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Real Options

ANSWERS TO END-OF-CHAPTER QUESTIONS

12-1 a. Real options occur when managers can influence the size and risk of a project’s cash

flows by taking different actions during the project’s life. They are referred to as real

options because they deal with real as opposed to financial assets. They are also

called managerial options because they give opportunities to managers to respond to

changing market conditions. Sometimes they are called strategic options because

they often deal with strategic issues. Finally, they are also called embedded options

because they are a part of another project.

b. Investment timing options give companies the option to delay a project rather than

implement it immediately. This option to wait allows a company to reduce the

uncertainty of market conditions before it decides to implement the project. Capacity

options allow a company to change the capacity of their output in response to

changing market conditions. This includes the option to contract or expand

production. Growth options allow a company to expand if market demand is higher

than expected. This includes the opportunity to expand into different geographic

markets and the opportunity to introduce complementary or second-generation

products. It also includes the option to abandon a project if market conditions

deteriorate too much.

c. Decision trees are a form of scenario analysis in which different actions are taken in

different scenarios.

12-2 Postponing the project means that cash flows come later rather than sooner; however,

waiting may allow you to take advantage of changing conditions. It might make sense,

however, to proceed today if there are important advantages to being the first competitor

to enter a market.

12-3 Timing options make it less likely that a project will be accepted today. Often, if a firm

can delay a decision, it can increase the expected NPV of a project.

12-4 Having the option to abandon a project makes it more likely that the project will be

accepted today.

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

12-1 a. 0 1 2 20

├─────┼─────┼────── • • • ────┤

-20 3 3 3

b. Wait 1 year:

PV @

0 13%

r= 1 2 3 21 Yr. 1

Tax imposed | | | | • • • |

50% Prob. 0 -20 2.2 2.2 2.2 15.45

50% Prob. 0 -20 3.8 3.8 3.8 26.69

Tax not imposed: NPV @ Yr 1 = (-20 + 26.69)/ (1.13) = 5.920

Expected NPV = .5(-4.027) + .5(5.920) = 0.947

Note though, that if the tax is imposed, the NPV of the project is negative and therefore

would not be undertaken. The value of this option of waiting one year is evaluated as

0.5($0) + (0.5)($ 5.920) = $2.96 million.

Since the NPV of waiting one year is greater than going ahead and proceeding with the

project today, it makes sense to wait.

12-2 a. 010% 1 2 3 4

├─────┼─────┼─────┼─────┤

-8 4 4 4 4

b. Wait 2 years:

PV @

0

r = 10%

1 2 3 4 5 6 Yr. 2

| | | | | | |

10% Prob. 0 0 -9 2.2 2.2 2.2 2.2 $6.974

| | | | | | |

90% Prob. 0 0 -9 4.2 4.2 4.2 4.2 $13.313

Low CF scenario: NPV = (-9 + 6.974)/(1.1)2 = -$1.674

High CF scenario: NPV = (-9 + 13.313)/(1.1)2 = $3.564

Expected NPV = .1(-1.674) + .9(3.564) = 3.040

If the cash flows are only $2.2 million, the NPV of the project is negative and, thus,

would not be undertaken. The value of the option of waiting two years is evaluated as

0.10($0) + 0.90($3.564) = $3.208 million.

Since the NPV of waiting two years is less than going ahead and proceeding with the

project today, it makes sense to drill today.

12-3 a. 0 13% 1 2 20

├─────┼─────┼────── • • • ────┤

-300 40 40 40

b. Wait 1 year:

NPV @

0

r = 13%

1 2 3 4 21 Yr. 0

| | | | | • • • |

50% Prob. 0 -300 30 30 30 30 -$78.9889

| | | | | • • • |

50% Prob. 0 -300 50 50 50 50 45.3430

If the cash flows are only $30 million per year, the NPV of the project is negative.

However, we’ve not considered the fact that the company could then be sold for $280

million. The decision tree would then look like this:

NPV @

0r = 13% 1 2 3 4 21 Yr. 0

| | | | | • • • |

50% Prob. 0 -300 30 30 + 280 0 0 -$27.1468

| | | | | • • • |

50% Prob. 0 -300 50 50 50 50 45.3430

million.

Given the option to sell, it makes sense to wait 1 year before deciding whether to

make the acquisition.

