© 2005 Real Options Group

Executive Training & Conferences

Real Options and Strategy

Lenos Trigeorgis

Objectives Why useful to know about real options Recognizing real options NPV and managerial flexibility Types of real options Valuing real options (principles) Competition & strategy Benefits of real options Areas of application

Flexible Plans

action plan

Expected plans

Time

Strategy

volatile marketsCurrent state Desired future states

Uncertainty

competition

Opportunities

new capabilities

flexibility

information

long-term strategy

Real Options/Flexibility Under Uncertainty

Example: Flexible Airline Ticket

right (but not obligation) to take a particular flight

pay more for an open ticket because it allows flexibility

- can change date of travel or destination

price difference between a flexible and fixed ticket reflects the

option value- additional value of flexibility to (adapt your plans to) changeflexibility

Recognizing Real Options

Real Options Ingredients

flexibility, choice or right (but not obligation) to do something (take a contingent course of action) only if beneficial

- upside-enhancing actions if circumstances prove favourable- downside loss-limiting actions if they prove unfavorable

specified cost to exercise the right

uncertainty - range of possible (value) outcomesoption ingredients

Recognizing Real Options

NPV and Managerial Flexibility

Traditional

Expected scenario of cash flows over prespecified life (discount ed at risk – adjusted rate, e.g., from

CAPM)

Treating projects as independent, make immediate accept/reject decision

I

k1

CEIVNPVE t

t

Ik1

CEt

t

rrrk M

NPV and Managerial Flexibility (cont.)

As if passive management; irrevocable commitment to implied “operating strategy” In reality, management can depart from original operating strategy/revise later decisions (e.g. defer, expand, abandon) Managerial flexibility as a collection of corporate real options Conventional NPV does not adequately account for options/flexibility due to discretionary character/ dependence on future events uncertain at present

Expanded (Strategic) NPV = Passive NPV + Real Option Value

Ik1

CEt

t

Traditional NPV: Limitations

Cannot properly account for active management (flexibility to adapt)

Ignores “strategic” value considerations

I

k1CE

tt

With uncertainty and managerial flexibility, NPV (DCF ) is inadequate to properly capture the asymmetries/ nonlinearities in the cash-flow distribution and the changing project risk profile or discount rates (across time and various states)

Managers understand resource allocation is a dynamic (and non-linear) process

Past Attempts toward Flexibility

Sensitivity analysis Scenario planning (correlated) Simulation (Monte Carlo) Decision (Tree) Analysis “Fudging” the discount rate in DCF Who sponsors (“champion”); “strategic” value

Incorporating Flexibility (Now)

Real options can capture the value of managerial operating flexibility and “strategic” value Real options can occur naturally or may be built in /acquired (at cost)

A firm may acquire real options through

Acquiring Real Options

Ownership of natural resources (real estate, oil field…) Technological Knowhow Reputation / Brand name Strategic alliances / Market position Organizational capabilities / Infrastructure, employees Intellectual property rights (patents, licenses,

leases…)

Some Common Types (Examples)

1. Defer 2. Staging/Abandon3. Expansion (Growth)4. Shut Down and Restart5. Switch (Operating Flexibility)6. Multiple Options (Portfolios)7. Interacting Options

Example 1 – Deferral Option(Oil company E&P license)

oil E&P license

Context- North Sea oil company acquired a number of licence blocks- E&P rights to explore and produce oil over next 8 years- at prevailing energy prices, most energy blocks unprofitable

(high development costs)

Categorizing (Common) Real Options

Example 1 – Deferral Option

Real Options Approach- some blocks may be uneconomic to develop now but could hold significant value in future should oil prices rise- oil company has flexibility to decide optimal timing to develop- develop (exercise option) when prices rise sufficiently to make production profitable

timing flexibility

Common Real Options

Example 1 – Deferral Option

development guidelines

DevelopmentRights

volatile oil pricesDevelop OperateOperate

INVEST

Common Real Options

Example 2 – Staging/Abandon Option

(Pharma R&D)

pharma R&D

Context

- Pharma R&D investment structured in multiple stages and full of uncertainties (a) technological uncertainty (to invent safe and effective products) (b) market uncertainty (probable demand for the drug)

Common Real Options

Example 2 – Staging/Abandon Option

Staging/gates

Stage 1:Initial

Research

Stage 2:Development/Clinical Trials

Stage 3:Marketing

Uncertainty: technologically feasible?

