Real options

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Advanced Corporate Finance & Strategy
©Michal Kaszas
ISTI Valuation & Strategy Specialist
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Welcome!

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Lesson Topic Dig Deeper – “Know Window”
15.2.2017 Introduction The Barbarians at the Gate (KKR)
22.2.2017 Strategic Value: Strategic Management Competitive Strategy/Advantage
1.3.2017 Real Options Tragedy & Genius
8.3.2017 Real Options | Game Theory Negotiation Genius | G.t. YES
15.3.2017 McKinsey‘s Karakolev on Valuation Leadership (Ted + Ian + Collins)
22.3.2017 Game Theory Lean Startup | ScalingUP
29.3.2017 Corp. Valuation: Cash Flow Forecast Playing at Acquisitions|Synergy Trap
5.4.2017 Corp. Valuation: Cost of
Capital; WACC; DCF
Ego is the Enemy | Obstacle is the
Way | Letters from a Stoic
12.4.2017 Corp. Valuation: LBOs, Debt Capacity
Adjusted Present Value
Intelligent Investor | Security
Analysis
19.4.2017 Corp. Valuation: Residual Income Covey | Frankl
26.4.2017 Hands-On – Mr. Zadrapa S. Schwarzman |sir R. Cohen
3.5.2017 Presentations Mindset | Meg Jay
10.5.2017 Surprise
Course Outline 1.

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Big Picture

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Building Blocks
Valuation should assume not only predictable future Cash Flows but also intertemporal &
interasset path dependencies (Real options) and also rival‘sresponses (Game Theory)
Competitive Advantage= Sustainably earning more (than CoC)
Adaptive Capability = Exploiting change in the market
Strategic Position = Interact & Win

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Revision – Class 1.

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Value Drivers
When do you create Value? (hint CoC)
How come there is such a possibility? (hint Value Drivers)

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Porter‘s 5 forces
1) External Approach
Industry Analysis (Michael E.Porter)
Suitable:
Specialization Acquisitions
Buy-and-Build
Consolidation of Industries
Rationale is that Scale
• improves competitive forces
• Increases barriers
• Increases power towards
suppliers|Customers
Unsuitable:
Diversifying strategies
PENTA Case - Healthcare
Cola Wars Case – Any Volunteers?

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Know WindowKnow-Window

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Outlook for today

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Benny‘s Wisdom
It is all about the OPTIONS! (and obviously, choices)

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Today‘s Objectives
Primer
Overview of Common Real Options
Let‘s BID
R&D as an Option
Soup-to-Nuts Application of Oil Exploration Investment

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Financial call option has the same characteristics as a levered
position in the underlying share
Position in the underlying share (equity) of a levered firm is on
itself an option on the firm‘s assets upon debt paydown.
Asset‘s value is a package of embedded corporate real options
RO Valuation = No-Arbitrage Method
Value never < 0
! Certainty Equivalent !
Primer
Let me make your head spin

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Volatility + fierce Competition = shrinking horizon over which
we can confidently estimate cash flows.
Real options add dynamic perspective to how the investment
paths may unfold. Management can learn, adapt and revise
future investment and strategic plans in response to the market
development.
Dynamic perspective is added by incorporating the valua of
this flexibility and growth opportunities.
NPV = “now or never”
Reality = “wait-and-see”
Primer

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Timing (Simple)
The option to delay an investment until more market
information becomes known (e.g. when to start with an
exploration of a resource, when to build a production facility)
Growth (Compound)
The option to grow when an initial investment is made and a
strategic position is acquired (e.g. R&D Investment, Brand-Name
embedded options – to introduce new products)
Operating
The option to abandon, to temporarily shut down, contract and
expand, to switch inputs/outputs which hedges the downside
risk of an investment or captures some upside potential (e.g.
option to temporarily shut down when output prices fall)
Overview of Real Options

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The (proprietary) option to wait is particularly valuable in
resource extraction industries, farming, paper products, and
real estate development due to the high uncertainties, long
investment horizons and limited competitive erosion
Shared investment opportunities. In high-tech industries such
as computers or consumer electronics, competitors can
substantially influence a firm’s opportunity. At a minimum,
exogenous competitive entry may introduce a dividend-like
effect on such a growth option’s value that may justify early
exercise (discussed next); endogenous competitive interactions
can add further complications that require a game-theoretic
treatment
Proprietary vs. Shared

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Real Options
Linking Strategy & Valuation

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The (Simple) Option to Defer
• The most valuablefor
irreversible investments
• Proprietary
• Extraction indust.
• Farming etc.
• Shared
(exogenous competition)
• High-tech indust.