12-4 a. 0 12% 1 14 15

| | • • • | |

-6,200,000 600,000 600,000 600,000

CF1-15 = 600,000; I = 12; and then solve for NPV = -$2,113,481.31.

b. 0 12% 1 14 15

| | • • • | |

-6,200,000 1,200,000 1,200,000 1,200,000

CF1-15 = 1,200,000; I = 12; and then solve for NPV = $1,973,037.39.

c. If they proceed with the project today, the project’s expected NPV = (0.5 × -

$2,113,481.31) + (0.5 × $1,973,037.39) = -$70,221.96. So, Hart Enterprises would not

do it.

d. Since the project’s NPV with the tax is negative, if the tax were imposed the firm

would abandon the project. Thus, the decision tree looks like this:

NPV @

0r= 12% 1 2 15 Yr. 0

50% Prob. | | | • • • |

Taxes -6,200,000 6,000,000 0 0 -$ 842,857.14

No Taxes | | | • • • |

50% Prob. -6,200,000 1,200,000 1,200,000 1,200,000 1,973,037.39

Expected NPV $ 565,090.13

Yes, the existence of the abandonment option changes the expected NPV of the project

from negative to positive. Given this option the firm would take on the project because

its expected NPV is $565,090.13.

e. NPV @

0r = 12% 1 Yr. 0

50% Prob. | |

Taxes NPV = ? -1,500,000 $ 0.00

+300,000 = NPV @ t = 1 }wouldn’t do

No Taxes | |

50% Prob. NPV = ? -1,500,000 2,232,142.86

+4,000,000 = NPV @ t = 1 Expected NPV $1,116,071.43

If the firm pays $1,116,071.43 for the option to purchase the land, then the NPV of the

project is exactly equal to zero. So the firm would not pay any more than this for the

option.

12-5 P = PV of all expected future cash flows if project is delayed. From Problem 15-3 we

know that PV @ Year 1 of Tax Imposed scenario is $15.45 and PV @ Year 1 of Tax Not

Imposed Scenario is $26.69. So the PV is:

X = $20.

t = 1.

rRF = 0.08.

σ 2 = 0.0687.

(.0687)0.5 (1)0.5

Chapter 13:

N(d1) = 0.5670

N(d2) = 0.4628

Using the Black-Scholes Option Pricing Model, you calculate the option’s value as:

= $18.646(0.5670) - $20e(-0.08)(1)(0.4628)

= $10.572 - $8.544

= $2.028 million.

12-6 P = PV of all expected future cash flows if project is delayed. From Problem 13-4 we

know that PV @ Year 2 of Low CF Scenario is $6.974 and PV @ Year 2 of High CF

Scenario is $13.313. So the PV is:

X = $9.

t = 2.

rRF = 0.06.

σ 2 = 0.0111.

(.0111)0.5 (2)0.5

Chapter 12:

N(d1) = 0.9713

N(d2) = 0.9601

Using the Black-Scholes Option Pricing Model, you calculate the option’s value as:

= $10.479(0.9713) - $9e(-0.06)(2)(0.9601)

= $10.178 - $7.664

= $2.514 million.

SOLUTION TO SPREADSHEET PROBLEMS

12-7 The detailed solution for the problem is available both on the instructor’s resource CD-

ROM (in the file Solution for FM11 Ch 12 P7 Build a Model.xls) and on the instructor’s

side of the textbook’s web site, http://brigham.swcollege.com.

MINI CASE

Assume that you have just been hired as a financial analyst by Tropical Sweets Inc., a mid-

sized California company that specializes in creating exotic candies from tropical fruits

such as mangoes, papayas, and dates. The firm's CEO, George Yamaguchi, recently

returned from an industry corporate executive conference in San Francisco, and one of the

sessions he attended was on real options. Since no one at Tropical Sweets is familiar with

the basics of real options, Yamaguchi has asked you to prepare a brief report that the

firm's executives could use to gain at least a cursory understanding of the topics.

To begin, you gathered some outside materials the subject and used these materials to

draft a list of pertinent questions that need to be answered. In fact, one possible approach

to the paper is to use a question-and-answer format. Now that the questions have been

drafted, you have to develop the answers.