Uncertainty: safe product?

Uncertainty: demand for drug?

Yes YesYes

No

Launch Drug

Abandon Abandon Abandon

No No

Common Real Options

Example 3 – Expansion (Growth) Option

(Bookseller Online)

Context- leading retail bookseller interested in selling products online- company excited about the spectacular growth of the Internet but unsure about the economics (early online retailers have seen spectacular growth but also low negative cash flows)- potential for cross selling into other areas (music, software…)

B2C eCommerce

Common Real Options

Example 3 – Expansion Option

expansion policies

Retail book sales

Sell BooksOnline

Sell Software

Online

Sell MusicOnline

Uncertainties: Demand growth?Competition?Capability?

Exercising the first option opens up numerous cross-

selling options

Common Real Options

Example 4 – Shut Down & Restart Option

(Energy Co’s Peak Power Plants)

peak power

Context - US energy company investing in new, inefficient peak power plants

(have 50-70% above-average marginal costs)- cheaper to build than more efficient plants

- peaking plants extremely profitable in short periods when electricity prices peak

- extreme volatility in power prices (can vary from $40 to $7000/MWh)

Common Real Options

Example 4 – Shut Down and Restart

Operating guidelines

OperatingRights

volatile electricity pricePowerOn

PowerOn

PowerOn

Common Real Options

marginal cost

Example 5 – Switch Option(Multinational Auto Production)

auto production

Context- US-based multinational auto producer considering where to base Latin American production facilities supplying region- concerned about exposure to

- exchange rate fluctuations- changing labor costs and tax policies - political uncertainty

Common Real Options

Example 5 – Switch Options

switch triggers

Produce Cars in Brazil

Uncertainties: Exchange Rate?Labor costs?Govt policies?

Switch toArgentina

Common Real Options

Example 6 – Multiple (Portfolio) Options

(Venture Capital)

venture capital

Context- Venture Capitalists manage portfolios of many investment opportunities- Each individual opportunity has a small chance of a very high payoff (with expected return close to zero)- Portfolio provides handsome returns (25-35%) due to flexibility to abandon failing projects while expanding successful ones as uncertainty about the venture gets resolved

Common Real Options

Example 6 – Multiple (Portfolio) Options

portfolios

ROI

Project 1

Project 2

Project 3

Project 4

Project 1

Project 2

Project 3

Project 4

Ideas

Terminated

Successful venture (exit/ sale)Breakeve

n

t=0 t=1 t=2

OPTION TO EXERCISE Usual VC Statistics

10% Success60% Breakeven30% Failure

Biz Plan

Option 1Option 2Option 3

25-35% ROI

Expected distributionof outcome for anindividual venture

Expected distribution of outcome for a VC portfolio

Common Real Options

0

trigger states

Un

cert

ain

un

der

lyin

g v

alu

e

unfavourable

Favourable

developments

Expand

Continue

Abandon

Time

Action Plan

Understanding Real Options

Options /Asymmetry in NPV Distribution

Ik1

CEt

t

Call Options on Stock vs. Real Options

Stock Call Option

Stock price

Exercise price Time to expiration

Stock return volatility Riskless interest rate Dividends

Real Option

(Gross) PV of expected cash flows Investment cost Time until opportunity disappears (patent, compet. entry)Project value (%) uncertainty Riskless interest rate Early operating cash flow or competitive erosion

Industry Volatility and PVG0/Price for Representative Industries

INDUSTRYPVGO/P

Market Model Risk free rate +6% premium

84% 83%

92% 83%

83% 70%

62% 38%

46% 47%

60% 48%

81% 72%

81% 55%

Information Technology 23%

Pharmaceuticals 14%

Consumer Electronics 26%

UNCERTAINTY2)

Transportation 9%

Chemicals 6%

Electric power 4%

Food 6%

Banking 6%

Source: Smit & Trigeorgis, Risk (1999)

