Question

Give an example in business for each of the following real options with clear explanations. If you manage to put some numbers in your examples and sketch how you may value such optionality the better but not required.

The option to expand if the immediate investment project succeeds.

The option to wait (and learn) before investing.

The option to shrink or abandon a project.

Answer 1

The real options approach to the valuation of projects
The real options approach to the capital investment decision provides a different insight into the valuation of projects. Real options can capture the value of managerial flexibility and strategic value, and provide intuition that may be contrary to popular thinking.

The option to expand if the immediate investment project succeeds.

Taking a project today may allow a firm to consider and take other valuable projects in the future. Thus, even though a project may have a negative NPV, it may be a project worth taking if the option it provides the firm (to take other projects in the future) provides a more-than-compensating value. These are the options that firms often call “strategic options” and use as a rationale for taking on “negative NPV” or even “negative return” projects.

An Example of an Expansion Option

Ambev is considering introducing a soft drink to the U.S. market. The drink will initially be introduced only in the metropolitan areas of the U.S. and the cost of this “limited introduction” is $ 500 million. A financial analysis of the cash flows from this investment suggests that the present value of the cash flows from this investment to Ambev will be only $ 400 million. Thus, by itself, the new investment has a negative NPV of $ 100 million. If the initial introduction works out well, Ambev could go ahead with a full-scale introduction to the entire market with an additional investment of $ 1 billion any time over the next 5 years. While the current expectation is that the cash flows from having this investment is only $ 750 million, there is considerable uncertainty about both the potential for the drink, leading to significant variance in this estimate.

Value of the Underlying Asset (S) = PV of Cash Flows from Expansion to entire U.S. market, if done now =$ 750 Million.

Strike Price (K) = Cost of Expansion into entire U.S market = $ 1000 Million .

We estimate the standard deviation in the estimate of the project value by using the annualized standard deviation in firm value of publicly traded firms in the beverage markets, which is approximately 34.25%. Standard Deviation in Underlying Asset’s Value = 34.25%

Time to expiration = Period for which expansion option applies = 5 years .

Call Value= $ 234 Million

NPV of Limited Introduction = $ 400 Million - $ 500 Million = - $ 100 Million .

Value of Option to Expand to full market= $ 234 Million.

NPV of Project with option to expand = - $ 100 million + $ 234 million = $ 134 million .

Therefore , Invest in the project

Option to abandon or shrink a project
The option to abandon a project can be viewed as a put option against the failure of a project. A firm may sometimes have the option to abandon a project, if the cash flows do not measure up to expectations. If abandoning the project allows the firm to save itself from further losses, this option can make a project more valuable. The exercise price is equal to the value of the project’s assets if sold or if used for alternative purposes. The exercise of this put option would occur if this were greater than the expected present value of future cashflows.

An Example of Abondon Option :

Airbus is considering a joint venture with Lear Aircraft to produce a small commercial airplane (capable of carrying 40-50 passengers on short haul flights) . Airbus will have to invest $ 500 million for a 50% share of the venture .Its share of the present value of expected cash flows is 480 million. Lear Aircraft, which is eager to enter into the deal, offers to buy Airbus’s 50% share of the investment anytime over the next five years for $ 400 million, if Airbus decides to get out of the venture. A simulation of the cash flows on this time share investment yields a variance in the present value of the cash flows from being in the partnership is 0.16. The project has a life of 30 years.

Value of the Underlying Asset (S) = PV of Cash Flows from Project = $ 480 million .

Strike Price (K) = Salvage Value from Abandonment = $ 400 million .

Variance in Underlying Asset’s Value = 0.16 .

Time to expiration = Life of the Project =5 years .

Dividend Yield = 1/Life of the Project = 1/30 = 0.033 (We are assuming that the project’s present value will drop by roughly 1/n each year into the project) .Assume that the five-year riskless rate is 6%. The value of the put option can be estimated as follows:

Value of Put =Ke-rt (1-N(d2))- Se-yt (1-N(d1)) =400 (exp(-0.06)(5) (1-0.4624) - 480 exp(-0.033)(5) (1-0.7882) = $ 73.23 million .

The value of this abandonment option has to be added on to the net present value of the project of -$ 20 million, yielding a total net present value with the abandonment option of $ 53.23 million.

Option to wait before investing
Sometimes it may be beneficial to defer the start of a project that currently has a positive NPV. This is because there is more value in waiting. This is analogous to the valuation of American call options (ie early exercise is allowable). Investing in a project immediately can be viewed as exercising an option, but sometimes it pays to wait and keep the option alive. The value of waiting is greatest when the cashflows forgone by waiting are small and there is greater volatility over future cashflows.

Real options are more often complex in practice:
– Cost of further investment or the price of abandonment is likely to vary over time.
– Abandonment of a project may occur at any time in a project and the reinstatement of a project may be possible.
– Postponement of a project and missing out on the first year’s cashflows in the anticipation of learning from them may sometimes provide no additional information.