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The (Simple) Option to Defer
Hold my hand valuation (License)
Net Present Value w Scenarios
Option Valuation is risk-neutral
Certainty equivalent
What is INVEST NOW vs WAIT-AND-SEE value?
What is really of interest in an uncertain world is not the value of investment per se, but
rather the value of an opprotunity to invest
Actual Probability = 50%
CoC = 20%
Risk-Free Rate = 8%
Investment Outlay 80 MIO

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Sony & Phillips both consider developing CD technology:
1. Sony goes alone
2. Sony waits and sahres the payoffs 50/50
Option value of the incumbent got eroded by exogenous
competitive entry – Game Theoretic element
A firm anticipating competitive entry, tends to commit to
excess capacity building to preempt the market
In the absence of the exogenous competition, firm might choose
to wait and enjoy the flexibility benefits
Shared option to defer
Exogenous competition

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Project‘s value:
Option to Expand/Contract

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Option to expand: C1 = Max[NPV of expansion (eV- I), 0]
Option to contract: C2 = Max[NPV of contraction (Rc - cV), 0]
Option Portfolio VALUE = C1 | C2 = Max[0, (eV – I), (Rc - cV)]
If +: Max[0, (0.5 x 180 - 40), (35 - 0.5 x180)] = 50 (expand by 50%)
If - : Max[0, (0.5 x 60 - 40), (35 - 0.5 x 60)] = 5 (contract to half the scale)
Expanded PV = static PV + value of the options
= 100 + [0.4x50+0.6x5]/1.08 = 121.3m
Project‘s value:
Option to Expand/Contract

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The Option:
to Abandon Production Capacity

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Expanded Present Value = Static Value V + Max[abandon (A-V), continue]
E+: Max[(V+, A+)] = Max[(180, 137.5)] = 180 = V+ (continue)
E- : Max[(V-, A-)] = Max[(60, 64)] = 64 = A- (abandon)
The Option:
to Abandon Production Capacity

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Option to temporarily
shut down

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Option
to switch inputs

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Options embedded in Stock Prices

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Merging
Strategic Management & Real Options
Established Industries
Porter‘s 5 forces FW
Company should decide
whether to focus on:
• Niche
• Cost Leadership
Emerging Industries
Game Theory vs. Real Options
Company should decide whether
to focus on:
• Market Preemption
• Game theory calc.
• Flexibility Value (a.k.a.
Uncertainty resolution)
• Real options

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Compound Options

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R&D Valuation
PV(t=0) of Inflows = 852 MIO USD
PV(t=2) of Inflows = 1 127 MIO USD
PV(t=0) of Outflows R&D = 63 MIO USD
Investment outlay (at t=2) = 1 200 MIO USD
PV(t=0) of Investment outl. = 1 109 MIO USD
𝜎 = 0,41
u = e%
= 𝟏, 𝟓
d =
1
u
= 𝟎, 𝟔𝟕
CoC= 15%
RF Rate = 4%
3 steps to value a compounded option
1. Construct an event tree of the underlying values
2. Make decision based on conditional payoffs
3. Calculate the PV of the conditional payoffs

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Smit‘s regular wisdom slam
Fancy Haircut-Soren

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Step 1. Extended
Decisions we face:
1. Should we undertake the R&D?
2. Should we invest afterwards?
Flexibility element is absolutely crucial!
Without it only a fool would undertake
R&D ventures.
Notice the similarity with call option:
Time to maturity: 2yr (European)
Exercise price: 1 200 MIO USD
Vega(Volatility): captured by sigma 0,41
The optimal decision is determined at the
end-node!
Remember, the worst possible outcome
after the exploration can be 0!

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Step 3. Calculate PV of the Payoffs
𝑝 =
1 + 0,04 − 0,67
1,5 − 0,67
= 0,45
𝐶 =
𝑝 ∗ 𝑉:
+ 1 − 𝑝 ∗ 𝑉;
1 + 𝑟
𝐶 =
0,45 ∗ 717 + 0,55 ∗ 0
1,04
= 310

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Winners Curse
If the average bid is accurate, than the highest bidder is the sucker!
By definition, winners in auction are lead to overpay
The average bid is unimportant
The more uncertainty there is, the more likely the winner is to overpay
UTS licences – all overpaid!

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1. Exploration Phase
• The option to start TEST DRILLING
• The option to invest in APPRAISAL WELLS
2. Production Phase
• The option to invest in DEVELOPMENT
• The option to abandon
3. Resolved Uncertainty
• Uncertainty in the Quantity
• Uncertainty in Oil Prices
Nested Options and Resolved Uncertainty

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Valuing the Production Phase
Estimate BRENT CRUDE Oil Futures Price
Based on a construction of a portfolio on capital markets with identical
payoffs and risk exposure as the project

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Reserve Valuation
Proven reserves vs. Volatility
The more uncertain the outcome,
the more valuable the option

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• Application is a MINDSET! Translate the quantitative logic into
qualitativethinking about investment opportunities
• As a valuation tool: The valuation part can create additional value by
quantifying the merits of strategic alternatives and helping assess tradeoffs
and attach price tags in investment decisions. The framework can
provide clear management recommendations and executable
actions.
• Real-life projects are often more complex, and may involve a collection of
interacting real options. Sometimes there may be a synergistic effect, but
the combined value typically is less than the sum of the parts.
Summary

Real options

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