Chapter 10 Real Options and Cross-Border Investment

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Chapter 10Real Options and Cross-Border
Investment

• 10.1 The Theory and Practice of Investment
• 10.2 Market Entry and the Option to Invest
• 10.3 Uncertainty and the Value of the Option to
  Invest
• 10.4 Market Exit and the Abandonment Option
• 10.5 The Multinationals Entry into New Markets
• 10.6 Options within Options
• 10.7 Option Theory as a Complement to NPV
• 10.8 Summary

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The theory of investment

• The conventional theory
• Discount expected future cash flows at an
  appropriate risk-adjusted discount rate.
• NPV St ECFt / (1i)t
• include only incremental cash flows
• include all opportunity costs

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Three investment puzzles

• Puzzle 1
• MNCs use of inflated hurdle rates
• Puzzle 2
• MNCs failure to abandon unprofitable
  investments
• Puzzle 3
• MNCs negative-NPV investments
• into new and emerging markets

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Puzzle 1 MNCs use of inflated hurdle rates

• Market entry and the option to invest
• By exercising its option to invest, the firm is
  foregoing the opportunity to invest at some
  future date.
• Consequently, a project must be compared not only
  against other projects today but also against
  similar versions of itself initiated at some
  future date.
• Because of the value of waiting for additional
  information, firms often demand hurdle rates that
  exceed investors required returns on investments
  into uncertain environments.

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An example of the option to invest

• Initial investment I0 20,000,000
• (For simplicity, the present value of this
  initial investment is assumed to be PV(I)
  20,000,000 regardless of when investment is
  made.)
• Price of Oil P0 20/bbl
• P1 either 30 or 10 with equal probability
• Þ EP 20
• Variable production cost V 8 per barrels
• Eproduction Q 200,000 barrels per year
• Discount rate i 10

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The option to invest as a now or never decision

• NPV (EP-V) (Q) / i - I0
• NPV(invest today)
• (20 - 8) (200,000) / .1 - 20,000,000
• 4,000,000 gt 0
• Þ invest today (?)

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Wait one year before deciding to invest
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The investment timing option

• NPV(wait one year½P130)
• ((30 - 8)(200,000) /.1)/(1.1) - 20,000,000
• 20,000,000 gt 0 Þ invest if P130
• NPV(wait one year½P110)
• ((10 - 8)(200,000) /.1)/(1.1) - 20,000,000
• -16,363,636 lt 0 Þ do not invest if P110
• NPV(wait one year) (½)(0) (½)(20,000,000)
• 10,000,000 gt 0
• Þ wait one year before deciding to invest

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The opportunity cost of investing today
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The opportunity cost of investing today

• Option Value Intrinsic Value Time Value
• NPV(wait one year) NPV(invest
  today) Opportunity cost
• of investing today
• 10,000,000 4,000,000 6,000,000
• Þ wait one year before deciding to invest

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A resolution of Puzzle 1 Use of inflated
hurdle rates

• Financial managers facing this type of
  uncertainty have four choices
• Ignore the timing option (?!)
• Estimate the value of the timing option using
  option pricing methods
• Adjust the cash flows with a decision tree that
  captures as many future states of the world as
  possible
• Inflate the hurdle rate (apply a fudge factor)
  to compensate for high uncertainty

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The investment call option

• Option value intrinsic value time value
• Intrinsic value value if exercised immediately
  (4 million in BP example)
• Time value additional value if left unexercised
  (6 million in BP example)

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Call option value determinants

• Increasing this determinant
• changes call option value
• Option value determinant BP example in the
  indicated direction
• Price of the underlying asset Poil
• Exercise price of the option K 20 million -
• Riskfree rate of interest RF 10
• Time to expiration of the option T one year
• Volatility of the underlying asset sPoil
• Option value intrinsic value time value
• Intrinsic value Asset value - exercise price
  (Poil - K)
• Time value f(Poil, K, RF , T, sPoil)

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Exogeneous price uncertainty

• Price of Oil P1 35 or 5 with equal
  probability
• Þ EP1 20/bbl
• NPV(invest today)
• ((20-8)(200,000) /.1)/(1.1)-20,000,000
• 20,000,000 gt 0 Þ invest today (?)

