(LT) Real options (2) Flashcards
What have we assumed about NPV so far?
They just passively hold assets( e.g. even if economic conditions change in the future they will not change their position.) This is not the case, lets say an asset has higher cash injections then projected, then you might increase the amount of money in asset to boost sales.
What is a real option?
The right but not the obligation to modify a project in the future, e.g. pharmaceuticals, they don’t put all money at once. ( this is different to financial options from last year because the underlying asset the option here is not tradeable ( it doesn’t have a market price.)
What can a value of an option never be?
It always has a non-negative price, a firm will only modify, abandon or scale investment if its in their interest to do so.
When will real options have a 0 value?
They will have a 0 value if future is certain, hence no need to deviate from plan.
When do real options have value?
What concluding sentence can we say about real options?
When the future is uncertain( which is basically always the case) e.g. costs might be higher or lower than expected, competition entering the market etc.
The more uncertain the future, the greater the value of the real option that provide this flexibility. So product valuations should account for the value of any built in real options, otherwise you undervalue value of NPV.
What visual tool will be use for real options
Decision tree ( shows sequential decisions and possible outcomes.
We are going to look at an example to highlight many different things about Real options, but first workout the cost of capital?
Just use CAPM to work it out.
EXPLAIN THIS?
There are 2 types of customers Berkeley( drink coffee) and Cleveland ( don’t drink coffee, hence fewer sales.
Also there is systematic risk( we cannot diversify away from it) such as economic growth ( boom, slump, recession) with different probabilities).
So if we are in BOOM Berkeley customers would make 10k more sales.
Lets look at decision tree with no real option, show this? e.g. show where to build or not then show another branch showing either customer with NPV.
( NO REAL OPTION) Calculate NPV of the Berkeley-type market and Cleveland type market ?
We work out the Expected cash flow given its Berkeley or Cleveland. Remember t = 10 years.
So if the market turns out to be the cleveland type, we are losing money.
Calculate overall NPV of building a coffee shop ?
on average you should build.
Suppose you can hire a market research firm that immediately tells you whether you the market type, what does this create?
It creates a real option but it isn’t the real option.
The diagram shows that the middle nod at the top, just shows what the market decides whether its B OR C, then after that you have 2 decision nods after.
So if you do the market research and market type tells you its cleveland and you decide not to do the project, your NPV is 0, not -27.82 without the option.
What is the expected NPV with market research but you haven’t paid anything for market research is what?
NPV = 0.8 × 32.33 + 0.2 × 0 = 25.86 ( theres a 0 because we will not take on project with cleveland type.
So we know that doing market research creates extra value of (25.86 - 20.3) = £5.56k for market research, so what is the maximum you are willing to pay for Market research?
You are willing to pay the extra value because your NPV with the market research = NPV without extra research.
What is another way we could of calculated the value of the real option ( 5.56k)?
20% of the time you avoid entering into a project when it has a negative NPV.
The ability to avoid the negative NPV project (Cleveland); the NPV
of savings equals 0.2 × 27.82 = £5.56K.
So far we have assumed that choosing to conduct market research has no impact on the timing of our project - in both cases, we can begin today ( t = 0), in reality, market research takes time, but in real life market research takes time to come into play. So lets say it takes one year to conduct research, so choosing to undertake the project will delay market research by 1 year. Without research you can start immediately, the question is, is it worthwhile to wait?
It depends,
its like an American call option, you have the right but not the obligation to buy the project for a specific price, which can be excercised today or in one year.
It depends whether the underlying asset is a dividend paying stock or a non dividend paying stock.
Remembering from last term when is it optimal and not optimal to exercise an American call option?
Early exercise of an American call on a non-dividend-paying stock is never optimal as By holding an option, you keep the potential for further profit from stock price increases, while limiting downside risk. Exercising the option early forfeits this potential upside.
Early exercise may be optimal for a dividend-paying stock (If the dividend is large enough, it may outweigh the benefits of holding the option until expiration. This happens because when a company pays a dividend, its stock price typically decreases by roughly the amount of the dividend, potentially reducing the value of the call option.)
So lets say that we can invest immediately or wait a year or so for market research to kick in, what are 2 advantages of waiting?
( Notice here CFs still end at yr 10, so we are essentially giving up a year of cash flow.
1) you will find out whether its Berkeley or cleveland type
2) you delay having to pay that initial outlay for a year, so in PV terms that initial outlay is worth less today.
Calculate the NPV with market research whilst waiting a year and compare it with market research when you don’t wait a year assuming market turns out to be Beckerley?
