

Week 6: Lecture 2 – Theory and Applications

Extra instruction…
• We will start-out the lecture by finishing the slides
provided for the last lecture (week 6 – lecture 1). In
particular,
 We will discuss the Black and Scholes option pricing
model, which is a continuous version of the binominal
model discussed
 And we will again discuss the properties of option prices,
i.e. build a qualitative understanding of what affects option
prices

These topics are discussed on slides 31-39 in the power

point presentation provided for last lecture.

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Now, real options – Life is full with choices

Investment decisions are not just yes/no decisions

with simple identifiable cash flows and probabilities
(this is the standard problem: just use NPV
analysis…)
 But: When to do them? And how do current
choices affect future opportunities?
Yes  this is core to your personal life (e.g. what
is the value of an extra year education?), but also
core to business decisions….

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 Life is full with choices…. (2)
Investment decisions are not just yes/no decisions with simple identifiable cash flows and
probabilities (this is the standard problem: just use NPV analysis…)
 But: When to do them? And how do current choices affect future opportunities?

Yes  this is core to your personal life (e.g. what is the value of an extra year education?),
but also core to business decisions….

•The example of KPN (and share buy backs) could

be interpreted as one where KPN killed its future
opportunities (‘options’) by choosing not to invest but
increase pay outs instead
•Option view also brings in a dynamic (timing)
element. E.g. if you have a piece of land, you can
develop it today (i.e. that is like exercising the option)
or wait…
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Real options are everywhere…
• One of the limitations of traditional investment analysis is
that they do not take into account the options embedded in
investments…
 The firm may have the option to delay taking a investment,
when a it has exclusive rights to it, until a later date
 Making investment may allow the firms to take advantage of
other opportunities (growth) in the future
 The firms may have the option to abandon an investment, if
the cash flows do not measure up
• Each of these options may add value to a project and may
turn a “bad” negative NPV investment (from traditional
analysis) into a positive NPV “good” one

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Technicalities versus realizing the
presence of real options

Option stuff sounds technical, but can be nicely

explained, and, yes, it is core innovation in theory of
finance
•Option valuation and pricing models, most famous, the
Black & Scholes Option Pricing Model (see last lecture)

But going beyond technicalities crucial

•Key is to recognize when there is a real option
present!

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 Todays agenda
Real options
[Chapter 22]
•Understanding real options, simple (?) discrete
examples as a start..
•Real options and using option pricing models

Options and corporate finance

[Chapter 20 –section 20.6]
•Debt and equity as options  yes, they could be
considered options…!!!

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Simple example of a real option
• You own a hotel – assume: keeping it open one
more year means a sure loss of 1 million (at t=1).
Closing it (at t=0) means no loss
If this is all that is going on, you close it of course
• But if you keep it open, Donald Trump might
discover your hotel, and decide ‘to make it great
again’.
• If he discovers the hotel (could only happen if you
keep it open), he buys it from you (at =1) for 3
million
What do you do? What is the option (value)?

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 Simple example of a real option (cont’d)
What do you do? What is the option (value)?
•The possibility of closing today, is like having a put
option with exercise price of zero [right to sell, i.e. get
rid of the hotel for zero]
•Keeping it open gives you -/-1mln or 2mln positive
•If you assume (no discounting etc.) that Trump shows
up with probability 0.25, then closing today is optimal
 Continuation gives expected value of 0.75x(-/-1mln) +
0.25(2mln) = -/-0.25mln. Closing gives zero
 Hence you exercise the option. Its value is 0.25mln (this is
what you gain by having the option)

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Real world banking example: ABNAMRO
and insurance
ABNAMRO put its insurance activities in 2001 in a
joint venture with Delta Lloyd rather than continuing
alone or selling it. Reason was that ABNAMRO was not good at it, and bankers did not like to sell
insurance products. So having insurer involved would make it more professional