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Exogeneous price uncertainty

• NPV(wait one year½P135)
• ((35-8)(200,000) /.1)/(1.1)-20,000,000
• 29,090,909 gt 0 Þ invest if P135
• NPV(wait one year½P15)
• ((5-8)(200,000) /.1)/(1.1)-20,000,000
• -25,454,545 lt 0 Þ do not invest if P15 (Þ
  NPV0)
• NPV(wait one year)
• (½)(0)(½)(29,090,909) 14,545,455 gt 0
• Þ wait one year before deciding to invest

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Exogeneous price uncertainty

• The effect of uncertainty over the future price
  of oil
• P1 30 or 10
• Option value Intrinsic value Time value
• 10,000,000 4,000,000 6,000,000
• P1 35 or 5
• Option value Intrinsic value Time value
• 14,545,455 4,000,000 10,545,455
• The time value of the investment option
• increases with exogeneous price uncertainty.

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A resolution of Puzzle 2Failure to abandon
unprofitable investments

• Why do firms remain in unprofitable markets even
  though they are losing money?
• Market exit - the option to disinvest
• By abandoning a losing venture today, the firm is
  foregoing the opportunity to abandon at a future
  date.
• A part of the exercise price of the abandonment
  option is the opportunity cost of exiting today
  rather than at a future date.
• Firms retain losing ventures because of the
  option value of waiting for additional
  information.

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The abandonment option

• Cost of disinvestment PV(I) 2,000,000
• Assume the present value of abandoning the oil
  well is 2 million regardless of when the well is
  abandoned
• Price of Oil P0 10/bbl
• P1 either 15 or 5 with equal probability
• Variable production cost V 12 per barrels
• Expected production Q 200,000 barrels per year
• Discount rate i 10

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The abandonment option

• NPV(now or never)
• -((10-12) (200,000)/.1)-2,000,000
• 2,000,000 gt 0 Þ abandon today (?)

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The abandonment option

• NPV(abandon in one year½P115)
• -((15-12) (200,000)/.1)/(1.10)-2,000,000
• -7,454,545 lt 0 (Þ NPV0)
• Þ do not abandon given P115
• NPV(abandon in one year½P15)
• -((5-12) (200,000)/.1)/(1.10)-2,000,000
• 10,727,273 gt 0
• Þ abandon in one year given P15
• NPV(wait one year)
• (½) (0) (½) (10,727,273)
• 5,363,636 gt 0
• Þ wait one year before deciding

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The abandonment option
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The opportunity cost of abandoning today

• Option Value Intrinsic Value Time Value
• NPV(wait one year) NPV(exit today) Opportunity
  cost
• of exiting today
• 5,363,636 2,000,000 3,363,636
• Þ wait one year before deciding to abandon

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Hysteresis Entry-exit decisions in combination

• Cross-border investments often have different
  thresholds for investment and disinvestment.
• Cross-border investments are often not undertaken
  until the expected return is well above the
  required return.
• Once invested, cross-border investments are
  frequently left in place well after they have
  turned unprofitable.
• This is called hysteresis - the failure of a
  phenomenon to reverse itself as its underlying
  cause is reversed.

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A resolution of Puzzle 3 Entry into emerging
markets

• Firms often make investments into emerging
  markets even though further investment does not
  seem warranted according to the accept all
  positive-NPV projects rule.
• The value of growth options
• Negative-NPV investments into emerging markets
  are often out-of-the-money call options entitling
  the MNC to make further investments should
  conditions improve.
• If conditions worsen, the MNC can avoid making a
  large sunk investment.
• If conditions improve, the MNC can choose to
  expand its investment.
• Vfirm Vassets-in-place Vgrowth options

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Why DCF fails

• Option volatility - Options are inherently
  riskier than the underlying asset on which they
  are based.
• Changing option volatility - Option volatility
  changes with changes in the value of the
  underlying asset.
• Returns on options are not normally distributed.

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The option pricing alternative

• Option pricing methods circumvent problems with
  the opportunity cost of capital by constructing a
  replicating portfolio that mimics the payoffs on
  the option.
• Costless arbitrage then ensures that the value of
  the option equals the value of the replicating
  portfolio.

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The option pricing alternative

• Option pricing works well for financial options
• low transactions costs facilitate arbitrage
• observable prices
• Option pricing is more difficult for real options
• higher transactions costs impede arbitrage
• the price of the underlying asset (such as a
  factory or product line) is usually unobservable