Finance, Real Options, Pricing Chapter

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Financial Analysis

Introduction ( a )

A real option is just that -- the option to do something, if a particular situation arises. The principle is the same as for a financial option. The difference is that real options pertain to physical things -- usually pieces of equipment, real estate or other such assets (Investopedia, 2015). An example of a real option would be when you sign a lease on a piece of equipment, with an option to buy after a year. If the equipment is scarce, that option might have value. Licensing arrangements can also contain real options in them as well. The key to the concept of the real option is that there is a value to such options, and the company should be aware of how to value real options.

Analyzing Real Options (b)

There are only really two methods for analyzing real options -- financial and non-financial. The financial approach can use any number of different measures and formulae to determine the value of the option. This will depend in part on the time frame. As with financial options, a real option's value at the time of the exercise decision is easiest to analyze. A real option's financial value is its NPV, IRR or other project metric that a company would otherwise use in a capital budgeting decision. The option has a value that is determined by the net present value of its future cash flows, relative to the cost of investment. So an option to buy a warehouse that the company has been leasing is worth whatever that purchase will cost, versus the benefits that the warehouse brings. Things like payback period are also sometimes used, though they probably should not be because of the inherent flaws in such techniques. Often, it is fairly straightforward from a financial analysis perspective to calculate all different metrics and use them to make a decision to whatever degree the management team prefers.

A non-financial approach would be more based on strategic considerations. To some degree, these can be quantified as well, and should be wherever possible. However, if something either cannot be quantified or is difficult to quantify in a realistic way, then strategic factors will also be taken into consideration -- how good is that option for the business.

The $70 Million Project ( c )

The first thing to note is that the expected cash flows for this project, which are the weighted-average cash flows are still $30 million per year. Thus, the net present value for this project will be as follows:

Year

0

1

2

3

Cost

-70

FCF

30

30

30

PV FCF

74.61

NPV

4.61

d

0.1

The net present value for this project is $4.61 million.

What a Delay Means (d)

If there is a delay in the timing of the investment, that will change the value of the investment. For example in this situation, the different revenue streams will be known with greater certainty. That will change the expected cash flows, because it will change either the value of the outlying (best, worst) case scenarios or it will change their likelihood. Further, the risk associated with the project may be lower overall, where there is greater certainty built into the cash flows. In the above model, cash flow risk was generally built into the weighted-average expected cash flows using the three (best, normal, worst) case scenarios, so that is where the changes would be reflected to value the same question one year from now.

This isn't a real option, however. There is no "option," just a hypothetical future decision that can be entirely reframed, rejected, replaced, at any point in the interim. For an option to exist, it has to be firm, definable, such that its intrinsic and time values can be calculated. Thus, an option must exist as part of a contract, not as a theoretical future decision. The latter is not a real option. Timing when you put your money into something will affect the future cash flows, but it's not an option because it does not exist in firm, contractual form where the variables can be clearly defined.

The best to value the greater degree of certainty will be determined prior to the analysis. The scenario provided tells nothing about the operations side, but it is the operations side that will tell us more about how the changes is expected demand will manifest.

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Are the outlying numbers going to be closer to the weighted-average because we have more demand data? Or are the odds of outliers going to change? In either case, those are the areas we will look at for making adjustments to the formula.

Decision-Tree ( e )

One of the techniques that can be used to help with decision-making is the decision tree. The example of the $70 million project is pretty simple, which means it uses very basic math, and a decision tree is entirely superfluous, but for more complex sets of decisions, especially where there are nested decisions, a decision tree can provide a good means by which the different potential outcomes can be visualized. Note that decision trees are hard to draw in Word.

The following is an example of using the decision tree on the investment timing example. The numbers are going to be fiction, of course, since as noted we don't know precisely what the new numbers will be -- the point of waiting a year is to get better clarity on the numbers. But we are trying to decide today the value of the project with or without the investment timing option. So to demonstrate, the assumption will be that the refined information on demand will tell us that the outliers are not as great as we presently believe, that the best case scenario is $35 and the worst case scenario is $25. And of course, all of the discounting starts one year later, so the discounting effect is greater. The tree would look like this:

Proceed Today

0.5

0.3

$41.91

$6.29

0.4

$4.61

$0.92

0.3

-$32.70

-$4.90

$2.30

Wait 1 year

0.5

0.3

$15.49

$2.32

0.4

$4.19

$0.84

0.3

-$7.12

-$1.07

$2.09

Total eNPV

$4.40

As we can see, if we wait a year, we will have greater certainty of results, but those results will be less valuable because everything is discounted by an additional year. The project still delivers a positive NPV under the best and normal case scenarios, and a negative NPV under the worst-case scenarios.

Value of Timing Option (f)

The timing option does not have value. First, it is not an option that the company purchases, so there is no market for it. It is simply the value of waiting to gather more information. The value of this will change depending on what assumptions that the company uses, but given the above scenario the NPV of the project is reduced by waiting, because the cash flows are a further one year out. The company loses more by waiting that it will gain by having a greater degree of certainty. But again, the numbers are dependent on the assumptions, and there was no meaningful information in the case that could be used to generate non-fictional numbers for the "delay" scenario. Financial options pricing mechanisms, like Black-Scholes, would not be of any value at all without some basis for generating realistic numbers, and there still needs to be an option that is a genuine option that might have market value.

Two Projects Scenario (g)

This is a straight NPV calculation. It is assumed that by "duplicated" that is identical, so that year four is simply a re-investment year with no positive cash flows.

Year

0

1

2

3

4

5

6

7

Cost

-70

FCF

30

30

30

-70

30

30

30

PV FCF

$77.75

NPV

7.75

d

0.1

The NPV for this would therefore be $7.75 million.

If Demand is High (h)

It is assumed that by "only if the demand is high," that this means only the "best" case scenario is applied. Thus, there is a 30% chance that the second project will be undertaken. The decision tree on that would be:

Proceed Today

0.5

0.3

$70.53

$10.58

0.4

$4.61

$0.92

0.3

-$32.70

-$4.90

$6.60

* This has the second project built into the "best" scenario only. The NPV would be $6.60 in this situation.

Valuation (i)

You wouldn't use a financial option model to value the growth option, because it's not an option. It's a scenario, with a 30% chance of occurring. That's not at all the same thing as an option. An option has to have intrinsic value + time value in order to be valued using something like.....

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