Note: Volatility ( 2 ) is estimated as the variance of monthly returns; PVGO is

estimated by subtracting the discounted value (with the discount rate estimated from the market model or the risk-free rate plus a 6% risk premium) of its perpetual stream of earnings (under a no-growth policy) from its market price (6/30/98)

Opportunity to invest I = $104 (m) in a project (plant) that a year later (at t = 1) will have realizable value of either V+

= $180 or V- = $60(k = 0.20, r = 0.08)

Valuing Real Options/Principles

A Generic Example

V= 100

V += 180

V -=60

q=0.5

0.5

Under traditional NPV, gross value of project´s cash inflows

V = [q V+ + (1 - q) V- ] / (1 + k) = [.5 x 180 + .5 x 60] / (1 + .20) = 100

Generic Project and “Twin Security”

V+=180, S+=36

V-=60, S-=12

V=?, S=20

q=0.5

1-q=0.5

I=104, k= 20% (CAPM), r=8%

t

t

k

CV

)1(V: PV of project´s expected cash inflows S: “twin security” priceI: required investment outlay E: value of investment opportunity to firm´s equityholdersk: discount rate (expected rate of return)r: risk–free interest rate

NPV = V-I

1-p

p=0.4 V+=180

V-

=60

V=100

Note also that (with risk-adjusted probability, p) V = [p V+ + (1-p) V-] / (1 + r) = [.4 x 180 + .6 x 60] / (1 + .08) = 100 (same)  Passive NPV = V – I = 100 – 104 = -4 (<0) Reject?  Expanded (Strategic) NPV = Passive NPV + Real Option Value

Risk-adjusted Probabilities

u=1.8

d=0.6

V+=180

V-=60

V=100

S+=36

S-

=12

S=20

E(R) = r p.u + (1-p).d = 1+ r

p = [(1 + r) - d]/(u - d) = = [1.08 - 0.6]/(1.8 - 0.6) = 0.4

p.S+ + (1-p)S- = S(1+ r)

p = [(1 + r)S - S-]/(S+ - S-) = [1.08×20-12]/(36-12) = 0.4

Option to Defer

Suppose the firm has a one-year license (patent/lease) giving it exclusive right to defer for a year

Call (E)180-112=68

1-p

p=0.4

t =0I=104

V=100

V+=180

V-=60t=1

Like call option on project value V with EX = I1 = 112(with I0 = 104 assumed to grow in one year at 8% to I1 = 112)

E+ = max (V+ - I1, 0) = max (180 – 112, 0) = 68 (invest)E- = max (V- - I1, 0) = max (60 – 112, 0) = 0 (do not invest)

0

With p = [(1 + r) S – S-] / (S+- S-) = [(1.08) 20 – 12] / (36 – 12) = 0.4 (vs. q = 0.5)  Total value of investment (expanded NPV with option to defer): E0 = [p E+ + (1 – p) E-] / (1 + r) = [ .4 x 68 + .6 x 0] / 1.08 = 25  Real Option Value (defer option/lease) = Expanded NPV – Passive NPV 

= 25 – (-4) = 29 (% of V)

Option to Expand (Growth Option)

p=0.4

1-p

V=100

V+=180

V-=60

Consider additional follow–on investment (expansion) if product does better

Original investment opportunity thought of as initial (base) scale project plus call option on future (expansion/growth) opportunity: V + max(eV – Ie, 0) Option to invest additional Ie= $80 next year

which would double scale and value of project/plant (e = 1) Now E = V + max(V - Ie, 0) = max(V, 2V - Ie)

V=100

V+=180

V-=60

E+ = max(V+, 2V+ - Ie´) = max(180, 360 – 80) = 280

(expand/double scale) E- = max (V-, 2V- - Ie

´) = max (60, 120 – 80) = 60 (same/base scale) Value of investment opportunity (with follow on option to expand): E0 = [p E+ + (1-p) E-] / (1 + r) – I0

= [.4 x 280 + .6 x 60] / 1.08 – 104 = 33 Option to expand = 33 – (-4) = 37 (or 37% of V)