•Needed to do something – its insurance activities (in Zwolle)

were not taken seriously within ABNAMRO
•Yes: joint venture with credible partner could give it more
strength
•And most importantly: ABNAMRO could buy out Delta Lloyd
and continue with insurance by itself if in the future insurance
activities would become vital for ABNAMRO  this made it a
real option!!! They literally kept their options open…
 Ultimately, all did not work out [but this is besides
the point: not clear beforehand]
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Investments and real options: extensive
example
• Assume you have negotiated a deal with an
electric car manufacturer to open one of its
dealerships in your hometown
• The terms of the contract specify that you must
open the dealership either immediately or in
exactly one year
• If you do neither, you lose the right to open the
dealership
• During the first year more information becomes
available about the profitability of the dealership
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Example: Investment and options (cont’d)

Key is that prior to t=1 new

information may come about.
This creates potential value to
waiting. And that makes
possibility to wait valuable option

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Example: investment and options (cont'd 2)
 It will cost $5 million to open the dealership, whether you
open it now or in one year
 If you open the dealership immediately (t=0), you expect
$600,000 in free cash flow the first year (t=1); future cash
flows are expected to grow with 2% per year
• If you start late (at t=1), your first expected cash flow (at t=2)
is $600,000 (no 2% growth yet in that case!)

Key is that you can wait with opening it. And waiting might
give you more information, which could affect your
decision on whether or not to open the dealership

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Example: investment and options (cont’d 3)
Waiting has value…
During the first year new information arrives about the expected
cash flows each period
• With equal probability, you get bad news (expected cash flows
down: x 7/12) or good news (up: x 17/12). 2% growth rate
remans the same (just the base/starting point changes)
• Thus with information you know whether expected cash flows
are 350,000 (7/12x600,000) or 850,000. If you do not wait, you
only know expected value 600,000 (is average of 350,000 and
850,000 by the way, so our example makes sense…
• This is the only moment new information can arrive and
permanently affect your per period expected cash flow
assessments
Cost of capital is 12%; risk free rate is 5%. Assume that the cost
of capital is 12% regardless of whether you wait or not
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Example: investment and options (cont’d 4)
If the dealership were to open today, the value of the dealership
would be: $600,000
V   $6 million
12%  2%
The NPV of investing today is $6mln - $5mln = $1 million

But, you have the flexibility to delay opening for one year:
•Benefit of waiting is that new information comes about, but you
are giving up the first year cash flow and delay that 2% growth
(but you free up investment funds)
•During first year it becomes clear that future expected cash
flows are low $350,000 (=7/12 of 600,000) or high $850,000.
Equal probability, average is $600,000; growths with 2%
 When should you open the dealership?
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Example: investment and options (cont’d 5)
• If we wait, we can distinguish two cases:
 Cash flow 350,000. Value is 350,000/(.12-.02) =3.5mln 
will we invest at t=1? At t=1 we have: NPV = 3.5mln - 5mln =
- 1.5mln  NO INVESTMENT
 Cash flow 850,000. Value is 8.5mln. At t=1 we have: NPV
= 8.5mln - 5mln = 3.5mln  INVEST
• Value at t=0 if we wait with investing till t=1:
 Recall risk-free rate is 5%
Only invest when NPV is
 NPV(at t=0;waiting till t=1) = positive  with prob 0.5.
And discount for one
[1/1.05] x {0.5 x 3.5mln} = $1.67mln period: you invest at t=1

