Lecture 7: Real Options Flashcards
1.) Understand real options including the option to delay investment, the option to expand operations, the option to abandon operations, and the option to remain flexible 2.) Understand real options in the context of the six drivers of option value 3.) Understand the use of real options within a decision-tree framework
What is a Real Option
Option/Option-like features embedded in an investment opportunity
What are the advantages of Real Options over NPV analysis
Real Options: Significant flexibility. Creates Flexibility = Creates value
NPV: ‘Now or Never’. Kills Flexibility = Decrease value
First Option: What is an Option to Delay
Firm obtains the right to determine the timing of investment
Advantage of Options to Delay
Opportunity to respond to new Information
Disadvantage of Options to Delay
Forgo cash flows from not investing immediately
What is S/Value of Underlying Asset in “Option to Delay”
PV of EXPECTED cash flow from investment
What is X/Exercise Price in “Option to Delay”
Cost of investment
When do we early exercise in “Option to Delay”
To avoid forgoing cash flows
Second Option: What is an Option to Expand. Can it undertake a negative NPV investment?
- Firm obtains the right to make a follow-up investment following the success of an initial investment
It may undertake an investment that has a negative NPV if it establishes a presence in a market and provide it up with follow-up options
What is S/Value of Underlying Asset in “Option to Expand”
PV of INCREMENTAL cash flow from expansion
What is X/Exercise Price in “Option to Expand”
Cost of expansion
When do we early exercise in “Option to Delay”
To avoid forgoing cash flows
Key difference between “Option to Expand” and “Option to Delay”
Option to Delay: Expected Cash Flow
Option to Expand: Incremental Cash Flow
Third Option: What is an Option to Abandon
- Firm obtains the right to abandon an investment and realize any salvage value
What is S/Value of Underlying Asset in “Option to Abandon”
PV of cash flow from investment
What is X/Exercise Price in “Option to Abandon”
Salvage Value of Assets
When do we early exercise in “Option to Abandon”
If the salvage value exceeds wealth expected from continuing operations (Deep in-the-money)
Fourth Option: What is an “Option to Remain Flexible”
- Firm can revise its operating decision in response to market conditions
“Option to Remain Flexible”: Examples
Option to alter the rate of production in response to changes in demand
Options to switch production lines
Options to switch inputs and technology to incorporate more efficient productive processes.
“Option to Expand”: Example
Companies establish small negative NPV operations in new markets to develop a ‘footprint’ for future expansion’
When are real options exceptionally important
- ) When the option value is “At the Money”
2. ) High uncertainty (volatility) and High flexibility (management) environments
Where do we observe real options (industries)
Industries like mining, technology, energy (uncertain industries). NOT low-growth stable industries like woolworths
Allows for managerial flexibility
What is S/Value of Underlying Asset in “Option to remain Flexible”
PV of INCREMENTAL cash flow from ALTERNATIVE operation
What is X/Exercise Price in “Option to remain Flexible”
Cost of Switching to Alternative
When do we early exercise in “Option to remain Flexible”
To avoid forgoing cash flows
In terms of a real option, the cash flows from the project play the same role as:
Dividends (Not stock price!!!)
Are most investment decisions irreversible
Yes, hence options are significant. Investment opportunities are like call options.
Explain what Dixit and Pindyck (1995) mean when they say managers should require more than just positive NPV from a project.
- By exercising the decision to invest, the manager is “killing” the TV associated with the option.
- NPV of immediate commencement of project needs to compensate the manager for the loss of the option / flexibility to invest at a later date.
How does real options explain why we observe exporters are slow to cease supplying overseas markets following adverse changes in exchange rates.
Option to remain flexible. By exercising/removing from marketing = give u option to continue operations if economic circumstances change.
Withdrawing too early might lead to irreversible loss of tangible + intangible asset used to build operation in export market.
What type of option is an option to expand operations?
In what situation might an option to expand operations be rationally exercised early?
Long Call.
- If you believed that by not exercising you were missing out on some cash flows associated with the project.
The option to expand operations may decrease in value as the riskiness of the
incremental cash flows from the expanded operations increases. (T/F)
True.
Systematic risk of the incremental cash flows increases = PV (Incremental Cash Flows) decline as IV drops
.
If the PV of the incremental cash flows was unaffected (and it was total risk of the cash flows
affected) – then we might expect an increase in the value of the option
When managers evaluate a project embedded with an option to delay, they should set the hurdle rate lower than the weighted-average cost of capital (WACC) (T/F)
False. Hurdle right should be higher.
- Managers require more than just positive NPV when they evaluate a project embedded with an option to delay (NPV of taking the project immediately must be
sufficiently large to cover the loss in the value of real option)
