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# Real Options & Decision Making by Ramabhadran S. Thirumalai

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Presented at Agile carnival Chandigarh on 7th-8th May at ISB Mohali Campus

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### Real Options & Decision Making by Ramabhadran S. Thirumalai

1. 1. Real Options & Decision Making Ramabhadran S. Thirumalai Indian School of Business Agile Carnival, Chandigarh May 8, 2016
2. 2. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Agenda 1 Introduction Capital Budgeting Option Types 2 Real Options 3 Option to Defer 4 Option to Abandon 5 A Four-Step Process 6 Wrap-Up Ram Thirumalai Real Options Agile Carnival 2 / 16
3. 3. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up A capital budgeting example • XYZ Pharma Ltd. is looking to make an additional R&D investment of |10 billion for a cure to cancer. • If the additional investment results in a breakthrough cure (probability of 0.05), the future net inﬂows are worth |200 billion at the end of year 1. • If the additional investment fails (probability of 0.95), the future net inﬂows are worth zero at the end of year 1. • The discount rate is 30%. • Traditional capital budgeting would say: NPV = 0.05 × 200 + 0 1.30 − 10 = −2 billion ⇒ Reject the project. Ram Thirumalai Real Options Agile Carnival 3 / 16
4. 4. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up A capital budgeting example . . . 2 • However, since this has signiﬁcant implications for the health of its citizens, the government agrees to pay the company |20 billion if the additional investment fails. • Does this change the decision? Ram Thirumalai Real Options Agile Carnival 4 / 16
5. 5. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up A capital budgeting example . . . 2 • However, since this has signiﬁcant implications for the health of its citizens, the government agrees to pay the company |20 billion if the additional investment fails. • Does this change the decision? • NPV = 0.05 × 200 + 0.95 × 20 1.30 − 10 = 12.31 billion ⇒ Accept the project. Ram Thirumalai Real Options Agile Carnival 4 / 16
6. 6. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up A capital budgeting example . . . 2 • However, since this has signiﬁcant implications for the health of its citizens, the government agrees to pay the company |20 billion if the additional investment fails. • Does this change the decision? • NPV = 0.05 × 200 + 0.95 × 20 1.30 − 10 = 12.31 billion ⇒ Accept the project. • Value of option = 12.31 − −2 = 14.31 billion. Ram Thirumalai Real Options Agile Carnival 4 / 16
7. 7. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Options contract • Option: It gives the holder the right to trade the underlying asset at a stated price (called the exercise or strike price). Right to buy: call. Right to sell: put. Ram Thirumalai Real Options Agile Carnival 5 / 16
8. 8. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Options contract • Option: It gives the holder the right to trade the underlying asset at a stated price (called the exercise or strike price). Right to buy: call. Right to sell: put. • Option in the previous example: call or put? Ram Thirumalai Real Options Agile Carnival 5 / 16
9. 9. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Options contract • Option: It gives the holder the right to trade the underlying asset at a stated price (called the exercise or strike price). Right to buy: call. Right to sell: put. • Option in the previous example: call or put? It is a put as it gives the company the right to “sell” the project to the government and receive the guaranteed amount if the additional investment is a failure. Ram Thirumalai Real Options Agile Carnival 5 / 16
10. 10. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Options contract • Option: It gives the holder the right to trade the underlying asset at a stated price (called the exercise or strike price). Right to buy: call. Right to sell: put. • Option in the previous example: call or put? It is a put as it gives the company the right to “sell” the project to the government and receive the guaranteed amount if the additional investment is a failure. • Can be viewed as insurance contracts. Ram Thirumalai Real Options Agile Carnival 5 / 16
11. 11. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Why real options? • Traditional valuation assumes that there is no uncertainty in cash ﬂows and projects are irreversible. • Ignoring options will lead to incorrect valuation and hence wrong decisions. • The decision to invest is an option itself, which need not be decided right away. For example, project may be unattractive if price drops by 10% in a year’s time but may be lucrative if price increases by 5% in a year’s time. So wait for a year (to resolve uncertainty in price) before deciding to accept or reject the project. • Flexibility is valuable and cannot be ignored. Ram Thirumalai Real Options Agile Carnival 6 / 16
12. 12. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Why real options? • Traditional valuation assumes that there is no uncertainty in cash ﬂows and projects are irreversible. • Ignoring options will lead to incorrect valuation and hence wrong decisions. • The decision to invest is an option itself, which need not be decided right away. For example, project may be unattractive if price drops by 10% in a year’s time but may be lucrative if price increases by 5% in a year’s time. So wait for a year (to resolve uncertainty in price) before deciding to accept or reject the project. • Flexibility is valuable and cannot be ignored. • Deﬁnition: A real option is an alternative or choice that is available or becomes available with a business investment opportunity. Ram Thirumalai Real Options Agile Carnival 6 / 16
