Options in Projects/Investments/Acquis itions One limitation of traditional investment analysis (NPV) is that it is static and does not adequately capture the options embedded in investment – Option to delay an investment, when a company has exclusive rights to it, until a later date – Taking one investment may allow taking advantage of other opportunities in the future – Option to abandon if the cash flows do not measure up These options add value to projects and may make a “bad” investment into a good one.
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Options in Projects/Investments/Acquisitions
One limitation of traditional investment analysis (NPV) is that it is static and does not adequately capture the options embedded in investment– Option to delay an investment, when a company has exclusive
rights to it, until a later date
– Taking one investment may allow taking advantage of other opportunities in the future
– Option to abandon if the cash flows do not measure up
These options add value to projects and may make a “bad” investment into a good one.
Option to Delay
When a company has exclusive rights to a project, product, technology for a specific period, it can delay taking this project or product until a later date
A traditional NPV analysis just answers the question of whether the project is a “good” one if taken today
Thus, the fact that a project has negative NPV today does not mean that the rights to this project are not valuable
Valuing the Option to Delay a Project
PV Expected Cash Flows
PV Cash Flows
From Project
Initial Investment in Project
- NPV range + NPV range
Insights for Investment Analyses
Having the exclusive rights to a product, project, or technology is valuable, even if it is not viable today.
The value of these rights increases with the volatility of the underlying business
The cost of acquiring these rights (by buying them or spending money on development, or by acquisition) has to be weighted against these benefits
Example 1: Valuing Product Patents as Options
A product patent provides the company with the right to develop the product and market it
It will do so only if the PV of the expected cash flows from the product sales > cost of development
If not, the company can shelve the patent and not incur any further costs
If I is the PV of the costs of developing the product, V is the PV of expected cash flows from development, the payoffs from owning a product patent are:
Payoff = V - I if V > I = 0 if V < I
Payoff on Product Option
PV Expected Cash Flows On product
Net payoff to
introducing product
Cost of product introduction
6 Levers of Financial Options
Uncertainty
Stock Price
DividendsRisk-Free
Exercise Price
Time to Expiry
6 Levers of Real Options
Unpredictability of cash flows
PV Cash Flows
Value lost over duration of optionRisk-Free
PV fixed costs
Period for which opportunity is valid
Inputs for Patent ValuationInput Estimation Process
1. Value of underlying asset - PV of cash flows from taking project now
2. Variance in value of underlying asset - Variance in cash flows of similar assets or firms
- Variance in PV from simulation
3. Exercise Price on Option - Option is exercised when investment is made- Investment cost assumed to remain constant
4. Expiration of the Option - Life of the patent
5. Dividend Yield - Cost of delay. Each year of delay is one less year
of value-creating cash flows- cost of delay/year = 1/n
NPV Simulation
Valuing a Product Patent: Avonex
Biogen has a patent on Avonex, a drug to treat MS, for the next 17 years, that it plans to produce and sell by itself. Key input assumptions:
PV Cash Flows from Introducing Drug Now = S = $3.422 billion PV Cost of Developing Drug for Commercial Use = K = $2.875
Patent life = t = 17 yrs Rf = 6.7% (17-year T-Bond) Variance of E(PV) = 0.224 (industry avg bio-tech firms) Expected Cost of Delay = y = 1/17 = 5.89%
Low High Likelihood of Receiving New Information Likelihood of Receiving New Information
Uncertainty
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Flexibility Value Greatest When:
1. High uncertainty about the future Very likely to receive new information
over time2. High room for managerial flexibility
Allows management to respond appropriately to this new information
1. High uncertainty about the future Very likely to receive new information
over time2. High room for managerial flexibility
Allows management to respond appropriately to this new information
+
3. NPV without flexibility near zero If a project is neither obviously good
nor obviously bad, flexibility to change course is more likely to be used and therefore is more valuable
3. NPV without flexibility near zero If a project is neither obviously good
nor obviously bad, flexibility to change course is more likely to be used and therefore is more valuable
Under these conditions, the difference between ROA and other decision tools is substantial
Under these conditions, the difference between ROA and other decision tools is substantial
In every scenario flexibility value is greatest when the project’s value without flexibility is close to break even
In every scenario flexibility value is greatest when the project’s value without flexibility is close to break even
The flexibility value comes from the ability to respond to information that may be received in the future. The greater the likelihood that this new future information will elicit a managerial response and alter the course of a project, the more value the option will have
Valuing a Company with Patents
Value = Value of Commercial Products (DCF) + Value of existing patents (OPM) + Value of New Patents obtained in the future – Cost of Obtaining Patents
The last term measures the efficiency of the company in converting R&D into commercial products. If we assume R = K from research, this term is 0.
