Question

The chief executive officer (CEO) of Faoilean Co has just returned from a discussion at a leading university on the 'application of options to investment decisions and corporate value'. She wants to understand how some of the ideas which were discussed can be applied to decisions made at Faoilean Co. She is still a little unclear about some of the discussion on options and their application, and wants further clarification on the following:

(i) Faoilean Co is involved in the exploration and extraction of oil and gas. Recently there have been indications that there could be significant deposits of oil and gas just off the shores of Ireland. The Government of Ireland has invited companies to submit bids for the rights to commence the initial exploration of the area to assess the likelihood and amount of oil and gas deposits, with further extraction rights to follow. Faoilean Co is considering putting in a bid for the rights. The speaker leading the discussion suggested that using options as an investment assessment tool would be particularly useful to Faoilean Co in this respect.

(ii) The speaker further suggested that options were useful in determining the value of equity and default risk, and suggested that this was why companies facing severe financial distress could still have a positive equity value.

(iii) Towards the end of the discussion, the speaker suggested that changes in the values of options can be measured in terms of a number of risk factors known as the 'greeks', such as the 'vega'. The CEO is unclear why option values are affected by so many different risk factors.

Required With regard to

(ii) above, discuss how options could be useful in determining the value of equity and default risk, and why companies facing severe financial distress still have positive equity values.

Answer 1

With conventional investment decisions, it is assumed that once a decision is made, it has to be taken immediately and carried to its conclusion.

These decisions are normally made through conventional assessments using methods such as net present value.

Assessing projects through option pricing may aid the investment decision making process.

Where there is uncertainty with regard to the investment decision and where a company has flexibility in its decision making, valuing projects using options can be particularly useful.

For example, situations may exist where a company does not have to make a decision on a now-or-never basis, or where it can abandon a decision, which has been made, at some future point, or where it has an opportunity for further expansion as a result of the original decision.

In such situations, using option pricing formulae, which incorporate the uncertainty surrounding a project and the time before a decision has to be made, can determine a value attached to this flexibility.

This value can be added to the conventional net present value computation to give a more accurate assessment of the project’s value.

In the situation which Faoilean Co is considering, the initial exploration rights may give it the opportunity to delay the decision
of whether to undertake the extraction of oil and gas to a later date.

In that time, using previous knowledge and experience, it can estimate the quantity of oil and gas which is present more accurately.

It can also use its knowledge to assess the variability of the likely quantity. Faoilean Co may be able to negotiate a longer time scale with the government of Ireland for undertaking the initial exploration, before it needs to make a final decision on whether and how much to extract.

Furthermore, Faoilean Co can explore the possibilities of it exiting the extraction project, once started, if it is proving not to be beneficial, or if world prices of oil and gas have moved against it.

It could, for example, negotiate a get-out clause which gives
it the right to sell the project back to the government at a later date at a pre-agreed price.

Alternatively, it could build facilities in such a way that it can redeploy them to other activities, or scale the production up or down more easily and at less cost.

These options give the company the opportunity to step out of a project at a future date, if uncertainties today become negative outcomes in the future.

Finally, Faoilean Co can explore whether or not applying for the rights to undertake this exploration project could give it priority
in terms of future projects, perhaps due to the new knowledge or technologies it builds during the current project.

These 22 opportunities would allow it to gain competitive advantage over rivals, which, in turn, could provide it with greater opportunities in the future, but which are uncertain at present.

Faoilean Co can incorporate these uncertainties and the time before the various decisions need to be made into the option formulae to determine the additional value of the project, on top of the initial net present value calculation.

The option price formula used with investment decisions is based on the Black-Scholes Option Pricing (BSOP) model. The BSOP model makes a number of assumptions as follows:

– The underlying asset operates in perfect markets and therefore the movement of market prices cannot be predicted;

– The BSOP model uses the risk-free rate of interest. It is assumed that this is known and remains constant, which may the time it takes for the option to expire may be long;

– The BSOP model assumes that volatility can be assessed and stays constant throughout the life of the project; again with long-term projects these assumptions may not be valid;

– The BSOP model assumes that the underlying asset can be traded freely. This is probably not accurate where the underlying asset is an investment project. These assumptions mean that the value based around the BSOP model is indicative and not definitive.