The £8.11K drop in value (32.33 − 24.22) is analogous to a dividend. We
miss out on the dividend by not exercising early. ( BUT tethnically comparison is wrong because its being discounted by different time periods, 9 and 10.
What is the Overall NPV now of the project, taking into account when taking MR you have to wait a year?
So NPV with market research is less than NPV if we took project today, hence excerise option now. ( the cost of waiting exceeds benefit of waiting).
Why do we discount at the risk free rate?
Because if we choose to wait between time 0 and 1 we choose to wait, that money is parked in a bank account, so no risk between time 0 and 1
So here we are going to be looking at option of abandonment, so as you can see gold is losing 10/ounce. As cash flows occur at beginning of each year then, at time 3 you discount it by 2 years. What is the expected price at time 1 and 2?
Shows the expectation today at t=0 of what the gold price will be at at time 1 and 2.
Calculate the NPV of the mine assuming there is no temporary abandonment options?
Looking at the price at time at each nod and then discounting it.
What are the cash flows in each state?
As you can see the cash flows are negative for 3 areas, so suppose we can abandon production ( stop extracting gold) and not incur any costs, so cash flows are 0. So replace the negative cash flows and what do we want to do?
We want to calculate the NPV of the project inclusive of the abandonment option. So calculating the expected NPV of the decision tree.
Calculate the NPV with the temporary abandonment ( hint there are 4 possibilities)?
What is the value of the abandonment option?
NPV with abandonment option - NPV without the abandonment option = 1978k - 126k = 1782k
Assume that the company holds the company for the full 2 years, we can see the cashflows . You can only sell company at time 0 or 1. We are going to answer when should you sell company and what is the value of the abandonment option we have been given?
So to determine the value of company, what are we going to use to solve this?
Backward induction, so at time 2 the value of the company just before when you receive the cash flows are at the end of the decision tree. We are not worried about time 2, we are worried for time 1, to determine whether we should take the option, as time 2 we already know the value.
Using backward induction calculate the value of company at each nod? ( start at time 2)
Just before receiving that first cash flow before time 1 in the upstate, you will receive 100, then time 2 you will either receive 120 or 90.
Same with bottom nod.
Does this mean you should sell the firm today?What is the value of the company assuming no abandonment option?
No because we have an American put option that we can exercise at time 1. We can sell the company for 150 if we end up with 102.72.
The 145.4 is the value of company assuming no abandonment option.
So we know that the value of the company in the bottom nod is negative, so we can replace this with 150 to find the value of company with abandonment option at time 0 is which is what?, should we sell company? What is the option value?
You should not sell today because the value of the company with the option embedded is 162, so we should hold onto company today, wait till time 1, if we hold onto company we hold onto company, if we end up in downstate we sell.
The value of company with option - value of company without option = 162 - 145 = 17
Now lets look at option to expand, but firstly we are going to look at going big from beginning, so overall we are going to calculate NPV of going big( find expected cash flow at time 1 and 2 and discount then to time 0, then at to initial outlay), so calculate this. )
Hint don’t use backward induction, start from time 1.
(OPTION TO EXPAND) Suppose t=1 demand is high and you buy that second plane workout NPV to when buy and when you don’t buy
Clearly buying a second plane is worthwhile it has a higher NPV
Now similarly to the turbo strategy calculate the NPV of the Piston-engine strategy
Remember no backward induction.
What can we deduce about staged implementation?
This explains why start ups have staged finance.
What is the value of the growth option?
The incremental value of the growth option is difference between the NPV of piston strategy with growth option - NPV of the piston strategy ignoring the growth option.
Now workout the NPV of the piston strategy ignoring the growth option. Then workout value of growth option.
WHAT IS THE DIRECT WAY OF CALCULATING THE VALUE OF GROWTH OPTION? ( HINT incremental cash flows)? ( same way we have been doing it before)
Now lets look at the option to wait.
What does this show?
HINT ITS LIKE HOLDING A AMERICAN CALL OPTION
The underlying asset is the project itself, the exercise price is the initial outlay
If the value today of future cash flows (PV) is less than the project’s initial cost, the project has a negative Net Present Value (NPV) and should be avoided. Conversely, if the PV is greater than the initial cost, the project has a positive NPV and should be considered.
Before an option’s expiration, its value includes both intrinsic value (profit if exercised immediately) and time value (potential future profit). For non-dividend paying assets, options are worth more than just their intrinsic value due to this time premium. Thus, it’s usually unwise to exercise these options early; if cash is needed, selling the option is typically better.