Note: do not double count and allow for a high growth rate in cash flows in the DCF valuation.
Value of Biogen’s Existing Products
Biogen had 2 commercial products that it had licensed to other pharmaceutical firms (Hepatitis B, Intron).
The license fees on the two products were expected to generate $50m in after-tax cash flows each year for 12 years.
Biogen continued to fund research into new products, spending $100m on R&D, expecting to grow 20% per year for 10 years, and 5% thereafter.
From past experience, every $ invested in R&D would create $1.25 in value in patents (valued using OPM described above) for 10 years, and breakeven after that
Cost of capital = 15%, given the risk
Value of Future R&DYear Value of Patents R&D Cost Excess Value PV (15%)
Value = Existing Products + Existing patents (Avonex option) + Value Future R&D
= $403.6 + $907 + $318.3 = $1,628.9 M Biogen had 35.5m shares outstanding, no debt
Value per share = $1,628.9/ 35.5 = $45.88 per share
Example 2: Valuing Natural Resource Options In a natural resource investment, the underlying asset is the
resource and the value of the asset is based on 2 variables: quantity and price of the resource available
There is a cost associated with developing the resource, and the difference between the value of the asset extracted and the cost of the development is the profit to the owner of the resource
If X is the cost of development, V is the estimated value of the resource, the potential payoffs on an natural resource option can be written as:
Payoff on natural resource investment = V - X if V > X = 0 if V < X
Payoff on Natural Resource Firms
PV Expected Cash Flows from natural
resource reserve
Net payoff
On extraction
Cost of developing reserve
Inputs for Natural Resource OptionsInput Estimation Process
1. Value of available reserves of the
resource
- PV of cash flows from resource (expert estimates, geologists on oil, etc.)
2. Variance in value of underlying asset - Variability of price of the resources and variability of available resources
3. Cost of Developing reserve
(exercise price)
- Past costs and the specifics of the investment
4. Time to Expiration - Relinquishment period or time to exhaust inventory, based on inventory and capacity output
5. Net production revenue (Dividend
Yield)
- Net production revenue every year as a % of market value
Valuing an Oil Reserve
Consider an offshore oil property with an estimated oil reserve of 50 million barrels of oil, where the PV of the development cost is $12/barrel and the development lag is 2 years
The firms has the rights to exploit this reserve for the next 20 years and the marginal value/barrel is $12 (price/barrel – marginal cost/barrel
Once developed, the net production revenue each year will be 5% of the value of the reserves
The risk-free rate is 8% and the variance in ln(oil prices) is 0.03
Inputs to Option Pricing Model
Current value of the asset = S = Value of the developed reserve discounted back the length of the development lag at the dividend yield = $12 * 50/(1.05)2 = $544.22
Note: If development is started today, the oil will not be available for sale until 2 years from now. The opportunity cost of this delay is the lost production revenue over the delay period, hence, the discounting of the reserve back at the dividend yield
Exercise Price = PV of development cost = $12 * 50 = $600 Time to expiration the option = 20 years Variance in the value of the underying asset = 0.03 Risk-free rate = 8% Dividend Yield = Net production revenue/Value of reserve = 5%
Valuing the Option
Based on these inputs, the Black-Scholes model provides the following value for the call:
d1 = 1.0359 N(d1) = 0.8498 d2 = 0.2613 N(d2) = 0.6030 Call Value = 544.22e(-.05)(20) (0.8498) – 600e(-0.08)(20) (0.6030) = $97.08 This oil reserve, although not viable at current prices,
still is a valuable property because of its potential to create value if oil prices go up.