13. 13. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Why real options? . . . 2 • Common examples of real options (from “Real Options” by Lenos Trigeorgis): Option to defer: company holds a lease on or an option to buy valuable land. Typical in oil extraction, mining and real-estate industries. Ram Thirumalai Real Options Agile Carnival 7 / 16
14. 14. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Why real options? . . . 2 • Common examples of real options (from “Real Options” by Lenos Trigeorgis): Option to defer: company holds a lease on or an option to buy valuable land. Typical in oil extraction, mining and real-estate industries. Staged investment: each stage may be viewed as an option on the subsequent stages. Typical in start-up, R&D-intensive and energy-generating industries. Ram Thirumalai Real Options Agile Carnival 7 / 16
15. 15. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Why real options? . . . 2 • Common examples of real options (from “Real Options” by Lenos Trigeorgis): Option to defer: company holds a lease on or an option to buy valuable land. Typical in oil extraction, mining and real-estate industries. Staged investment: each stage may be viewed as an option on the subsequent stages. Typical in start-up, R&D-intensive and energy-generating industries. Option to alter operating scale: expand, contract, shutdown and restart. Typical in consumer goods, mining and fashion apparel industries. Ram Thirumalai Real Options Agile Carnival 7 / 16
16. 16. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Why real options? . . . 2 • Common examples of real options (from “Real Options” by Lenos Trigeorgis): Option to defer: company holds a lease on or an option to buy valuable land. Typical in oil extraction, mining and real-estate industries. Staged investment: each stage may be viewed as an option on the subsequent stages. Typical in start-up, R&D-intensive and energy-generating industries. Option to alter operating scale: expand, contract, shutdown and restart. Typical in consumer goods, mining and fashion apparel industries. Option to abandon: sell all capital assets. Typical in capital-intensive industries. Ram Thirumalai Real Options Agile Carnival 7 / 16
17. 17. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Why real options? . . . 2 • Common examples of real options (from “Real Options” by Lenos Trigeorgis): Option to defer: company holds a lease on or an option to buy valuable land. Typical in oil extraction, mining and real-estate industries. Staged investment: each stage may be viewed as an option on the subsequent stages. Typical in start-up, R&D-intensive and energy-generating industries. Option to alter operating scale: expand, contract, shutdown and restart. Typical in consumer goods, mining and fashion apparel industries. Option to abandon: sell all capital assets. Typical in capital-intensive industries. Option to switch: change output mix or produce same output using diﬀerent inputs. Typical in toy industries, automobile. Ram Thirumalai Real Options Agile Carnival 7 / 16
18. 18. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Why real options? . . . 2 • Common examples of real options (from “Real Options” by Lenos Trigeorgis): Option to defer: company holds a lease on or an option to buy valuable land. Typical in oil extraction, mining and real-estate industries. Staged investment: each stage may be viewed as an option on the subsequent stages. Typical in start-up, R&D-intensive and energy-generating industries. Option to alter operating scale: expand, contract, shutdown and restart. Typical in consumer goods, mining and fashion apparel industries. Option to abandon: sell all capital assets. Typical in capital-intensive industries. Option to switch: change output mix or produce same output using diﬀerent inputs. Typical in toy industries, automobile. Even football clubs have real options: whether to hire players from school, when to ﬁre them, when to promote them to second team and full team. Ram Thirumalai Real Options Agile Carnival 7 / 16
19. 19. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Option to defer • Decide right now whether to precommit to a project that will cost \$115 million next year. • This produces cash ﬂows of \$170 million or \$65 million, with a probability of 0.50 each. • The alternative is to wait until the end of the year to decide. • Risk-free rate is 8% and the discount rate is 17.5% for the project. Ram Thirumalai Real Options Agile Carnival 8 / 16
20. 20. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Option to defer . . . 2 • NPV = 0.5 × 170 + 0.5 × 65 1 + 0.175 − 115 1.08 = −6.48 million. • Reject the project. Ram Thirumalai Real Options Agile Carnival 9 / 16
21. 21. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Option to defer . . . 2 • NPV = 0.5 × 170 + 0.5 × 65 1 + 0.175 − 115 1.08 = −6.48 million. • Reject the project. • Alternatively, if you wait a year, the uncertainty is resolved. If “good” state occurs, payoﬀ = max (170 − 115, 0) = 55. If “bad” state occurs, payoﬀ = max (65 − 115, 0) = 0. You will invest only in the “good” state. This is a simple call option. Ram Thirumalai Real Options Agile Carnival 9 / 16
22. 22. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Option to defer . . . 2 • NPV = 0.5 × 170 + 0.5 × 65 1 + 0.175 − 115 1.08 = −6.48 million. • Reject the project. • Alternatively, if you wait a year, the uncertainty is resolved. If “good” state occurs, payoﬀ = max (170 − 115, 0) = 55. If “bad” state occurs, payoﬀ = max (65 − 115, 0) = 0. You will invest only in the “good” state. This is a simple call option. NPV = 0.5 × 55 + 0.5 × 0 1 + 0.175 = 23.40. Value of option to defer = 23.40 − −6.48 = 29.88 million. Ram Thirumalai Real Options Agile Carnival 9 / 16
