chapter 4 real options and project analysis capital budgeting and investment analysis by alan...
TRANSCRIPT
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Chapter 4Real Options and Project Analysis
Capital Budgeting and Investment Analysis by Alan Shapiro
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Option valuation and Investment Decisions
• The ability of companies to change course in response to changing circumstances create what often termed real or growth options
• Many investments have very uncertain payoffs that are best valued with an options approach
• The down payment agreement is a call option– Option price– Strike price– Stock price
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Option valuation and investment decisions cont.
• A lease with an option to cancel can be viewed as a put option
• The purchase of an insurance policy on property can be also thought of as a put option
• Black-Scholes formula
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Option valuation and investment decisions cont.
• The opportunities that a firm may have to increase the profitability of its existing lines and benefit from expanding into new products or markets may be thought of as growth options
• Growth options are of great importance to new firms
• Very high P/E
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Option valuation and investment decisions cont.
• The owners of a gold mine may increase or decrease gold output depending on the current price
• The mine can be shutdown and then reopened when production and market conditions are more favorable or it can be abandoned permanently
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Valuing a Gold Mine
• Reopening a gold mine would cost $1 million• 40,000 ounces of gold remaining• Variable cost $390 per ounce• Expected gold price $400 per ounce• 15% yield required on such risky investment• Do you think the NPV is negative?!• DO NOT ignore the option not to produce gold
if it is unprofitable to do so
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Valuing a Gold Mine cont.
• Suppose two possibilities:• $300 per ounce and $500 per ounce each with
probability of 0.5• Mine gold if and only if the price of gold at
year’s end is $500 per ounce• Incorporating the mine owner’s option NOT to
mine gold when the price falls below the cost of extraction reveals a positive NPV of $913,043
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• The current value of mine can be thought of as a call option on the value of the gold in the mine
• The strike price equals the cost of reopening• The stock price equals the value of the gold
that could subsequently be produced• Firms have 3 choice:– Continue to invest in a project– Abandon the project– Delay the project
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Evaluating R&D investments using an option valuation approach
• The ability to alter decisions in response to new information may contribute significantly to the value of a project
• An investment in R&D gives the investor the right to acquire the outcomes of the R&D at the cost of commercialization
• Both investors in R&D and mine owner have put options, they can abandon their projects at an exercise price equal to the costs of shutdown
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Example• Product development cost $5 million a year from 2005
to 2007• Build a plant which cost $100 million in beginning of
2008• $13 million annual cash flow from yearend 2008 to
2017• Terminal value at yearend 2017 is $105 million• Discount rate of 14%• Costs are assumed to occur at the start of the year and
OCF at the end of the year
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• Option valuation allows for the decision NOT to build the plant and also values only those outcomes that will follow if the plant is built.
• Clearly, if R&D investment does not pan out or if market conditions are unfavorable, the plant will not be built
• Option valuation approach properly values ONLY positive NPV outcomes, whereas the traditional DCF analysis values ALL outcomes, negative as well as positive
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PV of CF items for new product development ($ millions)
CF item PV as of Jan 1st 2005 PV as of Jan 1st 2008
R&D expense -13.2 0
Plant cost (2008, beginning of year)
-67.5 -100
Post 2007 OCF (2008-2017) 45.8 67.8
Terminal value (2017) 16.8 28.3
NPV -18.2 -3.9
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PV on Jan 1 2005 R&D expense
2008 Plant cost
2008 possible payoff
2005 project NPV
DCF Analysis Assumes one outcome
-13.2 -100 96.1 -18.2
Option AnalysisAssumes manyPossible outcomes and measures each one separately each with probability 0.25
I -13.2 -100 223.9 70.4
II -13.2 -100 118.1 -1
III -13.2 0 33.9 -13.2
IV -13.2 0 8.6 -13.2
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Expected NPV of R&D investment in 2008 ($ millions)
Scenario Decision Cost Payoff NPV Prob. Value
I Build plant -100 223.9 123.9 0.25 31
II Build plant -100 118.1 18.1 0.25 4.5
III Don’t build 0 0 0 0.25 0
IV Don’t build 0 0 0 0.25 0
35.5
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• The expected project NPV in 2008 valuing only favorable outcomes is $35.5 million
• This yields PV in 2005 of $24 million• Subtract the $13.2 million PV of the R&D
investment and the result is a $10.7 million NPV
• Invest in new product development and exercise the option of proceeding forward in 2008 if the outcome looks favorable. Otherwise, the project should be abandoned at that point
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Strategic investments and growth options
• Many strategically important investments such as investments in R&D, factory automation, a brand name, or distribution network, provide growth opportunities because they are often but the first link in a chain of subsequent investment decisions
• Creating options on investment in other products, markets, or production processes are sometimes referred to as Growth option
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Strategic investments and growth options cont.
• Valuing investments that embody discretionary follow up projects requires an expanded NPV rule hat considers the attendant options
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Valuing a growth option
• According to option pricing theory, the discretion to invest or not in a project depends on:
• 1. The length of time the project can be deferred
• 2. The risk of the project • 3. The level of interest rates• 4. The proprietary nature of the option
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The length of time the project can be deferred
• The ability to defer a project gives the firm more time to examine the course of future events and to avoid costly errors if unfavorable developments occur
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The risk of the project
• Surprisingly, the riskier the investment is, the MORE valuable the option on it will be!
• The reason is the asymmetry between gains and losses
• Losses are limited by the option not to exercise when the project NPV is negative
• The riskier the project is, the greater the odds will be of a large gain without a corresponding increase in the size of the potential loss
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The level of interest rate
• The net effect is that high interest rates generally raise the value of projects that contain growth options
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The proprietary nature of the option
• Consideration of competitive conditions is what separates growth options from stock options
• Growth options are valuable because they allow the firm to delay investments to learn more about the value of the underlying growth opportunities
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Investment decisions and Real options
• Value of Project = Project’s value using traditional DCF + Value of strategic options
• VPROJ=VDCF + VSTRAT• The value of an option increases with
uncertainty• An option represents a right but not an
obligation to buy or sell an asset. There is no commitment to future investments unless conditions are favorable
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Investment decisions and real options cont.
• A company can exploit a project’s upside potential without incurring significant downside risks
• Decision to build a pilot plant to manufacture a new product. This mitigate losses if sales are disappointing
• If sales take off, the firm can invest in a higher capacity plant that would be more efficient
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Investment decisions and real options cont.
• The ability to abandon a project represents a put option for the firm
• A project should be abandoned if the abandonment value exceeds the PV of subsequent CFs
• Flexibility of a project represents a set of operating options
• A power plant that burns only oil VS. a plant that is capable of burning both oil and coal
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• The firm can use different raw material mixes to produce the same final product, or the same inputs (e.g., crude oil) to produce a variety of outputs (e.g., gasoline, heating oil)
• Other operating options:– Changing marketing (pricing/promotion)
strategies– Temporarily closing a plant in response to a
decline in demand– Reducing or increasing output in response to
demand– Redesigning a product in response to changing
demand or input costs
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Investment decisions and real options cont.
• According to Graham and Harvey (2002), more than one-fourth of the companies claimed to be using real options evaluation techniques
• NPV(project) + X = 0• Management would have to decide whether
they would be prepared to pay X dollars to acquire the strategic options associated with it.