Project Valuation Using Real Options

A Practitioner's Guide

Prasad S. Kodukula Kodukula, Chandra Papudesu

• Publisher: J. Ross Publishing
• Year: 2006
• Print ISBN:
  9781932159431
• eBook ISBN:
  9781604277098
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

Business leaders are frequently faced with investment decisions on new and ongoing projects. The challenge lies in deciding what projects to choose, expand, contract, defer, or abandon, and which method of valuation to use is the key tool in the process. This title presents a step-by-step, practical approach to real options valuation to make it easily understandable by practitioners as well as senior management. This systematic approach to project valuation helps you minimize upfront investment risks, exercise flexibility in decision making, and maximize the returns. Whereas the traditional decision tools such as discounted cash flow/net present value (DCF/NPV) analysis assume a "fixed" path ahead, real options analysis offers more flexible strategies. Considered one of the greatest innovations of modern finance, the real options approach is based on Nobel-prize winning work by three MIT economists, Fischer Black, Robert Merton, and Myron Scholes.

INTRODUCTION

Thales, a famous Sophist philosopher circa 600 B.C., gazed into the star-studded sky one evening and predicted an outstanding olive harvest the next season. For a small up-front fee, he bought the right from the owners of the olive presses to rent them for the usual rate during the harvest season. If the harvest turned out to be meager, there would be less need for the presses and Thales would not rent them, losing the up-front fee. But if the harvest was bountiful, he would rent the presses at the regular agreed-upon price and turn around and rent them out to the farmers at a significant margin. Sure enough, it was an outstanding harvest, and Thales rented the in-demand presses and made a fortune. He was apparently more interested in proving the wisdom of Sophists than making money, as Aristotle tells this story in Politics.

This is one of the frequently cited earliest examples of a real options contract, wherein Thales bought an option — a right, but not an obligation — to rent the presses, the underlying risky asset. This is called a real option, not a financial option, because the underlying asset is a real asset, not a financial asset. Real options evolved from financial options, and therefore the terminology is common to both. Using a simple financial example, let us first introduce the options terminology and draw parallels between commonly known financial options and poorly understood real options.

FINANCIAL OPTIONS EXAMPLE

HiTech* is a publicly held technology company whose stock is selling at $20 per share. The stock price is expected to rise significantly in the near future because of the company’s innovative products and market demand. At the same time, however, there is also market uncertainty that indicates a possible sharp drop in the stock price. As an investor, you can buy shares of this stock today at $20 per share or instead buy options to buy or sell the stock in the future. An option is a right — not an obligation — to either buy or sell the stock, the underlying asset, at a predetermined cost on or before a predetermined date.

For instance, let us say that you buy one option on the underlying stock of HiTech today at the market price of $2 that gives you a right — without any obligation whatsoever — to buy the stock one year from now at a price of $25. One year from now, if HiTech’s stock price drops below $25, you can walk away with no obligation to buy the stock and lose the $2 that you paid to acquire the option. On the other hand, if the stock price goes above $25, to say $35, as a rational investor, you will exercise your option and buy one share of the stock. This would be worth $35, but you pay only the agreed-upon price of $25, thus making a gross profit of $10. Accounting for the initial price of $2 paid to buy the option, your net profit is $8. Thus, using the options approach, you would exercise your option (i.e., buy the stock) only if it goes above your exercise price; otherwise, you would walk away and take your up-front fee as a loss.

In another scenario, you may acquire an option to sell. If you believe that the stock price of HiTech will be below $25 a share one year from now, you may buy one option of the stock at the market price of $2 that gives you a right — with no obligation — to sell the stock one year from now at a price of $25 per share. If the stock price is above $25 per share on that day, you will not exercise the option, which expires and becomes worthless. However, if the stock price drops below $25, to say $15, you will exercise your option to sell one share of the stock worth $15 for a price of $25, making a gross profit of $10 and a net profit of $8 after accounting for the initial option price of $2.

In both of the above scenarios, the options approach allows you to take advantage of the payoff when it is positive while limiting the downside risk.

OPTIONS TERMINOLOGY

The first scenario above involves an option to buy and is called a call option. The sell option in the second scenario is called a put option. The price at which the option is exercised is called the exercise price or strike price, which is $25 per share in both cases. A European option has a fixed maturity date, whereas an American option can be exercised on or any time before the option’s maturity or expiration date. Therefore, both of the above scenarios involved European options. The commonly used key options terms are summarized in Table 1-1.

Table 1-1. Options Terminology

Figures 1-1 and 1-2 are called payoff diagrams and show the cash payoff of a call and put option, respectively, at expiration. With a call option, if the underlying asset value is less than the strike price at the time of option expiration, the option is considered to be “out of the money” and, rationally speaking, will not be exercised. Thus, your net payoff in this case is negative and equal to the option price, also called the call price. If the asset value exceeds the strike price, the option is “in the money” and, rationally speaking, will be exercised and your gross payoff will be positive. Your net payoff, however, may be positive or negative depending on the call price. When the asset value is exactly equal to the strike price, the option is considered to be “at the money.” At this point, your gross profit is zero, but the net profit is negative and is equal to the call price.