2. Growth options

a. Expansion of existing product line

b. New products

c. New geographic markets

3. Abandonment options

a. Contraction

b. Temporary suspension

c. Complete abandonment

4. Flexibility options.

2. Qualitatively assess the value of the real option.

3. Decision tree analysis.

4. Use a model for a corresponding financial option, if possible.

5. Use financial engineering techniques if a corresponding financial option is not

available.

c. Tropical Sweets is considering a project that will cost $70 million and will

generate expected cash flows of $30 per year for three years. The cost of capital

for this type of project is 10 percent and the risk-free rate is 6 percent. After

discussions with the marketing department, you learn that there is a 30 percent

chance of high demand, with future cash flows of $45 million per year. There is

a 40 percent chance of average demand, with cash flows of $30 million per year.

If demand is low (a 30 percent chance), cash flows will be only $15 million per

year. What is the expected NPV?

Expected Cash Flows = $30 Million Per Year For Three Years

Cost Of Capital = 10%

PV Of Expected CFs = $74.61 Million

Expected NPV = $74.61 - $70

= $4.61 Million

Demand Probability Annual Cash Flow

High 30% $45

Average 40% $30

Low 30% $15

PV High: N=3 I=10 PV=? PMT=-45 FV=0

PV= 111.91

NPV High = $111.91 - $70 = $41.91 Million.

PV Average: N=3 I=10 PV=? PMT=-30 FV=0

PV= 74.61

NPV Average = $74.61 - $70 = $4.71 Million.

PV Low: N=3 I=10 PV=? PMT=-15 FV=0

PV= 37.30

NPV Low = $37.30 - $70 = -$32.70 Million.

E(NPV)=.3($41.91)+.4($4.61)+.3(-$32.70)

E(PV)= $4.61.

Mini Case: 12 - 10

d. Now suppose this project has an investment timing option, since it can be

delayed for a year. The cost will still be $70 million at the end of the year, and

the cash flows for the scenarios will still last three years. However, Tropical

Sweets will know the level of demand, and will implement the project only if it

adds value to the company. Perform a qualitative assessment of the investment

timing option’s value.

Answer: If we immediately proceed with the project, its expected NPV is $4.61 million.

However, the project is very risky. If demand is high, NPV will be $41.91

million. If demand is average, NPV will be $4.61 million. If demand is low, NPV

will be -$32.70 million. However, if we wait one year, we will find out additional

information regarding demand. If demand is low, we won’t implement project. If

we wait, the up-front cost and cash flows will stay the same, except they will be

shifted ahead by a year.

The value of any real option increases if the underlying project is very risky or if

there is a long time before you must exercise the option.

This project is risky and has one year before we must decide, so the option to wait

is probably valuable.

e. Use decision tree analysis to calculate the NPV of the project with the investment

timing option.

Here is the time line:

0 1 2 3 4

High $0 -$70 $45 $45 $45

Average $0 -$70 $30 $30 $30

Low $0 $0 $0 $0 $0

To find the NPVC, discount the cost at the risk-free rate of 6 percent since it is known

for certain, and discount the other risky cash flows at the 10 percent cost of capital.

Average: NPV = -$70/1.06 + $30/1.102 + $30/1.103 +$30/1.104 = $1.79

Low: NPV = $0.

Since this is much greater than the NPV of immediate implementation (which is

$4.61 million) we should wait. In other words, implementing immediately gives an

expected NPV of $4.61 million, but implementing immediately means we give up the

option to wait, which is worth $11.42 million.

f. Use a financial option pricing model to estimate the value of the investment

timing option.

Answer: The option to wait resembles a financial call option-- we get to “buy” the project for

$70 million in one year if value of project in one year is greater than $70 million.

This is like a call option with an exercise price of $70 million and an expiration date

of one year.

X = Exercise Price = Cost Of Implement Project = $70 Million.

RRF = Risk-Free Rate = 6%.

T = Time To Maturity = 1 year.

P = Current Price Of Stock = Current Value Of The Project’s Future Cash Flows.

σ 2 = Variance Of Stock Return = Variance Of Project’s Rate Of Return.

Just as the price of a stock is the present value of all the stock’s future cash flows, the

“price” of the real option is the present value of all the project’s cash flows that occur

beyond the exercise date. Notice that the exercise cost of an option does not affect

the stock price. Similarly, the cost to implement the real option does not affect the

current value of the underlying asset (which is the PV of the project’s cash flows). It

will be helpful in later steps if we break the calculation into two parts. First, we find

the value of all cash flows beyond the exercise date discounted back to the exercise

date. Then we find the expected present value of those values.

Step 1: Find the value of all cash flows beyond the exercise date discounted back to

the exercise date. Here is the time line. The exercise date is year 1, so we discount

all future cash flows back to year 1.

