Real Options in Project Evaluation

Stephen Gray Campbell R. Harvey

NPV and Real Options

NPV:
Often misapplied Ignores strategic values if misapplied

Real Option Valuation:

Values contingencies in project outcomes (i.e., alternative future uses of the asset).

NPV and Real Options

Many Types of Real Options

Key is to identify Often they are difficult to value however, even using judgment one can tell if they add or subtract value to the project

NPV and Real Options

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: A beef producer will value the option to switch between various feed sources, preferring to use the cheapest acceptable alternative

NPV and Real Options

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.

NPV and Real Options

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 cease producing a style of toy that has become unfashionable and quickly begin producing a popular new style of toy.

NPV and Real Options

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.

NPV and Real Options

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.

NPV and Real Options

Abandonment or Termination Options

NPV and Real Options

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.

NPV and Real Options

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.

NPV and Real Options

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.

NPV and Real Options

Intensity or Operating Scale Options

In order to obtain the option to expand production if demand increases suddenly, a firm may build production capacity in excess of the expected level of output. In this case, management has the right, but not the obligation to expand, and will exercise the option only if project conditions turn out to be favorable.

NPV and Real Options

Intensity or Operating Scale Options

Whereas the excess capacity will have an initial cost, the project with the option to expand is worth more than the project without the possibility of expansion, in which case the extra cost may be justified. Also, a firm may build a plant whose physical life exceeds the expected duration of use, thereby providing the firm with the option of producing more by extending the life of the project.

NPV and Real Options

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

NPV and Real Options

Option to Expand

NPV and Real Options

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.

NPV and Real Options

Option to Contract

NPV and Real Options

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.

NPV and Real Options

Option to Expand or Contract (Switching Option) Example:

A project whose operation can be dynamically turned on and off (or switched to two distinct locations) is worth more than the same project without the flexibility to switch.

NPV and Real Options

Option to Expand or Contract (Switching Option)

NPV and Real Options

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.

NPV and Real Options

Initiation or Deferment Options Examples:

Initiation options are particularly valuable in natural resource exploration where a firm can delay mining a deposit until market conditions are favorable. If natural resource companies were committed to producing all resources discovered, they would never explore in areas where the estimated extraction cost exceeded the expected future price at which the resource could be sold.

NPV and Real Options

Initiation or Deferment Options

NPV and Real Options

Intraproject vs. Interproject Options

Interproject options arise when the development of one project creates value that attach to other projects. Sequencing options, for example, are interproject options because the sequencing of projects creates value for subsequent projects as the direct result of undertaking the initial project. Traditional capital budgeting analysis will miss this option because projects evaluated on stand-alone basis.

NPV and Real Options

Growth Options
The value of the firm can exceed the market value of the projects currently in place because the firm may have the opportunity to undertake positive NPV projects in the future. Standard capital budgeting techniques involve establishing the present value of these projects based on anticipated implementation dates. However, this implicitly assumes that the firm is committed to go ahead with the projects.

NPV and Real Options

Growth Options
Since management need not make such a commitment, they retain the option to exercise only those projects that appear to be profitable at the time of initiation.

Example:
High-tech and software industries (where there are significant first-mover advantages)

NPV and Real Options

Shadow Costs
Standard valuation techniques may overvalue some projects by failing to recognize the losses in flexibility to the firm that result from implementation. The acceptance of one project may eliminate options that attach to other projects.

NPV and Real Options

Shadow Costs Example:

Building a plant in a particular city eliminates the options to expand the capacity of plants in nearby cities. Management time.

NPV and Real Options

Financial Flexibility
Choice of capital structure can affect value of project. Like operating flexibility, financial flexibility can be measured by the value of the financial options made available to the firm by its choice of capital structure. Interaction between financial and operating options can be strong -- especially for long-term investment projects with a lot of uncertainty

NPV and Real Options

Identifying Real Options

Why are there empty lots in prime commercial real estate areas in all major cities? Multipurpose real estate (hotel/apartment) Why to firms use a hurdle rate for project evaluation greater than their cost of capital?

NPV and Real Options

Detailed Example: Abandonment Abbeytown Copper 2-yr lease over a known deposit.

Deposit contains eight million pounds of copper Mining involves a one-year development phase, at a cost of $1.25 million immediately

Extraction costs (outsourced) at $0.85 / pound at beginning of extraction phase (one year after development phase is initiated)
Sale of copper would be at spot price of copper as of beginning of extraction phase

NPV and Real Options

Detailed Example: Abandonment

Current spot price of copper is $0.95 / pound Log change in copper prices are normally distributed with mean 7% and standard deviation 20% (p.a.) Abbeytown's required rate of return for this project is 10%, and the riskless rate is 5%

NPV and Real Options

Traditional NPV analysis:
Expected NPV = -1.25 + 8(E[S1] - 0.85) 1.1 where E[S1] = Expected price of Copper in one year's time Current price of Copper, S0 = 0.95 Expected rate of return on copper, r = 7% Expected price of copper in one year, S1 = 0.95e0.07 = 1.0189 Hence E[NPV] = -1.25 + 8(1.0189 - 0.85)/1.1 = - 0.022

Reject

NPV and Real Options

Option Analysis
S = 0.95 * 8 = 7.6 K = 0.85 * 8 = 6.8 r = 5% T = 1 year
= 20%

NPV and Real Options

Option Pricing Calculator

S X T rf

7.6 6.8 1.00 5.00% 20.00% 0.9061 0.7061 0.8176 0.7599 1.298 0.166

d1 d2 N(d 1 ) N(d 2 ) CE PE

Current Asset Value Exercise (Strike) Price Time to Maturity (Years) Riskless Interest Rate (% p.a.) Volatility (% p.a.)

