You are on page 1of 24

Real Options

Types of Managerial Flexibilities


The Value of Follow-On Investment Opportunities
The Abandonment Option- startups, New Drug Development, Mining, Non
Renewable Energy etc.
Abandon for Salvage Value
Differ Investment Mining exploration rights, Real Estate, Hi Tech
Expand corporations, mining etc.
Contract-build structures with higher variable costs. Temporarily shut down
and restart-cyclical industries. Low fixed cost structure (strike price is the
VC)
Switch Use (Inputs or process or outputs)Power plants with multiple inputs
choice, process flexibility by having supplier relation one may build choice of
input r.m., output flexibility more rampant among automobiles, consumer
electronics, toys or pharmaceuticals.

Corporate Options
3 types of Real Options
1 - The opportunity to expand and make follow-up
investments.
2 - The opportunity to wait and invest later.
3 - The opportunity to shrink or abandon a project.
Value Real Option = NPV with option
- NPV w/o option

Micro computers case (1982)


You are Asst. to CFO, Micro Computers. You are
helping him evaluate proposed introduction of Mark I
chip. DCF analysis is given below. NPV at hurdle
rate is $(46) Mn. (Accept/Reject).. You say For
Strategic reasons LAUNCH You have to prove to
CFO regarding MARK-Is value as an option..
(i)
(ii)
(iii)
(iv)

Decision to invest in Mark II after 3 years.


Mark II investment will be double that of Mark I
Expected return for the given risk class is 20%.
Sigma=35% and risk free rate is 10%

Microcomputer Forecasts
Example Mark I Microcomputer ($ millions)

1982
After-tax operating cash flow (1)
Capital investment (2)
Increase in working capital (3)
Net cash flow (1)-(2)-(3)

450
0
-450

NPV at 20% = - $46.45, or about -$46 million

1983
100
0
50
60

Year
1984
159
0
100
59

1985
295
0
100
195

1986
185
0
-125
310

1987
0
0
-125
125

Microcomputer Forecasts
Example Mark II Microcomputer ($ millions)
Forecasted cash flows from 1982
1982 .
After-tax operating cash flow
Increase in working capital
Net cash flow
Present Value @ 20%
Investment, PV @ 10%
Forecasted NPV in 1985

467
676

Year
1985

1986
220
100
120

807
900
-93

NPV(1982) =PV(inflows) -PV(investment)

= 467 676
= - $209 million

1987
318
200
118

1988
590
200
390

1989
370
-250
620

1990
0
-250
250

Microcomputer Forecasts
Example Mark II Microcomputer

PV (exercise price)

900
676
3
1.1

OC N ( d1 ) P N ( d 2 ) PV ( EX )

d1

log[ S / X ] (r
)T
2

2
(35%)
log(467 / 900) (10%
)3
2

0.1879
35% 3

d 2 d1 t .4184
N (d1 ) .574508

N (d 2 ) .337844

Call Value [0.574508 467} [0.337844 900] $56.83million

Microcomputer Forecasts
Example Mark II Microcomputer (1985)
Distribution of possible Present Values
Probability

Present value in 1985


Expected value

Required investment

($807)

($900)

Option to Wait
Intrinsic Value
Option
Price

Stock Price

Option to Wait
Intrinsic Value + Time Premium = Option Value
Time Premium = Vale of being able to wait
Option
Price

Stock Price

Option to Wait
More time = More value

Option
Price

Stock Price

Option to Wait
If you commit an investment worth $ 180Mn, you have a
project worth $ 200 Mn immediately. If the demand
turns out to be low in yr. 1, the cash flow will be $ 16
Mn and the value of the project will fall to $ 160 Mn.
But if the demand is high in year 1, the cash flow is $
25 Mn. And the value rises to $250 Mn. Should you
invest immediately or wait. Use the risk free rate of
5%.
Note: If you undertake the investment right away, you
capture the first years cash flow ($16 or $25). If you
delay you miss out on this.

Option to Abandon
Example - Abandon
Mrs. Mulla gives you a non-retractable offer to
buy your company for $150 mil at anytime
within the next year. Given the following
decision tree of possible outcomes, what is the
value of the offer (i.e. the put option) and what is
the most Mrs. Mulla could charge for the
option?

Use a discount rate of 10%

Option to Abandon
Example - Abandon
Mrs. Mulla gives you a non-retractable offer to buy your company for
$150 mil at anytime within the next year. Given the following decision
tree of possible outcomes, what is the value of the offer (i.e. the put
option) and what is the most Mrs. Mulla could charge for the option?

Year 0

Year 1

Year 2
120 (.6)

100 (.6)
90 (.4)
PV = 145
70 (.6)
50 (.4)
40 (.4)

Option to Abandon
Example - Abandon
Mrs. Mulla gives you a non-retractable offer to buy your company for
$150 mil at anytime within the next year. Given the following decision
tree of possible outcomes, what is the value of the offer (i.e. the put
option) and what is the most Mrs. Mulla could charge for the option?

Year 0

Year 1

Year 2
120 (.6)

100 (.6)
90 (.4)
PV = 162

Option Value =
162 - 145 =
150 (.4)

$17 mil

Option to Abandon
Dawn East, the chief financial officer of Maine Subductor
Corp., has to decide whether to start production of
zircon subductors. The investment required is $12 Mn.
$ 2 Mn. For roads and site preparation and $10 Mn.
For the equipment. To operate the equipment it costs
$ 0.7 Mn. p.a. (a fixed cost). The expected life of the
project is 10 years and the depreciation of the
machine is done following WDV method @ 10% p.a.
The revenue at todays prices is $1.7 Mn and shall
grow @ 9% p.a. Also, the S.D. of earnings is 14%.
The risk free rate is assumed to be 6% p.a.

Option to Abandon
Example Ms. East Value
u e T e0.14*1 1.15
1
d 0.87
u
Expected return 0.15* p 0.13*(1 p) .06
Prob of up change 0.6791
Prob of down change 0.3209

Option to Abandon
Example Ms. East - Revenues
2.25
1.96
1.7

1.7

1.48
1.29

Option to Abandon
Example Ms. East Cash Flows
1.55
1.26
1.0

1.0

0.78
0.59

Numericals

Numericals

Numericals

Numericals

Numericals