$104 { Ic = $58 (FV of $54) in year t = 1 Option to abandon project at t = 1 or halve scale (c = 0.5) and value of project by defaulting on I c= 58

Options to Stage/Abandon & Contract

Option to stage investment and abandon midstream, or contract scale of project´s operation by forgoing planned expenditures if product does poorly 

Seen as put option on part (c%) of project (V) that can be contracted or abandoned (V – Ic ) + Max(Ic – cV, 0) = Max(V – Ic, (1-c)V)

I0 = $50 now

0.6

p=0.4V+=180

V-=60

E+ = max(V+ - Ic, 0.5 V+) = max(180 – 58, 90) = 122 (continue) E- = max(V- - Ic, 0.5 V+) = max(60 – 58, 30) = 30 (contract/abandon)  Investment opportunity (with option to contract or abandon): E0 = [.4 x 122 + .6 x 30]/1.08 – 50 = 12  Option to contract (default) = 12 – (-4) = 16

0

50

100

150

200

250

300

350

8/9

/95

9/1

3/9

5

10/1

8/9

5

11/2

2/9

5

12/2

7/9

5

1/3

1/9

6

3/6

/96

4/1

0/9

6

5/1

5/9

6

6/1

9/9

6

7/2

4/9

6

8/2

8/9

6

10/2

/96

11/6

/96

12/1

1/9

6

1/1

5/9

7

2/1

9/9

7

3/2

6/9

7

4/3

0/9

7

6/4

/97

7/9

/97

8/1

3/9

7

9/1

7/9

7

Notes:1. In August 1995 Netscape goes public in providing software for the Internet (all firms indexed at 100 on 8/9/95).2. In March 1997 Microsoft allies with rival Hewlett-Packard to push its Windows NT program into corporate servers. 3. In April 1997 Microsoft agrees to buy WebTV, a start-up company that delivers Internet information directly to television sets.4. In May 1997 Microsoft announces an all-out attack into the lucrative heavy-duty corporate computing market.5. Also in May 1997 Oracle buys into Navio Communications, established by Netscape to develop Internet software for consumer electronics.6. Netscape and Microsoft make further strategic moves to gain an advantage in their continuing battle over who will be the Internet standard bearer. Through its superior strategic moves Microsoft gains a clear advantage over Netscape whose relative position is eroding.

A. Software

Microsoft´s strategic moves and superior market performance

over Netscape and other computer software rivals

Competitive Strategies and Relative Market Performance for High-Tech Firms

1

Microsoft

S&P 500 Computer IndexOracle Corp.

Netscape Communications

2 4

5

6

3

COMPETITION & STRATEGY

1. High-tech firm with 1-yr license to wait for commercial production2. Impact of exogenous competitive entry (“dividends”)3. Early investment to preempt (two-stage investment)4. Should it invest in R&D to acquire proprietry option to invest in more cost-effective commercial production in stage 2?5. Impact of endogenous competition in production (stage 2) What difference if proprietary vs. shared benefits, contrarian vs. reciprocating competitive reaction?6. What if compete in R&D (stage 1) sequentially (innovation race with first-mover advantage?). What if both invest simultaneously and get hurt?7. Benefits of cooperating in R&D?

Passive NPV

V=100

q=0.5

1-q=0.5

V+=180

V-=60

Invest now (commitment value) = NPV = V – I = 100 – 80 = 20 (>0)

I=80

Investment cost: I = 80 Risk neutral prob.:

Discount rate: k = 0.20 (Gross)Project value: Risk-free rate: r =0 .08

Actual probability: q = 0.5

10008.1

606.01804.0

1

)1(

r

VpVpV

4.0)1(

VV

VVrp

No flexibility to deviate from expected: Invest Now

Proprietary Opportunity (license)

Wait to invest under uncertainty

V=100

V-=60

V+=180q=0.5

1-q=0.5

C

C+=Max(V+-I,0) (Invest) =180 – 80 = 100

C-=0 (Do not invest)t =0 t =1

I=80

Opportunity to invest provided by license (call option): C

p C 1 p C

1 r

.4 100 .6 0

1.0837

Shared Opportunity

Invest now if can preempt competitionA. Impact of exogenous competitive entry: reduced option value (50% cash-flow “dividends”)

V=100

V+=180

V-=60

(V+)’=90

(V-)’=30

Wait (call option with “dividends”):

(half of 37) C'. ( ) .