European Call Value ($) European Put Value ($)

NPV and Real Options

Option Analysis
Call Value = 1.3 Option Cost = 1.25 Option-adjusted Present Value = 0.05

Accept

NPV and Real Options

Why does the option to abandon have value?
Can choose to abandon the project if the price of copper is low after one year.

NPV and Real Options

What is the probability that we will abandon?
Probability that we will abandon = 1 - Prob(exercise) = 1 - N(d2) = 1 - 0.76 = 0.24

NPV and Real Options

What is the probability that we will abandon?
Option Pricing Calculator

S X T rf

7.6 6.8 1.00 5.00% 20.00% 0.9061 0.7061 0.8176 0.7599 1.298 0.166

d1 d2 N(d 1 ) N(d 2 ) CE PE

Current Asset Value Exercise (Strike) Price Time to Maturity (Years) Riskless Interest Rate (% p.a.) Volatility (% p.a.)

Probality of exercise European Call Value ($) European Put Value ($)

NPV and Real Options

Detailed Example: Deferment Option
A company has the opportunity to build a new power project in a foreign country. Net cash flows are $100mm in the first year of operation.

NPV and Real Options

Net cash flows in the second year of operation depend upon whether the government sponsors a link to bypass a transmission bottleneck. There is a 50% probability the government will intervene. This is an example of political risk.

NPV and Real Options

If the link goes ahead, demand for power from the new plant will be low and net cash flow will be $80 mm. If the link does not go ahead, demand for power from the new plant will be high and net cash flow will be $125 mm. Similar uncertainty surrounds Year 3 net cash flows. Cash flows beyond Year 3 are perpetual.

0.5

156 ...

0.5

125
0.5

100
0.5 0.5

100 ...

80
0.5

64

...

Expected Net Cash Flow

100

103

105

...

...

Expected Net Cash Flow

100

103

105

...

...

100 103 105 1 PV0 1,044. 2 2 1.10 1.10 0.10 1.10

Scenario 1a
Build now or never. Cost to build is 1,100. NPV=1,044 - 1,100 = -56. Negative NPV. Reject the project.

Scenario 1b
Build now or never. Cost to build is reduced to 1,000. NPV=1,044 - 1,000 = +44. Positive NPV. Accept the project.

Scenario 2
Option to delay for one year. During this one-year delay, the generator learns whether or not the new entrepreneurial link will proceed. Based on this additional information, a smarter decision can be made. Cost to build is 1,100.

0.5

156 ...

up state

125
0.5 0.5

100 ...

down state

80
0.5

64 128 82 3

... ... ...

Expected Net Cash Flow in up state

125 80 2

Expected Net Cash Flow in down state

0 1

...

Expected Net Cash Flow in up state

125

128

...

...

125 128 1 PV1 1,277. 1.10 0.10 1.10

Expected Net Cash Flow in down state

80

82

...

...

80 82 1 PV1 818. 1.10 0.10 1.10

Scenario 2a (continued)
Option to delay for one year. Cost to build is 1,100. Wait one year:

proceed if up state, NPV=177. reject if down state, NPV=0.

Expected NPV today is:

NPV0

0.5177 0.50 80.

1.10

Scenario 2a (continued)

Expected NPV today is:

NPV0

0.5177 0.50 80.

1.10

Compare with NPV without delay: NPV without delay = - 56 Difference: 136

Scenario 2b
Option to delay for one year. Cost to build is 1,000. If we build now, NPV0 = 44. What if we wait one year?

Scenario 2b

Wait one year:

proceed if up state, NPV=277. reject if down state, NPV=0.

Expected NPV today is:

NPV0

0.5277 0.50 126.

1.10

Scenario 2b

Expected NPV today is:

NPV0

0.5277 0.50 126.

1.10

Compare with NPV without 1 yr delay:

NPV without delay = 44

Difference: 82

Remarks
The option to delay can be valuable, even if the project has positive NPV if started immediately. The value of these options is ignored by standard DCF techniques. Proper analysis of these options is needed not just for project valuation, but also for project timing.

Scenario 3 Add abandonment

Plant can be abandoned at any time for 800. This option will be exercised whenever the PV of future cash flows falls below 800. This only happens at the lowest node, where perpetual cash flows are 64.

156 ... 125 100 80 800 100 ... Yearly Cash Flows

One-time Liquidation Value

Scenario 3 (continued)
When the abandonment option is incorporated, the NPV of building the project now is +77. The NPV of waiting for one year is +126. It is still optimal to delay for one year in this case, although the incremental value of delaying has decreased. The value of the option to delay is lower if it is easy to exit a bad investment.

NPV and Real Options

Only as good as the inputs

Drift, variance, probabilities

Beware of mean reversion Theory relies on availability of a replicating portfolio Equilibrium issues

NPV and Real Options

How do real options impact discount rates? How far can we take real options theory in understanding major issues in corporate finance?