Option to Expand/Follow-On Projects
Taking a project today may allow a company to consider and take other valuable projects in the future
Therefore, even though a project may have a negative NPV, it may be a project worth taking if the option it provides the company to take other projects in the future provides a compensatory value
These are the options that companies often call “strategic options” and use as a rationale for taking on “negative NPV” or even “negative return” projects
Option to Expand
PV Expected Cash Flows on Expansion
PV of Cash Flows
From Expansion
Additional Investment to Expand
Company will not expand
in this section
Expansion becomes attractive
in this section
Option to Expand: Example
AmBev is considering introducing a soft drink to the U.S. market. The drink will initially be introduced only in the metropolitan areas of the U.S. and the cost of this limited introduction is $500m
A financial analysis of the cash flows from this investment suggest that the PV of the cash flows from this investment to AmBev will be only $400m. Thus, by itself, the new investment has a negative NPV of $100m
If the initial introduction works well, AmBev could go ahead with a full-scale introduction to the entire market with an additional investment of $1b any time over the next 5 years. While the current expectation is that the cash flows from having this investment is only $750m, there is considerable uncertainty about both the potential for the drink, leading to significant variance in this estimate
Valuing the Expansion Option
Value of Underlying Asset (S) = PV of Cash Flows from expansion to entire U.S. market, if done now = $750m
Exercise Price (K) = Cost of Expansion into entire U.S. market = $1,000m
σ of project value = annualized σ in value of publicly-traded companies in the beverage markets = 34.25%
Time to expiration = period for which expansion option applies = 5 years
Call Value = $234 m
Project with Expansion Option
NPV of limited introduction = $400 - $500 = -$100 m Value of Option to Expand to full market = $234m NPV of project with option to expand
= - $100 + $234
= $134 Invest in Project !
NPV’ = NPVpassive + Option Value
Link to Strategy
In many investments, especially acquisitions, strategic options or considerations are used to take investments that otherwise do not meet financial standards
These strategic options or considerations are usually related to the expansion option described here. Key differences are:– Unlike “strategic options” which are usually qualitative and not
valued, expansion options can be assigned a value and can be incorporated into the investment analysis
– Not all “strategic considerations” have option value. For an expansion option to have value, the first investment (acquisition) must be necessary for the later expansion (investment). If not, there is no option value that can be added on to the first investment
The Determinants of Real Option Value
Does taking the 1st investment/expenditure provide the firm with an exclusive advantage on taking on the 2nd investment?– If yes, the firm is entitled to consider 100% of the value of the real
option– If no, the firm is entitled to only a portion of the value of the real
option with the proportion determined by the degree of exclusivity provided by the 1st investment
Is there a possibility of earning significant and sustainable excess returns on the 2nd investment?– If yes, the real option will have significant value– If no, the real option has no value
The Exclusivity Requirement in Option Value
Is the 1st investment necessary for the 2nd investment?
Not necessary Pre-Requisite
Zero Competitive Advantage on 2nd Investment
Exclusive Right to 2nd Investment
No Option Value 100% of Option Value
The Exclusivity Requirement in Option Value
Zero Competitive Advantage on 2nd Investment
Exclusive Right to 2nd Investment
No Option Value 100% of Option Value
Increasing competitive advantage / Barriers to entry
Threa t o f pre- em ptio n ; the m a rketpo w er o f do m ina nt firm s increa sestheir ab ility to o bta in fu ll va lue o fthe o ptio ns exercised .
Tendency to de la y o ptio n exerciseuntil the w ea ker p layers exercisethem .
N o threa t o f to ta l p re- em ptio n ; butrisk o f lo ss o f va lue o f the o ptio nbecause o f co m petitio n .
Tendency to exercise the o ptio n ea rlyin o rder to a vo id ero d ing the va lueo f the o ptio n .
D o m ina nt firm s ca n benefit fu lly fro mthe va lue o f the o ptio n .
N o risk o f pre - em ptio n ; o ptio ns a reheld until m a turity.
Little a b ility to benefit fro m the fu llva lue o f a n investm ent o ppo rtunity.
Q u ick exercise o f o ptio ns in orderto surpa ss a co m petito r o r fo rdefensive rea so ns.