0 1 2 3 4

High $45 $45 $45

Average $30 $30 $30

Low $15 $15 $15

Average: PV1 = $30/1.10 + $30/1.102 + $30/1.103 = $74.61

Low: PV1 = $15/1.10 + $15/1.102 + $15/1.103 = $37.30

P = 0.3[$111.91/1.1] + 0.4[$74.61/1.1] + 0.3[$37.30/1.1] = $67.82.

For a stock option, σ2 is the variance of the stock return, not the variance of the stock

price. Therefore, for a real option we need the variance of the project’s rate of return.

There are three ways to estimate this variance. First, we can use subjective judgment.

Second, we can calculate the project’s return in each scenario and then calculate the

return’s variance. This is the direct approach. Third, we know the projects value at

each scenario at the expiration date, and we know the current value of the project.

Mini Case: 12 - 12

Thus, we can find a variance of project return that gives the range of project values

that can occur at expiration. This is the indirect approach.

Subjective estimate:

The typical stock has σ2 of about 12%. Most projects will be somewhat riskier than

the firm, since the risk of the firm reflects the diversification that comes from having

many projects. Subjectively scale the variance of the company’s stock return up or

down to reflect the risk of the project. The company in our example has a stock with

a variance of 10%, so we might expect the project to have a variance in the range of

12% to 19%.

Direct approach:

From our previous analysis, we know the current value of the project and the value

for each scenario at the time the option expires (year 1). Here is the time line:

Year 0 Year 1

High $67.82 $111.91

Average $67.82 $74.61

Low $67.82 $37.30

High: Return = ($111.91/$67.82) – 1 = 65%.

High: Average = ($74.61/$67.82) – 1 = 10%.

High: Return = ($37.30/$67.82) – 1 = -45%.

= 10%.

= 0.182 = 18.2%.

The direct approach gives an estimate of 18.2% for the variance of the project’s

return.

The indirect approach:

Given a current stock price and an anticipated range of possible stock prices at some

point in the future, we can use our knowledge of the distribution of stock returns

(which is lognormal) to relate the variance of the stock’s rate of return to the range of

possible outcomes for stock price. To use this formula, we need the coefficient of

variation of stock price at the time the option expires. To calculate the coefficient of

variation, we need the expected stock price and the standard deviation of the stock

price (both of these are measured at the time the option expires). For the real option,

we need the expected value of the project’s cash flows at the date the real option

expires, and the standard deviation of the project’s value at the date the real option

expires.

We previously calculated the value of the project at the time the option expires, and

we can use this to calculate the expected value and the standard deviation.

Value At Expiration

Year 1

High $111.91

Average $74.61

Low $37.30

= $74.61.

σ value = [.3($111.91-$74.61)2 + .4($74.61-$74.61)2

+ .3($37.30-$74.61)2]1/2

= $28.90.

CV = $74.61 / $28.90 = 0.39.

Here is a formula for the variance of a stock’s return, if you know the coefficient of

variation of the expected stock price at some point in the future. The CV should be

for the entire project, including all scenarios:

σ2 = LN[CV2 + 1]/T = LN[0.392 + 1]/1 = 14.2%.

Mini Case: 12 - 14

Now, we proceed to use the OPM:

V = $67.83[N(d1)] - $70e-(0.06)(1)[N(d2)].

d1 = 0.5 0.5

(. 142 ) (1)

= 0.2641.

= -0.1127.

therefore,

V = $67.83(0.6041) - $70e-0.06(0.4551)

= $10.98.

g. Now suppose the cost of the project is $75 million and the project cannot be

delayed. But if Tropical Sweets implements the project, then Tropical Sweets

will have a growth option. It will have the opportunity to replicate the original

project at the end of its life. What is the total expected NPV of the two projects

if both are implemented?

Answer: Suppose the cost of the project is $75 million instead of $70 million, and there is no

option to wait.

NPV = PV of future cash flows - cost

= $74.61 - $75 = -$0.39 million.

The project now looks like a loser. Using NPV analysis:

NPV = NPV Of Original Project + NPV Of Replication Project

= -$0.39 + -$0.39/(1+0.10)3

= -$0.39 + -$0.30 = -$0.69.

Still looks like a loser, but you will only implement project 2 if demand is high. We

might have chosen to discount the cost of the replication project at the risk-free rate,

and this would have made the NPV even lower.

h. Tropical Sweets will replicate the original project only if demand is high. Using

decision tree analysis, estimate the value of the project with the growth option.

