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[CFDM] Real Option Analysis

·1465 words·7 mins
Author
Frederic Liu
BS.c. Maths and Stats in OR
Table of Contents

Real Option Introduced
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Concept
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Keypoints

  • Real options do exist because in real-world scenarios, you can always choose to do something in response to new information exposed to.
  • The choice to do has a value, which is defined real options
  • Real options are discretionary/strategic opportunities or options embedded in a firms’ real investment project
    • These options are rights, not obligations
    • The option exercise decisions can be optimally made in response to new information in the market

Call back principles - Financial Options

  • Put option: A right to sell at the end of the period (or during the period, as to say American options)
    • The payoff function is $\max(P_{Exercise} - P_{Market},0)$, whose graph looks decreasing as market price rises
    • The turning point is $P_{Exercise}$, lower beyond which we should exercise the right to sell, selling our asset (and potentially buy the asset at market price, which gives the payoff function) at a premium to market price and hedging against price drop
  • Call option: A right to buy at the end of the period (or during the period)
    • The payoff function is $\max(P_{Market} - P_{Exercise}, 0)$, whose graph looks increasing as market price drops
    • The turning point is $P_{Exercise}$, higher upon which we should exercise the right to buy, buying some asset (and potentially sell the asset at market price, which gives the payoff function) at an infimum to market price and hedging against price rise

Real Option Analysis
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Standard NPV v.s. Real Option Analysis

  • Standard NPV treats each project decisions as a now-or-never decision
  • Standard NPV is static, whereas real option analysis is dynamic
  • Standard NPV is based on information available now, whereas real option analysis captures future flexibility to adapt its future actions in response to future market conditions

Identifying Real Options
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Concept
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Overview

  • Timing Option: Delay making an investment
  • Growth Option: Expand operations by making follow-up investments
  • Exit Option: Abandon the project
  • Flexibility Option: Vary the output or production methods (change expenses)

Timing Option
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Keypoints

  • Advantage: Delaying provides the chance to respond to new market information
  • Disadvantage: Delaying may reduce the PV of cash flows (due to firm missing early cash flows or due to competitors moving first etc)
  • This option may not come without costs as the firm may need to maintain access to market information or obtain a license/patent so that it can act in the future
  • This may be considered a call option in comparison to a financial option
  • The underlying asset may be the PV of expected project cashflows
  • The exercise price is the investment costs(outlay), since we focus on the NPV at the time deciding whether to invest, and that if the investment outlay is lower than the NPV(at that time) of net cash flows, it creates positive NPV to invest
  • Yet an initial investment is required, so the payoff diagram may be shift down

Example: A pharmaceutical company may obtain a patent first then choose to produce a medicine later without losing the opportunity, or produce the medicine now. Obtaining a patent can be seen as taking a timing option

Growth Option
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Keypoints

  • Taking a project today may allow a firm to expand its operations later if the original project is successful, it creates the option to enter the market, even if itself may have a negative NPV
  • This may be considered a call option on the expand market in comparison to a financial decision
  • The underlying asset may be the PV of expected incremental cash flows from expansion
  • The exercise price is the cost of expansion, since we focus on the NPV at the time deciding whether to expand, and similar logic applies (see Timing Option)

Example: Microsoft founded Azure China to explore potential opportunities in China, even if it keeps absorbing cash flows of the original Azure company, they are still operating it for future opportunities as there is a very large cloud computing market in China. Investing in a company then keeps operating it even if it has negative NPV can be seen as taking a growth option as it provides with opportunity to expand

Exit Option
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Keypoints

  • A firm may sometimes have the option to abandon the project if it turns out to be unsuccessful, it creates the option to withdraw from the investment if the project does not go as planned
  • This may be considered as a put option in comparison to financial option
  • The underlying asset is the PV of expected project cash flows
  • The exercise price is the salvage value of assets, as we are focusing on the NPV of the decision (in comparison to taking the opposite, i.e. not to sell), and similar logic applies (see Timing Option)

Example: Airbus founded a joint venture with Learjet to produce planes, and Learjet offers to buy Airbus’ part of shares over the next five years. The price offered by Airbus will be lower than the actual value of the shares now, but it provides an option to quickly withdraw from the market. It can be seen as taking a exit option as it provides with opportunity to exit with some salvage value.

Flexibility Option
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Keypoints

  • A flexibility option arises when a firm can revise its operating decisions for a fixed costs in response to market conditions
  • This may be considered as a call option comparing with financial options
  • The underlying asset is the PV of expected incremental cashflows from switching to better operating decisions
  • The exercise price is the cost of switching to the decision, and similar logic applies (see Timing Option)

Example: A firm smelting aluminum can switch to nuclear energy at a later stage, but it requires to build a voltage converter at the early stage of factory planning, which can operate for five years. Building the voltage converter provides with the option to switch to cheaper source of energy (if the firm grew larger and the price of nuclear energy is at an infimum of the current energy). It can be seen as taking a flexibility option as it provides with some flexibility to control operating overheads

Valuing Real Options
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General
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Main idea:

$$ \begin{aligned} NPV_{\text{with real option(with RO)}} &= NPV_{\text{w/o RO}} + PV_{RO} \\\\ \implies PV_{RO} &= NPV_{\text{with RO}} - NPV_{\text{w/o RO}} \end{aligned} $$

Implications from real option analysis

  • $NPV_{w/o\ RO} > 0$ may not be sufficient to warrant an investment’s profitability as the value of the real option may let the NPV be higher (e.g. delay the investment decision if $PV_{RO\ delay} > 0$)
  • $NPV_{w/o\ RO} < 0$ may not be sufficient to reject an investment as the value of the real option may be large enough so that $NPV_{with\ RO}>0$

Analysis
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Process: We use decision-tree analysis

  • Value the project with and without the real option - with the option we take the best outcome, and without the option we take the weighted-average outcome
  • Take the difference of the value with the option and without the option
  • If the cost of establishing the option exceeds the estimated cost, we do not take the option.

Keypoints

  • We only incorporate the expected cash flows in the NPV calculation, as we only focus on the original/incremental PV of cash flows - we do not incorporate the cost of establishing the option

Black-Scholes-Merton Option Pricing Model
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Keypoints

  • It uses the value of the underlying asset, exercise price, volatility of the underlying asset, time to maturity, and risk-free rate of return
  • It is not viable in most scenarios as we cannot obtain the volatility of the underlying asset easily
  • Formula not assessed

Financial Options Concluded
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  • It has longer maturity
  • Underlying assets are project cash flows instead of financial assets
  • Managements’ forecasts and flexibility affects value
  • Not traded, firm-specific
  • Not comparable with other options/assets in the market
  • Not clear how rigorously firms value real options

Importance of Real Options
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Keypoints

  • Higher the likelihood of receiving new information or ability to respond, higher the value of the real option and the importance of real option analysis
  • Managerial behavior is consistent with managers’ awareness (and use) of real option analysis
    • Firms absorb losses before abandoning negative NPV projects - exit option
    • Foreign importers/exporters slow to withdraw from markets even after an adverse currency movement - expand option
  • Counterintuitively, only approx. a third of managers use ROA. It is possibly their unis did not teach them - it is a relatively new technique

Keypoints for not using ROA

  • Lack of top management support - ROA technique requires in-depth data to analyse
  • Discounted cash flow method is a proven method - too lazy to use
  • Requires too much sophistication - not learning it, it is quite easy
  • Encourages too much risk taking - It is completely erroneous. In addition to that, ROA limits downside risk and provide managers with more flexibility to new information.