Proprieta ryO ptions
M inima lCompetitive
Riva lry
Figure 11. Stra tegy a nd O p tion Va lue
Internet Companies as Options
Some analysts have justified the valuation of Internet companies on the basis that you are buying the option to expand into a very large market.– Is there an option to expand embedded in these
companies?– Is it a valuable option
NPV’ = NPVpassive + Option Value
Amazon.com: Building Value Through Options
Start
Success
Success
Success
Failure
Failure
Failure
Books Music Video
Amazon.com: Building Value Through Options
DCF books
Option Value
DCF books
DCF Music
Option Value
DCF books
DCF Music
Option Value
DCF Video
Mar
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TIME
Value of whole strategy
Product call 1st expansion call (2nd expansion
Introduction value option value option)PV + +
Option to Abandon
A firm may sometimes have the option to abandon a project, if the cash flows do not meet expectations
If abandoning the project allows the firm to save itself from further losses, this option can make a project more valuable
Payoff on Put Option
Price of underlying asset
Net payoff on put
Exercise price
If asset value > exercise price, you lose what you paid for put
Option to Abandon
PV Project Expected Cash Flows
PV Cash Flows from Project
Cost of Abandonment
Valuing the Option to Abandon
Airbus is considering a joint venture with Lear Aircraft to produce a small commercial 40-50 passenger airplane on short haul flights– Airbus will have to invest $500m for a 50% share of the
venture– Its share of the PV of Expected Cash Flows is $480m
Lear Aircraft offers to buy Airbus’ 50% share of the investment anytime over the next 5 years for $400m, if Airbus decides to get out of the venture
A simulation of the cash flows yields a variance of the PV of expected cash flow from the partnership of 0.16
Project life is 30 years
Valuing the Option to Abandon Value of Underlying Asset (S) = PV of Cash Flows
from project = $480m Exercise Price (K) = Salvage Value from Abandonment = $400m σ2 in Underlying Asset’s value = 0.16 Time to expiration = Life of the Project= 5 yrs Dividend Yield = 1/Life = 1/30 = 0.033 (i.e. PV will drop by 1/30 each year) Rf = 6%
Put Value = $73 m
Should Airbus Enter the Joint Venture?
Value of Put = Ke-rt[1 – N(d2)] – Se-yt[1 – N(d1)]
= $73m Value of abandonment option has to be added to the
NPV of the project of -$20m, yielding a total NPV with the abandonment option of $53m
Implications for Investment Analysis Having an option to abandon a project can make otherwise
unacceptable projects acceptable Actions that increase the value of the abandonment option:
– More cost flexibility, i.e., make more of the costs of the projects into variable vs fixed costs
– Fewer long-term contracts/obligations with employees and customers because these add to the cost of abandoning a project
– Find partners in the investment who are willing to acquire your share of the investment in the future
These actions will cost the firm some value, but this has to be weighted off against the increase in the value of the abandonment option
Option Analysis at Merck
Project Gamma - new line of business that required the acquisition of appropriate technologies from a small biotech company called Gamma
Merck would make a $2 million payment to Gamma over a period of three years
Merck would pay royalties to Gamma should the product ever come to market
Merck had the option to terminate the agreement at any time if dissatisfied with the research
Option Analysis at Merck
Merck’s finance group used the Black-Scholes option-pricing model
– Exercise price = capital investment to be made 2 years hence
– Stock price = present value of cash flows from the project
– Time to expiration = varied over two, three and four years (with market entry unfeasible after four years)
– Volatility = standard deviation of returns for typical biotech stocks
– Risk-free interest rate = U.S. Treasury rate over the two to four year period
Example:
Business Plan: Option to Launch New Product
Business Plan
Spend $12M on Market Launch
If Launch, obtain value of established participant
Year
1
Year
2
Year
3
Raise $4M
X
spend $0.5M/quarter on product development
fixed cash flow
optional cash flow
But there is no obligation to launch the product, only an option
NPV has 2 parts “hardwired” investment schedule single roll of the dice on revenue
Recognizing the option to launch multitude of outcomes optimal response to each outcome, including the no launch
decision
Valuing the option to launch
Black-Scholes formula was a Nobel Prize winning breakthrough
When applicable, the Black-Scholes formula is an easy-to-use and quick “option calculator”
Beauty of formula No-arbitrage pricing only 5 inputs no forecasting
A Generic Example
Types of Option Flexibility
Option to Defer Option to Default Option to Expand Option to Contract Option to Shut Down Option to Abandon Option to Switch Use Corporate Growth Options
An Oil Extraction and Refinery Project
1-yr lease on undeveloped land with potential oil reserves Initial exploration costs I1
Processing facility I2
Extraction can begin only after construction is complete Management can choose to reduce scale of operation by c%,
saving a portion of the last outlay IC or
Processing can be expanded by x% with a follow-up outlay of IE
At any time management can salvage a portion of its investment or switch them to an alternative use A.