Figure 1-1. Payoff Diagram for a Call Option

As shown in Figure 1-2, the net payoff of a put option remains negative and equivalent to the put price (price paid to buy the option), as long as the underlying asset value at the expiration time remains above the strike price or the option is out of the money. In other words, you lose what you paid for the put. If the asset value is less than the strike price (that is, the option is in the money), the gross payoff is equal to the difference between the strike price and the value

Figure 1-2. Payoff Diagram for a Put Option

of the underlying asset. The net payoff will be negative until the put price is recovered and from that point goes into the positive territory.

FINANCIAL VERSUS REAL OPTIONS

Options can be classified into two broad categories, financial and real, based on whether the underlying asset is a financial or real asset. Financial assets are primarily stocks and bonds that are traded in financial markets. The options for most of these assets are listed on exchanges such as the Chicago Board Options Exchange and the American Stock Exchange. Real assets may include real estate, projects, and intellectual property, most of which are not usually traded. A real option is a right — not an obligation — to take an action on an underlying nonfinancial, real asset. The action may involve, for example, abandoning, expanding, or contracting a project or even deferring the decision until a later time. The real options can be either American, which can be exercised on or before a predetermined expiration date, or European, which can be exercised on a fixed date only. They share the same characteristics as the financial options and, therefore, the same terminology is used. Table 1-2 provides a comparison of financial and real options.

REAL OPTIONS EXAMPLES

In the historic example cited at the outset of this chapter, Thales used a call option, presumably an American one, and exercised it when it was in the money. Let us now review three modern-day examples. To keep the illustrations simple, we will ignore the time value of money.

GeneMiracles is a 21st century biotechnology company that specializes in human genomics. It invented a new technology for which it obtained two patents, based on which it plans to develop a new product. Because the potential market for the product is uncertain, management does not want to commit to fully invest in its development and chooses to create an option to sell the technology if at any time during the development effort it becomes clear that the future payoff on the product would not be favorable. Genes & Foods (G&F) is another biotech company with a market niche in genetically modified foods. It has great interest in GeneMiracles’ new technology, which fits very well with its product portfolio. Both companies sign an options contract which allows GeneMiracles to sell its patented technology to G&F for a price of $60 million anytime during the three years of product development time. To acquire this option, GeneMiracles pays G&F $10 million. After completing two years of

Table 1-2. Financial Versus Real Options

development work, based on the most reliable market information, GeneMiracles estimates the net future payoff on the product to be a paltry $50 million. Management therefore exercises its put option by selling the intellectual property to G&F for $60 million.

MoneyMaker Drugs, with healthy cash reserves and good potential for future profitability, is contemplating expanding one of its operations by 50% by possibly acquiring a start-up company. Due to market uncertainty, executive management does not want to commit to the full investment at this point. Therefore, it creates an option to expand anytime over the next two years, which it would exercise by acquiring the start-up for $6 million, if the market uncertainty clears and shows positive results. In return for this option, MMD invests $1 million in the start-up company. At the end of the second year, the market information becomes clear, showing an estimated $10 million payoff due to the planned expansion. At this time, MoneyMaker Drugs exercises its option by acquiring the start-up company and expands the operations. It would have maintained the status quo and not invested in the acquisition if the expected market value of operations expansion had turned out to be less than the exercise price of $6 million.

MobileVDO, a telecom company, paid $20 million to buy a patent for ultrawideband wireless technology that can transfer streaming video at high speeds with minimal power requirements. MobileVDO estimates that it will take another $200 million to develop and commercialize this technology, but there is great uncertainty about the payoff. It therefore plans to wait for the uncertainty to clear before investing in development and commercialization. Buying the patent gives MobileVDO an option to develop and commercialize the technology. In the next three years, if the market uncertainty clears and the payoff from commercialization is expected to be greater than $200 million, MobileVDO would make the investment. It may even fund initial studies such as focused market surveys to clear some of the uncertainty to facilitate a more informed decision. However, if the uncertainty does not clear in a reasonable time, the telecom may let the patent expire.

Table 1-3 analyzes the characteristics of the options available in each example presented above. In every example, the payoff was uncertain and the management decisions were contingent. Therefore, the options approach made sense. But an important question that the decision makers presumably faced was: What is the value of the option? If the value of the option is significant, only then would it make sense to create an option. Otherwise, the decision might as well be made up front, instead of waiting for the uncertainty to clear. The managers created options in every case, because their evaluation presumably showed enough option value to wait until the uncertainty cleared.

Table 1-3. Option Characteristics for the Real Options Examples

OPTIONS VALUATION

Senior business executives and managers struggle every day in making project investment decisions. The decision may be whether to invest in a new project now or wait a while, or it may be whether to contract, expand, or abandon an ongoing project. The decision makers often are looking for tools that can help them make the right decisions. The most fundamental information needed to make such decisions relates to the value of the project in financial terms. Net present value (NPV) based on discounted cash flow (DCF) analysis is the most commonly used tool today in project valuation. You will invest in a project if the NPV of the project is positive. The universal use of DCF notwithstanding, the technique has certain limitations. The NPV is based on a set of fixed assumptions ...

Table of contents

• Cover
• Title
• Chapter 1 Introduction
• Chapter 2 Traditional Project Valuation Tools
• Chapter 3 Challenges with Traditional Tools
• Chapter 4 Real Options Analysis: The New Tool
• Chapter 5 Real Options Analysis Calculations
• Chapter 6 Real Options Analysis Application
• Chapter 7 Simple Options
• Chapter 8 Advanced Options
• Chapter 9 Real Options in the Real World
• References