..

4 90 40 6 0

108185

p=0.4

1-p

(C+)’=90-40=50

(C-)’=Max(30-40,0)=0

Shared opportunity

B. Invest now/ exercise early (e.g., build excess plant capacity) to preempt competitive erosion or capture cash-flow “dividends”

Invest now if can preempt competition

Invest now: V - I = 100 - 80 = 20 (> 18.5)

V+=180

V-=60

V=100

Simultaneous Investment Timing Game

Compete/invest early (prisoners’ dilemma)

B

Wait Invest

Wait

Firm A

Invest

(18.5,18.5)

(10,10)*

Invest

WaitA

Firm B

B

Invest

Wait

(0, 20)

(20,0)

(18.5,18.5)

Invest

Wait

Extensive form

(share NPV=20)

(share 37)

(10,10)*(20,0)

(0,20)

A: Invest regardless of B (dominant) B: Invest regardless of A

But better if wait

Two-stage (Growth) Investment R&D/ infrastructure/ growth option

V++ = 324

V+- = 108

V-- = 36

V+ = 180p=0.4

V = 100

1-p

V- = 60II = 30 III = 80

t = 0Stage I Stage II

t = 1 t = 2

NPV NPV NPV I II

30 80

1.08

.5 180 .5 60

1.20

30 ( )74 100 30 26 4 0

NPV NPV Option * I II

30 . ( ) .

1.08

4 180 80 6 0

30 37 7 0

Competitive Strategies (Dog)

Contrarian Reciprocating

flexible and inoffensive commiting and offensive

flexible and offensive commiting and inoffensive

COMPETITION

PIONEER (A)

Proprietary (capture most of

total market value)

Shared

Preemptive commitment (+) effect

Vulnerable (-) effect

Non-provoking (-) effect

Cooperative commitment (+) effect (+) effect

(fixed market value)

e.g., Quantity competition

(altered market value) e.g., Price competition

(share total market value)

1 2

4 3

Depend on type of investment (proprietary vs. shared) and competitive reaction (contrarian vs. reciprocating)

Proprietary (2/3) / Contrarian (1) Invest in R&D (offensive strategy to preempt )

Wait Invest

Wait

Invest

(10,0)*

(0,-20)

1

4

(0,-20)

2

(-20,0)

3

High Demand (V+=180) Low Demand (V-=60)

Wait Invest

Wait

Invest (100,0)

(0,100)(81, 25)

(80,20)*3

21

4

Nash (A invest, B invest);

IIA = 30; III

A = 40; III = IIIA + III

B = 80 (if preemption IIIA = III

B = 80)

5353008.1

106.0804.030NPV*

A

NPV 0 0.4 20 0.6 0

1.08 7B

*

Firm A

Firm B

*

*V

V -

V +p

1-p

Proprietary (2/3) / Reciprocating (-1/4)

Do not invest in R&D (avoid rivalry and price war)

Wait Invest

Wait

Invest

(10,0)*

(-10,-25)

1

4

(0,-20)

2

(-20,0)

3

High Demand (V+=180) Low Demand (V-=60)

Wait Invest

Wait

Invest (100,0)

(0, 100)(61,15)

(50,5)*3

21

4

*A

0.4 50 0.6 10NPV 30 30 24 6 0

1.08

21.08

00.650.40NPV*

B

A

B

Shared (1/2) / Reciprocating (+1/4)

Invest in R&D (expanded pie from coordination)

Wait Invest

Wait

Invest

(10,10)*

(-3,-3)

1

4

(0,-20)

2

(-20,0)

3

High Demand (V+=180) Low Demand (V-=60)

Wait Invest

Wait

Invest (100,0)

(0, 100)(75,75)

(73,73)*3

21

4

Nash (A invest, B invest) Shared (coordination): wait

NPV . .