• Recall: Opening today has a NPV of $1 million

CONCLUSION: Better to wait, and option that allows you to
wait has a value of 1.67mln - 1mln = $0.67mln
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Example: investment and options (cont’d 6)
Interpretation of gain (=option value of waiting)
•Recall waiting gave advantage of 0.67 mln in NPV. This
consists of four things:
1. (minus) opportunity cost of loss of cash flows due to waiting:
no 600,000 cash flow in the first period
2. (plus) investing one period later gives you opportunity gain on
having the 5mln funds for investment freely available for one
period – benefit 600,000 (is the 12% that you would have
required as return on the project)
3. (plus) benefit of learning: gain of not investing in bad 350,000
cash flow scenario. Thus, preventing negative NPV (-/-
1.5mln), gain is 1.5mln with probability 0.5, hence 0.75mln
4. (minus) extra opportunity cost because by delaying you delay
the 2% growth from kicking in
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 The same car dealer example can be done
using the Black & Scholes formula
Check it yourself – see also the book (section 22.3)
• Recall: deal with an electric car manufacturer to open one
of its dealerships in your hometown
 The terms of the contract specify that you must open the
dealership either immediately or in exactly one year
• Now: the payoff if you delay is equivalent to the payoff of a
one-year European call option on the dealership with a
strike price of $5 million (note: right to start=right to
buy=call option)
 The volatility in the value of the dealership is 40% (this replaces
the arbitrary 3.5mln/8.5mln assumption). Risk-free rate still 5%
 If you wait to open the dealership you have an opportunity cost of
$600,000 (the free cash flow in the first year that you give up)
We are now going to use Black & Scholes
option pricing formula 18
 Black-Scholes option value parameters for
evaluating the real option to invest

Note: NPV of opening today is still 1mln. For the option, note
that apart from the cost of delay, which is really like losing a
dividend if you do not immediately exercise the option (i.e. start
the dealership immediately), all looks standard. One other
exception: how to look at the value S? See next slide!
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 Investment as a call option (cont'd)
Note that S in the option pricing formula refers to a
non-dividend paying underlying security. Now we
have ‘a dealership’ which does pay out every year
•We can easily correct for this by subtracting the cash flow
in the first year (fortunately no other intermediate payments to
consider, so this takes care of it!)
•The current value of the asset without the “dividends” that
will be missed is:
$0.6 million
S x  S  PV (Div)  $6 million   $5.46 million
1.12
•The present value of the cost to open the dealership in
one year is:
$5 million
PV (K )   $4.76 million
1.05
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Investment as a call option (cont’d 2)
Now just use the formula!!
•The current value of the call option to open the
dealership is:
ln[S x / PV (K )]  T ln(5.46 / 4.76)
d1     0.20  0.543
 T 2 0.40
d 2  d1   T  0.543  0.40  0.143

C  S x N (d1 )  PV (K )N (d 2 )
 ($5.46 million)  (0.706)  ($4.76 million)  (0.557)
 $1.20 million

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Investment as a call option (cont’d 3)

• The value today from waiting to invest in the

dealership till next year (and only opening it then if
it is profitable to do so) is $1.20 million
• This exceeds the NPV of $1 million from opening
the dealership today. Thus, you are better off
waiting to invest, and the value of the waiting
feature is $200,000
Note that the numbers are different in the
simple discrete example (up or down)
that we had before, but in spirit it is
identical!
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Investment as a call option (cont’d 4)

• What is the advantage of waiting in this case?

Like before!!
 If you wait, you will learn more about the likely success
of the business
 Because the investment in the dealership is not yet
committed, you can cancel your plans if the popularity
of the dealership should decline. By opening the
dealership today, you give up this option to “walk away”

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Investment as a call option (cont’d 5)
• Whether it is optimal to invest today or in one year will
depend on the magnitude of any lost profits from the
first year (and lost growth in our earlier discrete
example), compared to the benefit of preserving your
right to change your decision

• Also note that if S today had been higher, you might

have chosen to invest immediately. Why? Higher S
means higher NPV today!*
*For the interested: this is incomplete. NPV goes up one-for-one with S. The call option also
increases in S, but less than one-to-one. Hence the NPV effect dominates, and investing
immediately is more likely when S today is higher. All this is behind the picture on the next
slide

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The decision to invest in the dealership

Higher S today makes NPV higher, and leads to immediate exercise (meaning
immediate opening of dealership). See last slide. It turns out that the break-even
point is S=6.66mln. Thus, if current prospects had been better (>6.66mln),
investing immediately would have been superior 25
More on real options
• Common types op real options:
 Option to expand (e.g. after prototype; or just continuing
to be relevant if future opportunities come about)
 Option to abandon, downscale, temporarily suspend
 Option to delay the start of the project
 Option to change input or output mix
• The value of real options should be included in
project analysis
• Real option valuation: use decision trees. This helps
you see all the possibilities and choices
 While with NPV analysis, writing down time line crucial!)