The Option to Defer Investment
The lease enables management to defer investment and benefit from resolution of uncertainty about oil prices
Early investment sacrifices the option to wait and the option value loss is like an additional opportunity cost
Investment is justified only if the value of cash benefits actually exceeds the inital outlay by a substantial premium
The option to wait is extremely valuable in resource extraction industries due to high uncertainties and long investment horizons
The Option to Default During Construction
The staging of capital investment outlays over time create options to “default” at any given stage
Thus each stage can be viewed as an option on the value of subsequent stages
This option is valuable in highly uncertain, long-development capital intensive industries and R&D industries
The Option to Expand
If oil prices are more favorable than expected, management can expand the scale of production by x% by incurring a follow-up outlay of IE
This is similar to a call option to acquire and additional part (x%) of the base project, paying IE as exercise price
Management may deliberately favor a more expensive technology for the built-in flexibility to expand production if and when it becomes desirable - allows management to capitalize on future growth opportunities
Can make a seemingly unprofitable NPV project worth undertaking
The Option to Contract
If market conditions are weaker than expected, management can reduce the scale of operations by c% and save part of investment outlays IC
This is analogous to a put option on part (c%) of the base project with exercise price equal to IC savings
May be valuable for new product introductions in uncertain markets
May be preferable to build a plant with lower initial construction costs and higher maintenance expenditures in order to acquire flexibility to contract by cutting maintenance
The Option to Shut Down (and Restart) Operations
If the costs of switching between operating and idle modes are small, it may be better to suspend operations temporarily when revenues do not cover variable costs
Operations in each year are a call option to acquire that year’s cash revenues by paying the variable costs of operation as the exercise price
The options are typical in the natural resource industries,
cyclical industries and consumer good industries
The Option to Abandon
Abandoning the project permanently in exchange for its salvage value
Can be valued as a put option on the current project value with the exercise price the salvage value or best alternative use value
Found in capital intensive industries, financial services and in new product introductions in uncertain markets
The Option to Switch Use
Suppose the oil refinery can be designed to use alternative forms of energy inputs (oil, gas, electricity) to process oil
The firm should be willing to pay a premium for such a flexible technology
Can gain this flexibility through technology, relationships with suppliers, subcontracting, locating production facilities in other countries
Valuable option in feedstock-dependent facilities Product flexibility (alternative outputs) is valuable for auto and
pharmaceutical manufacturers
Corporate Growth Options
Many early investments can be seen as links in a chain of interrelated projects
The value of these projects can not be derived from directly measurable cash flows, but from unlocking future growth opportunities
For example, investment in a first generation high-tech product is an option on options
Despite its negative NPV, the infrastructure, experience and potential by-products act as springboards for future generations of that product or new applications into other areas
Examples of Options Embedded in Strategic Acquisitions
Examples of Growth Options
A computer firm purchases another software start-up company rather than developing its own competing software.
An international airline acquires a U.S. airline to break into the U.S. market and increase traffic on existing or potential future routes.
A large publishing firm buys a smaller niche periodical firm enabling launches into related specialized periodicals in the future.
Examples of Flexibility Options
A firm in the aggregates business buys undeveloped quarry sites which have future potential for municipal waste disposal.
A diversified retailer switches use of shopping mall leased space in response to varying market conditions for each business.
A newsprint maker with virgin fiber mills acquires a mill capable of using recycled fiber.
Examples of Divestiture Options
An acquirer can divest real estate with a more valuable alternative use.
An acquiring airline can sell off selected routes or airport gates after purchasing another airline.
An acquirer sells companies that have not met growth targets, thereby truncating downside risk
You cannot analyze everything using Black-Scholes!
American and exotic option features Path dependency Compound options Multiple underlyings Logical inconsistency
Important nuances
Mapping the project back to a traded asset. If not, may need to calculate a risk premium.
Returns to ownership. What is analogue to the dividend received by a stock?
Multiple risk factors.
Current Industry Applications of the Real Options Approach
Valuing R&D and patents Drug development Value of vacant land Venture capital investments Flexible capacity expansion Oil exploration and development Flexible manufacturing Value of electricity generation capacity Intellectual property Value of growth options in M&As
Conclusion:The Real Value of Real Options
Reshaping our thinking about strategic investments under uncertainty
Communicating value internally and to the financial markets
Making strategic decisions that increase shareholder value
Conclusion:The Real Value of Real Options
Growth related options significantly undervalued by traditional tools
Need to change the frame of reference: Face the uncertainty Identify the options Is the value of the option > cost of acquiring or maintaining it? What does it take to keep the option alive and valuable?
Option-based decision-making links strategy and valuation
Strategic Planning and Financial Theory
Strategic Investments
Options Analysis
Managing a Portfolio of Options
Strategic PlanningOptions Management
Acquiring Options– Investing in R&D– Product Design– Loss-Leaders
Abandoning Options– Abandon options far “out of the money”