.A*

300 4 73 0 6 10

10830 33 3 33330NPV*

B

A

B

Shared (1/2) /Contrarian (1)

Do not invest (avoid subsidizing aggressive rival)

Wait Invest

Wait

Invest

(5,5)*

(-10,-10)

1

4

(0,-20)

2

(-20,0)

3

High Demand (V+=180) Low Demand (V-=60)

Wait Invest

Wait

Invest (100,0)

(0, 100)(53,53)

(50,50)*3

21

4

*A

0.4 50 0.6 5NPV 30 30 21 9

1.08

21210NPV*B (< 0);

A

B

Sequential R&D Investment Race

Invest to preempt (first mover 2/3 or time-to-market)

BWait Invest

Wait

Firm A

Invest

(16,16)

(22,-17)

1

4

A invests; given that, B waits Winner takes all

(0, 35)

2

(35,0)*

3

(22,-17)

Invest

WaitA

Firm B

B

Invest

Wait

(0, 35)(35,0)

(16,16)

Invest

Wait

1

2

3

4

Simultaneous R&D Investment Battle

Invest prematurely (prisoners’ dilemma)

Firm BWait Invest

Wait

Firm A

Invest

(16, 16)

(2, 2)*

1

4

(35, 0)

3

2

(0, 35)

Invest prematurely; both get hurt (worse than wait)

Cooperate in Technology Investment

Joint R&D Ventures

Firm BWait Invest

Wait

Firm A

Invest

(22,22)*

(17,17)

1

4

Save (share) costs; better appropriate (jointly)

option value of waiting

Benefits of Real Options Valuation

Helps systematize the analytical process  Structures problem to uncover important aspects

and provide deeper insight ·    Focuses on the primary uncertainties and value

drivers·    Captures the value of optionality and strategic

thinking   Much benefit derives from the structuring process

itself (beyond the evaluation results)

Provides a common language for communication among

different functions (R&D, finance, strategy, marketing)

Provides intuition, that may sometimes challenge conventional thinking, e.g.,

 •     Higher volatility may increase value•     Accepting negative-NPV projects or delaying positive-

NPV ones may be rational/justified  Provides better interface between capital budgeting,

strategic planning, incentives and control systems

AREAS WITH USEFUL OPTION APPLICATIONS

R & D (new products/processes) & innovation

·     Industries: high-tech, computers & semiconductors, pharma, bio-tech, chemicals, other growth industries with multiple stages, product generations or applications

 

·     Options: staging (time-to-build) and growth/expansion options (multi-staged investment)

Infrastructure (platform/capabilities)

Info.-technology network (e.g., to develop capabilities to expand

more efficiently), ports/airports/railroads/road network, power plants (e.g., electricity), corporate core capabilities to adapt

 .    Industries: transportation, info./telecom, energy etc. ·     Options: compound options, portfolios of options 

Strategy and competition

Growth options to acquire foothold in new/foreign markets (e.g., in Greece to enter EU), sourcing/multinational network operations (switch labor, exchange rates, human capital), strategic acquisitions (new market or technology), goodwill/brand name, joint ventures to build network/ relationships (e.g., in India, China), patent races/product standard

      Industries: new/foreign/emerging markets, M&As, goodwill intensive, electronics, pharmaceuticals, detergents, airlines etc

·     Options: growth (compound)/expansion options, abandonment options, switch/exchange options, competitive games etc.

Flexible manufacturing (multiple inputs/outputs)

•  Industries: energy (e.g., power plants using diverse

fuel inputs), autos (CAD/CAM), toys, consumer electronics, fashion, info. technology, flexible publishing

  •   Options: options to switch/exchange

Intellectual/property rights

Patents, leases, movie rights, software licenses, goodwill/ brand name etc.

·  Industries: high-tech, pharmaceuticals, biotech, software, media/entertainment, publishing etc.

 ·     Options: wait to invest, compound/expand options etc.

Performance measurement/compensation

Develop more dynamic economic value added (EVA)–like measures consistent with option-based expanded-NPV, integrating capital budgeting with strategic planning and control; develop conditional control targets (e.g., ROA, growth) contingent on exercise of major future options; recognize agency conflicts (e.g., expansion) and distortions in optimal exercise policies and design corrective incentive contracts