Lecture 7: Real Options

Question 1

What is a Real Option

Answer 1

Option/Option-like features embedded in an investment opportunity

Question 2

What are the advantages of Real Options over NPV analysis

Answer 2

Real Options: Significant flexibility. Creates Flexibility = Creates value

NPV: ‘Now or Never’. Kills Flexibility = Decrease value

Question 3

First Option: What is an Option to Delay

Answer 3

Firm obtains the right to determine the timing of investment

Question 4

Advantage of Options to Delay

Answer 4

Opportunity to respond to new Information

Question 5

Disadvantage of Options to Delay

Answer 5

Forgo cash flows from not investing immediately

Question 6

What is S/Value of Underlying Asset in “Option to Delay”

Answer 6

PV of EXPECTED cash flow from investment

Question 7

What is X/Exercise Price in “Option to Delay”

Answer 7

Cost of investment

Question 8

When do we early exercise in “Option to Delay”

Answer 8

To avoid forgoing cash flows

Question 9

Second Option: What is an Option to Expand. Can it undertake a negative NPV investment?

Answer 9

• 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

Question 10

What is S/Value of Underlying Asset in “Option to Expand”

Answer 10

PV of INCREMENTAL cash flow from expansion

Question 11

What is X/Exercise Price in “Option to Expand”

Answer 11

Cost of expansion

Question 12

When do we early exercise in “Option to Delay”

Answer 12

To avoid forgoing cash flows

Question 13

Key difference between “Option to Expand” and “Option to Delay”

Answer 13

Option to Delay: Expected Cash Flow

Option to Expand: Incremental Cash Flow

Question 14

Third Option: What is an Option to Abandon

Answer 14

• Firm obtains the right to abandon an investment and realize any salvage value

Question 15

What is S/Value of Underlying Asset in “Option to Abandon”

Answer 15

PV of cash flow from investment

Question 16

What is X/Exercise Price in “Option to Abandon”

Answer 16

Salvage Value of Assets

Question 17

When do we early exercise in “Option to Abandon”

Answer 17

If the salvage value exceeds wealth expected from continuing operations (Deep in-the-money)

Question 18

Fourth Option: What is an “Option to Remain Flexible”

Answer 18

• Firm can revise its operating decision in response to market conditions

Question 19

“Option to Remain Flexible”: Examples

Answer 19

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.

Question 20

“Option to Expand”: Example

Answer 20

Companies establish small negative NPV operations in new markets to develop a ‘footprint’ for future expansion’

Question 21

When are real options exceptionally important

Answer 21

1. ) When the option value is “At the Money”

2. ) High uncertainty (volatility) and High flexibility (management) environments

Question 22

Where do we observe real options (industries)

Answer 22

Industries like mining, technology, energy (uncertain industries). NOT low-growth stable industries like woolworths

Allows for managerial flexibility

Question 23

What is S/Value of Underlying Asset in “Option to remain Flexible”

Answer 23

PV of INCREMENTAL cash flow from ALTERNATIVE operation

Question 24

What is X/Exercise Price in “Option to remain Flexible”

Answer 24

Cost of Switching to Alternative

Question 25

When do we early exercise in “Option to remain Flexible”

Answer 25

To avoid forgoing cash flows

Question 26

In terms of a real option, the cash flows from the project play the same role as:

Answer 26

Dividends (Not stock price!!!)

Question 27

Are most investment decisions irreversible

Answer 27

Yes, hence options are significant. Investment opportunities are like call options.

Question 28

Explain what Dixit and Pindyck (1995) mean when they say managers should require more than just positive NPV from a project.

Answer 28

• 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.

Question 29

How does real options explain why we observe exporters are slow to cease supplying overseas markets following adverse changes in exchange rates.

Answer 29

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.

Question 30

What type of option is an option to expand operations?

In what situation might an option to expand operations be rationally exercised early?

Answer 30

Long Call.

• If you believed that by not exercising you were missing out on some cash flows associated with the project.

Question 31

The option to expand operations may decrease in value as the riskiness of the
incremental cash flows from the expanded operations increases. (T/F)

Answer 31

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

Question 32

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)

Answer 32

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)