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Real versus financial options
• A key distinction between real options and financial
options is that real options, and the underlying
assets on which they are based, are typically not
traded in competitive markets
• What does this mean?
 Recall: key to derivation of option pricing formula’s (see
last lecture) was arbitrage argument using ‘law of one
price’
 And with no markets in which things are being traded,
arbitrage is impossible
• To see this, recall the replicating portfolios  since they were
replicating they needed to have the same value, but without
market to trade them on you can not force this
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 Options and Corporate Finance
(Chapter 20, section 20.6)
It is interesting to look at debt and equity, and see that
in essence they can be considered options as well
•Equity as a call option
 A share of stock can be thought of as a call option on the
assets of the firm with a strike price equal to the value of
debt outstanding. To see this, note:
• If the firm’s value does not exceed the value of debt outstanding
at the end of the period, the firm must declare bankruptcy and
the equity holders receive nothing
• If the value exceeds the value of debt outstanding,
the equity holders get whatever is left once the debt has been
repaid
• And this is very much what a call option is…
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 Equity as a Call Option (cont’d)

• Equity holders are considered owners of the firm,

and have “the right to buy the firm at the value of
what is owed to debtholders”
• The upside is what is left for the equity holders, and
that is very much the payoff of a call option on the
firm

 See picture on next slide!

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 Figure 20.8 Equity as a Call Option

And immediately it follows from the call option characteristics that

equity holders benefit from more risk…
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 Debt as an Option

We can now also link debt to options

•Debt holders can be viewed as owners of the firm (!!), yet
having sold a call option with a strike price equal to the
required debt payment  debt holders have thus written an
option!
 If the value of the firm exceeds the required debt payment, equity
holders will exercise the call option; the debt holders will therefore
receive the strike price and have to give up the firm
 If the value of the firm does not exceed the required debt
payment, the call will be worthless, the firm will declare
bankruptcy, and the debt holders will be entitled to the firm’s
assets

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 Debt as an Option (cont'd)
• Now think carefully! Debt can also be viewed as a portfolio of
riskless debt and a short position in a put option on the firm’s
assets with a strike price equal to the required debt payment.
Check this!
 When the firm’s assets are worth less than the required debt payment,
the owner of the put option will exercise the option and receive the
difference between the required debt payment and the firm’s asset
value. This leaves the debt holder with just the assets of the firm
 If the firm’s value is greater than the required debt payment, the debt
holder only receives the required debt payment

• Thus: Risky debt = riskless debt – put option on assets

 And that put option is a Credit Default Swap (CDS)!!

A CDS covers the losses associated

with default on a firm’s debt. And that
is precisely what this put option does!
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Figure 20.9 Debt as an Option Portfolio

Do we see put-call parity??

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 Agency Conflicts
• In addition to pricing, the option characterization of debt
and equity securities provides a new interpretation of
agency conflicts
• As we already eluded to, because equity is like a call
option, equity holders will benefit from risky
investments
• Debt is a short put option position, so debt holders will
be hurt by an increase in risk
 This can potentially lead to an overinvestment problem
where the firm undertakes negative NPV projects with
sufficient risk in the interest of its shareholders... Equity
holders like the risk…
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 Agency Conflicts (cont’d)
• When the firm makes new equity-financed
investments that increase the value of its assets, that
typically will reduce the risk for debt holders, i.e. the
value of the put option will decline
• Because debt holders are short a put, the value of
the firm’s debt will increase, so some fraction of the
increase in the value of assets will go to debt holders
This reduces equity holders’ incentives to invest, and
could imply underinvestment. This is the typical debt
overhang situation

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Finally…

• We have seen that options are everywhere

• Fascinating applications to capital budgeting
• It truly complements NPV analysis, and makes us
think much more strategic
• Moreover, we have even seen that equity and
debt themselves can be considered options!

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