Project Valuation Using Real Options: A Practitioner's Guide
256
Project Valuation Using Real Options: A Practitioner's Guide
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Product Details
| ISBN-13: | 9781604277098 |
|---|---|
| Publisher: | Ross, J. Publishing, Incorporated |
| Publication date: | 07/01/2006 |
| Sold by: | INDEPENDENT PUB GROUP - EPUB - EBKS |
| Format: | eBook |
| Pages: | 256 |
| File size: | 9 MB |
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Read an Excerpt
CHAPTER 1
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.
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.
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 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 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.
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 related to the project payoff (a deterministic approach), whereas the payoff is uncertain and probabilistic. DCF does not take into consideration the contingent decisions available and the managerial flexibility to act on those decisions. For example, the value of the future flexibility to expand, contract, or abandon is not captured by DCF. Furthermore, DCF analysis accounts for only the downside of the risk without considering the rewards. This inherent bias leads to rejection of highly promising projects because of their uncertainty. Many of today's technology projects exhibit such characteristics; therefore, the limitations of DCF are of enormous significance in their valuation.
Real-options-based valuation, referred to as real options analysis (ROA) in this book, offers new ways to address these limitations of DCF. To be sure, ROA is not a substitute for DCF. It is a supplement that fills the gaps that DCF cannot address. ROA uses DCF as a building block and captures the value of the options — expressed as real options value in this book — embedded in growth projects that DCF alone cannot measure. It integrates traditional valuation tools into a more sophisticated framework that provides practicing financial analysts and decision makers with more complete and meaningful information. Whereas real options embedded in projects are implicitly recognized by organizations, the formal valuation using ROA makes them explicit and quantifies their value, thereby helping management make rational decisions.
ROA evolved from financial options valuation, which has been the subject of numerous technical papers and books for decades. The Nobel Prize-winning work of MIT economists Fisher Black, Robert Merton, and Myron Scholes was the foundation of the financial options theory.
In this book, we attempt to briefly describe the theory behind options valuation and focus on how a practicing professional (say, a financial analyst) involved in project valuation can use the options models to calculate the value of different types of project investments. We also compare and contrast the real options approach with the traditional tools of valuation. Furthermore, we discuss the benefits and limitations of ROA in terms of practical application.
PROBLEMS
1-1. Fuel Sells holds several patents related to a new technology that provides power to laptops and cellular devices using fuel cells in lieu of the conventional batteries. The development cost for this technology is expected to be $100 million. If the technology is proven effective, the net payoff over the project's lifetime is estimated at $105 million. Since there is considerable technology as well as market uncertainty, Fuel Sells made an agreement to sell its assets to Cool Buys for $50 million, if the project is deemed unattractive within the next three years. What is the option created by Fuel Sells? Is it a call or a put? What is the strike price? What is the option life?
1-2. Seamless Transitions is contemplating whether to launch within the next three years a new technology that allows seamless transition of networks from landline to cellular so that the same phone handset can be used with both networks. Since there is enormous uncertainty related to this technology, the company decides to conduct a pilot test in a small market before a "full-blown" launch. It initiates a pilot test in a small metropolitan area, which is expected to cost $200 million. If the pilot test proves the project's large-scale commercial viability, the company will launch the seamless technology and its related products in seven major metropolitan areas at an estimated investment cost of $1 billion. What is the option created by Seamless Transitions? Is it a call or a put? What is the price of the option? What is its strike price?
1-3. Priceless Polymers invested $100 million to build a new manufacturing plant, the lifetime payoff from which was expected to be $120 million at the time the project was initiated. Since there was a great deal of uncertainty regarding this estimate, the company decided at the time of project initiation that it would sell its assets for an expected salvage value of $20 million if at any time within the next three years the uncertainty cleared and the expected payoff dropped below the salvage value. At the end of the third year, the market uncertainty cleared and the expected project payoff was estimated to be merely $15 million. The company then sold its assets and terminated the project. What option did Priceless Polymers create to begin with? Was it a call or a put? What was its strike price? What was the option life? What was the option value at the exercise time?
(Continues…)
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Table of Contents
Preface,
Acknowledgments,
About the Authors,
Web Added Value™,
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,
Appendix A. Replicating Portfolio,
Appendix B. Real Options Analysis Application Assessment Tool,
Notation,
A Glossary of Terms,