Answer: The future cash flows of the optimal decisions are shown below. The cash flow in

year 3 for the high demand scenario is the cash flow from the original project and the

cost of the replication project.

0 1 2 3 4 5 6

High -$75 $45 $45 $45 -$70 $45 $45 $45

Average -$75 $30 $30 $30 $0 $0 $0

Low -$75 $15 $15 $15 $0 $0 $0

To find the NPV, we discount the risky cash flows at the 10 percent cost of capital,

and the non-risky cost to replicate (i.e., the $75 million) at the risk-free rate.

+ $45/1.105 + $45/1.106 - $75/1.063

= $58.02

NPV average = -$75 + $30/1.10 + $30/1.102 + $30/1.103 = -$0.39

NPV average = -$75 + $15/1.10 + $15/1.102 + $15/1.103 = -$37.70

Thus, the option to replicate adds enough value that the project now has a positive

NPV.

i. Use a financial option model to estimate the value of the growth option.

RRF = Risk-Free Rate = 6%.

T = Time To Maturity = 3 years.

P = Current Price Of Stock = Current Value Of The Project’s Future Cash Flows.

σ2 = Variance Of Stock Return = Variance Of Project’s Rate Of Return.

Step 1: Find the value of all cash flows beyond the exercise date discounted back to

the exercise date. Here is the time line. The exercise date is year 1, so we discount

all future cash flows back to year 3.

0 1 2 3 4 5 6

High $45 $45 $45

Average $30 $30 $30

Low $15 $15 $15

Mini Case: 12 - 16

High: PV3 = $45/1.10 + $45/1.102 + $45/1.103 = $111.91

Average: PV3 = $30/1.10 + $30/1.102 + $30/1.103 = $74.61

Low: PV3 = $15/1.10 + $15/1.102 + $15/1.103 = $37.30

P = 0.3[$111.91/1.13] + 0.4[$74.61/1.13] + 0.3[$37.30/1.13] = $56.05.

From our previous analysis, we know the current value of the project and the value

for each scenario at the time the option expires (year 3). Here is the time line:

Year 0 Year 3

High $56.02 $111.91

Average $56.02 $74.61

Low $56.02 $37.30

High: Return = ($111.91/$56.02)(1/3) – 1 = 25.9%.

High: Average = ($74.61/$56.02)(1/3) – 1 = 10%.

High: Return = ($37.30/$56.02)(1/3) – 1 = -12.7%.

= 8.0%.

= 0.182 = 2.3%.

This is lower than the variance found for the previous option because the dispersion

of cash flows for the replication project is the same as for the original, even though

the replication occurs much later. Therefore, the rate of return for the replication is

less volatile. We do sensitivity analysis later.

First, find the coefficient of variation for the value of the project at the time the option

expires (year 3).

We previously calculated the value of the project at the time the option expires, and

we can use this to calculate the expected value and the standard deviation.

Value At Expiration

Year 3

High $111.91

Average $74.61

Low $37.30

= $74.61.

σ value = [.3($111.91-$74.61)2 + .4($74.61-$74.61)2

+ .3($37.30-$74.61)2]1/2

= $28.90.

CV = $74.61 / $28.90 = 0.39.

To find the variance of the project’s rate or return, we use the formula below:

σ2 = LN[CV2 + 1]/T = LN[0.392 + 1]/3 = 4.7%.

V = $56.06[N(d1)] - $75e-(0.06)(3)[N(d2)].

d1 = 0 .5 0.5

( 0.047 ) ( 3)

= -0.1085.

= -0.4840.

Therefore,

V = $56.06(0.4568) - $75e-(0.06)(3)(0.3142)

= $5.92.

=-$0.39 + $5.92

= $5.5 million

Mini Case: 12 - 18

j. What happens to the value of the growth option if the variance of the project’s

return is 14.2 percent? What if it is 50 percent? How might this explain the

high valuations of many dot.com companies?

Answer: If risk, defined by σ2, goes up, then value of growth option goes up (see the file ch 12

mini case.xls for calculations):

σ2 = 4.7%, option value = $5.92

σ2 = 14.2%, option value = $12.10

σ2 = 50%, option value = $24.09

If the future profitability of dot.com companies is very volatile (i.e., there is the

potential for very high profits), then a company with a real option on those profits

might have a very high value for its growth option.

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