Practical I ssues in Capital Budgeting

(FM-I I )
Real Options
J anuary 17, 2014
Dr. Triptendu Prakash Ghosh
January 17, 2014
I ntroduction to Options 1
First, we introduce the concept of options
Using example of options on stocks
An option is a right, but not obligation,
to its owner (buyer)
to buy or sell a specific asset (called the underlying)
at a specific price (called the strike price)
On (European option) / on or before (American option) a
specified date (the expiry date or maturity date)
Option to buy is termed as Call Option, to sell as Put
Option
See Example 1
What will you do? Buy the option? Sell the option?
How much profit you expect from your decision?
January 17, 2014
I ntroduction to Options 2
Since there are buyers of options, there must be sellers as
well
Otherwise a market cannot exist
Since the buyer enjoys the right without obligation, must
pay a price
And the seller will receive it
See Example 2
Nobody knows what will be the spot price on expiry date
But buyer of an option is protected against loss (since it is
not obligation), but ensures profit (since it is right)
Thus it is an insurance
Hence the buyer pays a price, and it is called the premium
For both call and put option
January 17, 2014
I ntroduction to Options 3
For the seller, an option contract is the obligation (in case
buyer decides to exercise the option), but not right
To sell (call) or buy (put) at a specified price (strike) on or
before the expiry date
Seller of (call or put) option is exposed to unlimited risk
against limited gain
Seller needs to be compensated
Hence the seller receives the premium
Whether to invest or not depends on the expected trade-off
Let us try to test our understanding in MS-Excel
January 17, 2014
Real Options 1
We analyze projects on the basis of estimated cash flows
and discount rate as on the date
But the variables keep on changing in reality over time
And so does (varies) the actual NPV from time to time
A project estimated to have negative NPV today may turn
into a positive-NPV project in future
The reverse is also possible
In a competitive environment, this should not matter
Because, in such case, firms do not have special advantage over
their competitors in taking projects
However, if the firm is in a position that no competitor can
take this project over the next n years
Due to legal restrictions, patent protection, rights to natural
resource like land / coal/ petroleum etc., and so on)
January 17, 2014
Real Options 2
Legal restriction: A contractor awarded rights to invest and
collect user charges for 10 years road, berths of sea-port,
airport (passenger & cargo), and so on
Patent Protection: Patents have a life of 20 years; especially
important for Pharma companies; Creative Artists (e.g., authors)
have rights for 60 (50+10 in India) years after death of author in
India Publisher & copyright-holder dynamics play a role
Movie rights face a different regulatory structure in India (just look
at re-makes and sequels)
Rights to Natural Resources: Coal-block allocation; KG-D6
block of Reliance and gas pricing; Oil exploration by Cairn India
Ltd. in blocks of Rajasthan and its merger with the parent
(London stock market listed Sterlite Industries) and the
associated debate
It is debated profusely in India
January 17, 2014
Real Options 3
All such cases are examples of Real Options (from the point
of view of the firm)
Such firms will benefit a lot by analysing Real Options
The Setting of Real Options
X: Initial investment required
V: PV of expected cash inflows estimated right now
Then NPV = V X
Assume that
Firm has exclusive right to the project for n years
PV of CF may change over time due to chane in either discount
rate, or CF or both
Project may have a negative NPV now, but may turn into a
good project if the firm waits
January 17, 2014
Real Options 4
Underlying asset: The project
Strike Price: X (investment needed)
Spot Price (S
T
): V (present value now, which keeps on
changing regularly) current price/value of the project
The firm is owning a long call option
Next we introduce the Black-Scholes model BSOPM
Where C (S, t) is the value of a call option and P(S, t) is the
value of a put option at time t
January 17, 2014
Real Options 5
( ) ( ) ( )
( ) t T r
Ke d N S d N t S C

=
2 1
,
( )
( )
( ) ( )
( )
( )S d N Ke d N t S C S Ke t S P
t T r t T r
1 2
, , = + =

Where S here is V of our notation, and others are described
below:
( )
(

|
|
.
|

\
|
+ +
|
.
|

\
|

= t T r
K
S
t T
d
2
ln
1
2
1
o
o
( )
(

|
|
.
|

\
|
+
|
.
|

\
|

= t T r
K
S
t T
d
2
ln
1
2
2
o
o
t T d d = o
1 2
January 17, 2014
Real Options 6
N(.) is the cumulative distribution function of the standard
normal distribution
(T t) is the time to maturity (t being today)
S is the spot price of the underlying asset (our V)
K is the strike price (X in our notation)
r is the risk free rate (annual rate, expressed in terms of
continuous compounding)
o is the volatility of returns of the underlying asset Firms
January 17, 2014
Real Options 7
The value of the option depends on the following factors:
Value of the underlying asset (V or S) as estimated today
Subject to substantial estimation error and that is the
opportunity exploited by real options
Volatility of the value of V (or S) (o)
The strike price X (initial investment)
The risk-free rate (r)
The time to expiry (T) (life of the project n years)
Of these, most difficult parameter to estimate is o
For equities, it can estimated from past prices not possible in
this setting
Three approaches are available
January 17, 2014
Real Options 8
A) Use variances of (actual) cash flows of similar projects
launched in the recent past
B) Assign probabilities to various scenarios obtaine
corresponding estimates of V and compute the variance
estimate
The reasons for variance in V are:
(i) Uncertainty due to potential market size and competition
(ii) Technological shifts leading to a different cost structure and
profitability from what is assumed now
(iii) Changing macro conditions, leading to change in r & CF
In such situation, a well-developed model incorporating all
above, combined with simulation (say 5,000 times) help to arrive
at a good estimate of the variance
Also applied in many areas of earth sciences
January 17, 2014
Real Options 9
C) Use the variance estimated from values of listed
companies that are in the business same as the project

The value of the option depends more on the variance, than
on other factors
A project delay option is exercised when the firm decides to
invest in it
Doing the transaction by paying K(X) making the investment
It is best assumed to remain constant (in PV terms) over the life
Uncertainty related to the investment is captured through
variance in V (or S)
The project delay option expires when the rights to the
project expires
January 17, 2014
Real Options 10
Now, the NPV becomes zero
Since competitors drive down the yield to the WACC
NPV is basically due to excess profit made possible by higher
profitability coming from absence of competition
Cost of Delay: When the NPV is positive, there is a cost of
delay
Excess profits will disappear after the expiry
Each year of delay leads to one less year of value creating cash
flow
Assuming cash flows are evenly distributed over time, each year
of delay implies a loss or cost of (1/n) percentage of V
January 17, 2014
Real Options 11
Finally, the BSOPM needs to be modified to apply to real
option
Note the original formula for value of call option:
( ) ( ) ( )
( ) t T r
Ke d N S d N t S C

=
2 1
,
BSOPM considers a dividend yield which is continuously
received by the owner of the asset (not explicit in formula)
By not exercising the option (i.e. not investing in the
project), the firm loses out on NPV for every year of delay
Thus, if y is the annual cost of delay, this has to be factored
in
By the factor e
-yt
multplied to N(d
1
)*S
See Example 7.
January 17, 2014
Real Options 12
So the modified formula stands out to be:
( ) ( ) ( )
( ) t T r t T y
Ke d N Se d N t S C

=
2
) (
1
,
Where y is the annual cost of delay in percentage terms
See Example 7.
Assignment
Do the calculations for worked out examples in the text in
excel for Option to Expand and Option to Abandon (pp.
299 307) of AD6 (softcopy provided)
January 17, 2014
Readings
AD6 & RWJK23 (see course outline for detailed reference)