IND481 Real Options

Real Options Models

Fransiscus R. Pratikto
frianp@unpar.ac.id
Option to abandon1
Suppose a pharmaceutical company is developing a particular drug. However, due to the uncertain
nature of the drug’s development progress, market demand, success in human and animal testing, and
FDA approval, management has decided that it will create a strategic abandonment option. That is, at any
time period within the next five years of development, management can review the progress of the
research and development effort and decide whether to terminate the drug development program. After
five years, the firm would have either succeeded or completely failed in its drug development initiative,
and there exists no option value after that time period. If the program is terminated, the firm can
potentially sell off its intellectual property rights of the drug in question to another pharmaceutical firm
with which it has a contractual agreement. This contract with the other firm is exercisable at any time
within this time period, at the whim of the firm owning the patents.
Using a traditional discounted cash flow model, the present value of the expected future cash flows
discounted at an appropriate market risk-adjusted discount rate is found to be $150 million. Using Monte
Carlo simulation, the implied volatility of the logarithmic returns on future cash flows is found to be 30
percent. The risk-free rate on a riskless asset for the same time frame is 5 percent, and you understand
from the intellectual property officer of the firm that the drug’s patent is worth $100 million if sold within
the next five years. For simplicity, assume that this $100 million salvage value is fixed for the next five
years.

Real Options 2
Option to abandon2
From the problem we have
𝑆0 = 150 million
𝜎 = 30%
𝑟 = 5% p.a.
𝑇 = 5 years
Salvage value = 100 million
 Using ∆𝑡 = 0.5 years, make a lattice of the asset values!
 Make a lattice of the abandonment option values, and determine the optimal abandonment
strategy!

Real Options 3
Option to expand1
Suppose a growth firm has a static valuation of future profitability using a discounted cash flow
model (that is, the present value of the expected future cash flows discounted at an appropriate
market risk-adjusted discount rate) is found to be $400 million. Using Monte Carlo simulation, you
calculate the implied volatility of the logarithmic returns on the projected future cash flows to be 35
percent. The risk-free rate on a riskless asset for the next five years is found to be yielding 7 percent.
Suppose that the firm has the option to expand and double its operations by acquiring its
competitor for a sum of $250 million at any time over the next five years.
 Which financial option does resemble this situation?
 Using ∆𝑡 = 0.5 years, make a lattice of the asset values!
 Make a lattice of the expansion option values and determine the option value!

Real Options 4
Option to expand2
We have
𝑆0 = 400 million
𝜎 = 35%
𝑟 = 7% p.a.
𝑇 = 5 years
Expansion cost to double operations = 250 million
 Which financial option does resemble this situation?
 Using ∆𝑡 = 0.5 years, make a lattice of the asset values!
 Make a lattice of the expansion option values and determine the option value!

Real Options 5
Option to contract1
You work for a large aeronautical manufacturing firm that is unsure of the technological efficacy and
market demand of its new fleet of long-range supersonic jets. The firm decides to hedge itself
through the use of strategic options, specifically an option to contract 50 percent of its
manufacturing facilities at any time within the next five years. Suppose the firm has a current
operating structure whose static valuation of future profitability using a discounted cash flow model
(that is, the present value of the expected future cash flows discounted at an appropriate market
risk-adjusted discount rate) is found to be $1 billion. Using Monte Carlo simulation, you calculate
the implied volatility of the logarithmic returns on the projected future cash flows to be 50 percent.
The risk-free rate on a riskless asset for the next five years is found to be yielding 5 percent.
Suppose the firm has the option to contract 50 percent of its current operations at any time over
the next five years, thereby creating an additional $400 million in savings after this contraction. This
is done through a legal contractual agreement with one of its vendors, who has agreed to take up
the excess capacity and space of the firm, and at the same time, the firm can scale back its existing
work force to obtain this level of savings.

Real Options 6
Option to contract2
We have
𝑆0 = 1 billion
𝜎 = 50%
𝑟 = 5% p.a.
𝑇 = 5 years
Benefit from contracting 50% of operation = 400 million
 Using ∆𝑡 = 0.5 years, make a lattice of the asset values!
 Make a lattice of the option value and determine the option value!

Real Options 7
Option to choose1
Suppose a large manufacturing firm decides to hedge itself through the use of strategic options.
Specifically it has the option to choose among three strategies: expanding its current manufacturing
operations, contracting its manufacturing operations, or completely abandoning its business unit at
any time within the next five years. Suppose the firm has a current operating structure whose static
valuation of future profitability using a discounted cash flow model (that is, the present value of the
future cash flows discounted at an appropriate market risk-adjusted discount rate) is found to be
$100 million. Using Monte Carlo simulation, you calculate the implied volatility of the Real Options
logarithmic returns on the projected future cash flows to be 15 percent. The risk-free rate on a
riskless asset for the next five years is found to be yielding 5 percent annualized returns. Suppose
the firm has the option to contract 10 percent of its current operations at any time over the next
five years, thereby creating an additional $25 million in savings after this contraction. The expansion
option will increase the firm’s operations by 30 percent with a $20 million implementation cost.
Finally, by abandoning its operations, the firm can sell its intellectual property for $100 million.

Real Options 8
Option to choose2
We have
𝑆0 = 100 million
𝜎 = 15%
𝑟 = 5% p.a.
𝑇 = 5 years
Benefit from contracting 10% of operation = 25 million
Cost for expanding 30% of operation = 20 million
Benefit of abandoning the operation = 100 million
 Using ∆𝑡 = 0.5 years, make a lattice of the asset values!
 Make a lattice of the option value and determine the option value!

Real Options 9
Compound options1
A pharmaceutical company currently going through a particular FDA drug approval process has to go
through human trials. The success of the FDA approval depends heavily on the success of human
testing, both occurring at the same time. Suppose that the former costs $900 million and the latter
$500 million. Further suppose that both phases occur simultaneously and take three years to
complete. Using Monte Carlo simulation, you calculate the implied volatility of the logarithmic
returns on the projected future cash flows to be 30 percent. The risk-free rate on a riskless asset for
the next three years is found to be yielding 7.7 percent. The drug development effort’s static
valuation of future profitability using a discounted cash flow model (that is, the present value of the
expected future cash flows discounted at an appropriate market risk-adjusted discount rate) is
found to be $1 billion. What is the total value of this firm assuming you account for these options?

Real Options 10
Compound options2
We have
𝑆0 = 1 billion
𝜎 = 30%
𝑟 = 7.7% p.a.
𝑇 = 3 years
Human trial cost = 500 million
FDA approval cost = 900 million
 Using ∆𝑡 = 0.5 years, make a lattice of the asset values!
 Make the lattice of the FDA approval option!
 Make the lattice of human trial cost!
 Determine the option value!

Real Options 11