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Real options in investment design, A Real-World Way to Manage Real Options

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Types of real options[ edit ] Simple Examples Investment This simple example shows the relevance of the real option to delay investment and wait for further information, and is adapted from "Investment Example".

Consider a firm that has the option to invest in a new factory. It can invest this year or next year.

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The question is: when should the firm invest? If the firm invests this year, it has an income stream earlier. But, if it invests next year, the firm obtains further information about the state of the economy, which can prevent it from investing with losses.

Next Section They are called real options because they are investments in tangible assets, products, processes, and services rather than financial instruments such as stocks. For financial investments, option-pricing techniques are heavily used to take into account the flexibility issue. The most popular is the Black—Scholes option-pricing model where the option value is determined by five input values of the exercise price of an option, the time to exercise date, the current price of the asset, the variance per period of rate of return on asset, and the risk-free rate of interest. If you plug all these values into the Black—Scholes option-pricing model, you would get a positive value do not forget all options have a positive value.

The firm knows its discounted cash flows if it invests this year: 5M. If it invests next year, the discounted cash flows are 6M with a The investment cost is 4M. If the firm invests next year, the present value of the investment cost is 3. Following the net present value rule for investment, the firm should invest this year because the discounted cash flows 5M are greater than the investment costs 4M by 1M.

Yet, if the firm waits for next year, it only invests if discounted cash flows do not decrease.

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If discounted cash flows decrease to 3M, then investment is no longer profitable. If, they grow to 6M, then the firm invests. This implies that the firm invests next year with a Thus the value to invest next year is 1. Given that the value to invest next year exceeds the value to invest this year, the firm should wait for further information to prevent losses. This simple example shows how the net present value may lead the firm to take unnecessary risk, which could be prevented by real options valuation.

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Staged Investment Staged investments are quite often in the pharmaceutical, mineral, and oil industries. In this example, it is studied a staged investment abroad in which a firm decides whether to open one or two stores in a foreign country. This is adapted from "Staged Investment Example".

The firm does not know how well its stores are accepted in a foreign country.

Making Real Options Really Work

If their stores have high demand, the discounted cash flows per store is 10M. If their stores have low demand, the discounted cash flows per store is 5M.

It is also known that if the store's demand is independent of the store: if one store has high demand, the other also has high demand. The investment cost per store is 8M.

Real options valuation

Should the firm invest in one store, two stores, or not invest? The net present value suggests the firm should not invest: the net present value is But is it the best alternative?

Following real options valuation, it is not: the firm has the real option to open one store this year, wait a year to know its demand, and invest in the new store next year if demand is high.

The value to open one store this year is 7.

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Thus the value of the real option to invest in one store, wait a year, and invest next year is 0. Given this, the firm should opt by opening one store. This simple example shows that a negative net present value does not imply that the firm should not invest. Options relating to project size[ edit ] Where the project's scope is uncertain, flexibility as to the size of the relevant facilities is valuable, and constitutes optionality.

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A project with the option to expand will cost more to establish, the excess being the option premiumbut is worth more than the same without the possibility of expansion. This is equivalent to a call option.

Integrating Options and Discounted Cash Flow

Option to contract : The project is engineered such that output can be contracted in future should conditions turn out to be unfavourable. Forgoing these future expenditures constitutes option exercise.

CFOs tell us that real options overestimate the value of uncertain projects, encouraging companies to overinvest in them. These concerns are legitimate, but we believe that abandoning real options as a valuation model is just as bad. How can managers escape this dilemma? In exploring their reservations about real-option analysis as a valuation methodology, we have come to the conclusion that much of the problem lies in the unspoken assumption that the real-option and DCF valuation methods are mutually exclusive. We believe this assumption is false.

This is the equivalent to a put optionand again, the excess upfront expenditure is the option premium. Option real options in investment design expand or contract: Here the project is designed such that its operation can be dynamically turned on and off.

Management may shut down part or all of the operation when conditions are unfavorable a put optionand may restart operations when conditions improve a call option.

A flexible manufacturing system FMS is a good example of this type of option. This option is also known as a Switching option.

Choosing the Right Model

Options relating to project life and timing[ edit ] Where there is uncertainty as to when, and how, business or other conditions will eventuate, flexibility as to the timing of the relevant project s is valuable, and constitutes optionality. Initiation or deferment options: Here management has flexibility as to when to start a project. For example, in natural resource exploration a firm can delay mining a deposit until market conditions are favorable. This constitutes an American styled call option.

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Delay option with a product patent: A firm with a patent right on a product has a right to develop and market the product exclusively until the expiration of the patent. The firm will market and develop the product only if the present value of the expected cash flows from the product sales exceeds the cost of development.

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If this does not occur, the firm can shelve the patent and not incur any further costs. Option to abandon: Management may have the option to cease a project during its life, and, possibly, to realise its salvage value. Here, when the present value of the remaining cash flows falls below the liquidation value, the asset may be sold, and this act is effectively the exercising of a put option. This option is also known as a Termination option. Abandonment options are American styled.

Sequencing options: This option is related to the initiation option above, although entails flexibility as to the timing of more than one inter-related projects: the analysis here is as to whether it is advantageous to implement these sequentially or in parallel.

Adjusting for Cost

Here, observing the outcomes relating to the first project, the firm can resolve some of the uncertainty relating to the venture overall. Once resolved, management has the option to proceed or not with the development of the other projects.

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If taken in parallel, management would have already spent the resources and the value of the option not to spend them is lost. The sequencing of projects is an important issue in corporate strategy. Related here is also the notion of Intraproject vs.

A Real-World Way to Manage Real Options

Interproject options. Option to prototype: New energy generation and storage systems are continuously being developed due to climate change, resource scarcity, and environmental laws. Some systems are incremental innovations of existing systems while others are radical innovations. Radical innovation systems real options in investment design risky investments due to their relevant technical and economic real options in investment design.

Prototyping can hedge these risks by spending a fraction of the cost of a full-scale system and in return receiving economic and technical information regarding the system. In economic terms, prototyping is an option to hedge risk coming at a cost that needs to be properly assessed.

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This flexibility constitutes optionality. Output mix options: The option to produce different outputs from the same facility is known as an output mix option or product flexibility.

These options are particularly valuable in industries where demand is volatile or where quantities demanded in total for a particular good are typically low, and management would wish to change to a different product quickly if required.

For example, a farmer will value the option to switch between various feed sources, preferring to use the cheapest acceptable alternative. An electric utilityfor example, may have the option to switch between various fuel sources to produce electricity, and therefore a flexible plant, although more expensive may actually be more valuable. Operating scale options: Management may have the option to change the output rate per unit of time or to change the total length of production run time, for example in response to market conditions.

These options are also known as Intensity options. Valuation[ edit ] Given the above, it is clear that there is an analogy between real options and financial options[18] and we would therefore expect options-based modelling and analysis to be applied here.

At the same time, it is nevertheless important to understand why the more standard valuation techniques may not be applicable for ROV. The NPV framework implicitly assumes that management is "passive" with regard to their Capital Investment once committed.

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Some analysts account for this uncertainty by i adjusting the discount rate, e. Real options consider "all" scenarios or "states" and indicate the best corporate action in each of these contingent events. The contingent nature of future profits in real option models is captured by employing the techniques developed for financial options in the literature on contingent claims analysis. Here the approach, known as risk-neutral valuation, consists in adjusting the probability distribution for risk considerationwhile discounting at the risk-free rate.

This technique is also known as the "martingale" approach, and uses a risk-neutral measure.

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