23. 23. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Option to abandon: An example • A company is looking at a new project. • The current investment for the project is |550 million. • If the project succeeds, the project will generate |150 million in annual cash ﬂows in perpetuity. • If the project fails, the project will generate |50 million in annual cash ﬂows in perpetuity. • Success and failure are equally likely. • The management has the option to terminate the project at the end of the ﬁrst year and sell all equipment and assets for |400 million. • What is the value of this option to the company? • What type of an option is this: call or put? • A discount rate of 20 percent is appropriate for all cash ﬂows. Ram Thirumalai Real Options Agile Carnival 10 / 16
24. 24. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Example . . . 2 • First step: what is the NPV without the option to abandon? Ram Thirumalai Real Options Agile Carnival 11 / 16
25. 25. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Example . . . 2 • First step: what is the NPV without the option to abandon? • If the project is a success, NPV = −550 + 150/0.20 = 200 million Ram Thirumalai Real Options Agile Carnival 11 / 16
26. 26. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Example . . . 2 • First step: what is the NPV without the option to abandon? • If the project is a success, NPV = −550 + 150/0.20 = 200 million • If the project is a failure, NPV = −550 + 50/0.20 = −300 million Ram Thirumalai Real Options Agile Carnival 11 / 16
27. 27. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Example . . . 2 • First step: what is the NPV without the option to abandon? • If the project is a success, NPV = −550 + 150/0.20 = 200 million • If the project is a failure, NPV = −550 + 50/0.20 = −300 million • Expected NPV = 0.5 × 200 + 0.5 × −300 = −50 million Ram Thirumalai Real Options Agile Carnival 11 / 16
28. 28. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Example . . . 3 • Now assume that the abandonment option exists. • Payoﬀ at end of year 1 if project is a success = max (400, 150/0.20) = 750 million • NPV at time 0 if project is a success = −550 + (750 + 150) / (1 + 0.20) = 200 million Ram Thirumalai Real Options Agile Carnival 12 / 16
29. 29. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Example . . . 3 • Now assume that the abandonment option exists. • Payoﬀ at end of year 1 if project is a success = max (400, 150/0.20) = 750 million • NPV at time 0 if project is a success = −550 + (750 + 150) / (1 + 0.20) = 200 million • Payoﬀ at end of year 1 if project is a failure = max (400, 50/0.20) = 400 million • NPV at time 0 if project is a failure = −550 + (400 + 50) / (1 + 0.20) = −175 million Ram Thirumalai Real Options Agile Carnival 12 / 16
30. 30. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Example . . . 3 • Now assume that the abandonment option exists. • Payoﬀ at end of year 1 if project is a success = max (400, 150/0.20) = 750 million • NPV at time 0 if project is a success = −550 + (750 + 150) / (1 + 0.20) = 200 million • Payoﬀ at end of year 1 if project is a failure = max (400, 50/0.20) = 400 million • NPV at time 0 if project is a failure = −550 + (400 + 50) / (1 + 0.20) = −175 million • Expected NPV = 0.5 × 200 + 0.5 × −175 = 12.5 million Ram Thirumalai Real Options Agile Carnival 12 / 16
31. 31. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Example . . . 3 • Now assume that the abandonment option exists. • Payoﬀ at end of year 1 if project is a success = max (400, 150/0.20) = 750 million • NPV at time 0 if project is a success = −550 + (750 + 150) / (1 + 0.20) = 200 million • Payoﬀ at end of year 1 if project is a failure = max (400, 50/0.20) = 400 million • NPV at time 0 if project is a failure = −550 + (400 + 50) / (1 + 0.20) = −175 million • Expected NPV = 0.5 × 200 + 0.5 × −175 = 12.5 million • Value of option = 12.5 − (−50) = 62.5 million Ram Thirumalai Real Options Agile Carnival 12 / 16
32. 32. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Example . . . 4 • This is a put option because the company has the right to sell its assets if the project is a failure. Ram Thirumalai Real Options Agile Carnival 13 / 16
33. 33. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up A four-step process • Compute base case NPV without ﬂexibility using traditional discounted cash ﬂow methodology. • Model the uncertainties using trees. This is NOT a decision tree. This step allows you to get a better understanding of the uncertainties that drive the value of the project through time. In other words, you build a tree that shows how the project value (of base case) evolves over time. Using a Monte Carlo simulation will help in building this tree. Ram Thirumalai Real Options Agile Carnival 14 / 16
34. 34. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up A four-step process . . . 2 • Identify the managerial ﬂexibilities and incorporate them in the tree built in the previous step. Now the tree is a decision tree. • Value the real option. Most diﬃcult step! Ram Thirumalai Real Options Agile Carnival 15 / 16
35. 35. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up Wrap-up • Real options are valuable and cannot be ignored. • Factoring them could change the decision to accept/reject the project. • These options are valuable only if they help resolve uncertainty. • These options have positive value i.e., including them in NPV calculations will increase NPV. Ram Thirumalai Real Options Agile Carnival 16 / 16