Chapter%204:%20Getting%20Real%20about%20Real%20Options

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Real Options
Mehmet Bozbay Hoksung Yau Laura Goadrich Ping
Fong Hsieh Sirisha Sumanth March 8, 2004
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Chapter 4 Getting Real About Real Options
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Objectives

• Overview
• Terminology
• Real options in the Real world
• Overvaluing options (Agouron)
• Exploring options (Cisco)
• Case study (Nole)
• Summary

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Issues in Real Options

• Advantages
• Successfully explains valuation of multiple
  companies believed to have substantial real
  options
• Explain some of the difference in markets not
  accounted by traditional techniques
• Disadvantage
• Real Options can be miscaluculated/misused and
  misvalue a company
• Provides a method to exemplify market outcomes
  using nontraditional techniques

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Overview Real Options

• Helps investors determine whether a companys
  stock is over- or undervalued
• Real options considers impact of
• Risk
• New technology
• New market
• Real-World Examples Agouron Pharmaceuticals,
  Cisco, Nole

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Terminology

• Scope-up options
• Opportunities to increase variability in product
  lines
• Eg. IBM expanding to create graphic cards
• Scale-up options
• Opportunities to expand capacity
• Eg. Power Packaging took over one plant of
  General Mills
• Learning options
• Opportunities to acquire companies with the goal
  of entering into new businesses
• Eg. GE taking over Datex-Ohmeda
• Equity Stakes
• Purchasing equity in start-up companies

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Real-World Example Agouron Pharmaceuticals

• Kellogg Charnes (2000) Financial Analysts
  Journal
• Illustrates the problem of valuing a company with
  real options and how that valuation can differ
  from the markets valuation
• Background biotechnology companies known for
  having high values when their products are in
  development (no positive cash flow)

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Real-World Example Agouron Pharmaceuticals

• Types of real options available
• Growth option
• Expand production if favorable in the market
• Abandonment option (why choose?)
• Viable reasons for abandonment
• inhibit share holder loss
• scrap failing projects

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Real-World Example Agouron Pharmaceuticals
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Real World Example Agouron Pharmaceuticals

• Valuations of Agouron based on real options
  differed from the actual market values of the
  companys stock as a particular drug progressed
  through the development process
• Discovery
• Preclinical
• Clinical trial- phase I
• Clinical trial- phase II
• Clinical trial- phase III
• FDA filing and review
• Once the drug hit the market, the drug can vary
  in quality from
• Breakthrough - Above Average - Average -
  Below Average - Dog

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Real World Example Agouron Pharmaceuticals

• Root cause of differences
• The abandonment of a drug is rarely announced
• Only one drug made it to phase II and III
• Potential projects were included in the valuation
  when they were not part of the product pipeline
• Investors were making different assumptions
• Political pressure for FDA to approve drugs for
  HIV-positive patients
• Assumed need less than eight years from phase II
  to launch, but only took two years
• Sales were four times expectations in the first
  year
• Lesson real options were not overlooked by the
  market, but may have been overvalued

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Real-World ExampleCisco Basics

• Sell Networking supplies
• Scale-up options
• Supply network equipment for Internet
  connectivity
• Scope-up options
• Supplies businesses and individuals
• Learning options
• Integrating voice, video and data in their network

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Real-World Example Cisco Example

• Traditional discounted cash flow example
• Market Value (FY 2000) 445.1 billion
• Assumptions
• Earnings will grow at a rate of 10 annually
  after 2005
• The risk-free rate is 5
• The market risk premium is 6
• There is no adjustment for earnings after 5 years

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Real-World Example Cisco Evaluation
CostOfCapital riskFreeRateOfInterest
riskPremiumOfMarket Volatility
5 (6 1.45) 13.7
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Real-World Example Cisco Sensitivity Analysis

• DCF 266.565billion vs. Market Value
  445.1billion
• Difference 178.535billion
• Sensitivity Analysis
• Vary constant growth rate of 10 to 11
• DCF MarketValue 91.061million
• Vary cost of capital from 13.7 to 16
• Difference 284.873million
• Lesson Not considering options poorly represents
  the actual market value.

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Real-World Example Nole Background

• Example illustrating valuing an option.
• Initial start-up costs
• capital expenditures 500million
• investment in working capital 50million
• Depreciation capital expenditures
  100million/year
• Option 1 Not expand
• Revenues
• Y1 1billion Y2 1.2billion Y3
  1.44billion
• Y4 1.526billion Y5 1.617billion Y6
  1.715billion

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Real-World Example Nole Choices

• Option 2 Expand in year 3 with 2billion
• Annual depreciation 200million
• Expenditures
• Annual capital expenditures year 4, 5, 6 each
  100million
• No additional capital expenditures
• Revenues
• Y1 1billion Y2 1.2billion Y3
  1.44billion
• Y4 1.9billion Y5 2.47billion Y6
  3.211billion

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Real-World Example Nole Expanding in Y3, init Y0
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Real-World Example Nole Without Expanding in
Y3, init Y0
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Real-World Example Nole Value of Expanding
Option
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Real-World Example Nole Strategic Value
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Real-World Example Nole Expanding Black-Scholes
Value of option P x N(d1) X
x e r x t x N(d2)
1,231 x 0.4678 2,300 x e-6 x 3 x
0.1718 245million Value of Expansion
Option using DCF -31million
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Real-World Example Nole Volitility
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Real-World Example Nole Variability of
Volatility
Increasing volatility increases cost of
capital decreases value of underlying
decreases value of option
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Summary

• Agouron showed a large difference between real
  world valuations and traditional methods.
• Cisco illustrated the positive impact of using
  options.
• Nole compared the valuation traditional verses
  options and clearly expressed the need for
  options to describe the marketplace.

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Chapter 5 Pitfalls and Pratfalls in Real Option
Valuation
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• Complication from Internal and External
  Interactions
• Interaction between option holders and
  underlying assets value can complicate the
  analysis of real option.

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• Inability to Explain Absurd Valuation
• The options a company has are usually not
  independent with each other. Their values are not
  additive. Its questionable whether the presence
  of real options can explain the absurd price that
  were witnessed in recent years for many Internet
  stock.

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• Model Risk
• The risk associated with the use of an
  incorrect model or incorrect inputs
• Example
• American put option on a stock priced 100
• The exercise price is 100
• Risk-free is 5
• One year to expiration
• Volatility is 32
• The correct model (binomial model) gives
  the price value 16.41
• Incorrect model ( Black-Scholes) gives the
  price value 15.48
• Error 5.7

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• Failure to meet Assumption
• Major Assumptions
• Lognormality
• Randomness
• Known and constant volatility
• Minor Assumptions
• Known and constant risk-free rate
• No taxes and transaction costs
• American-style option

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• Major Assumptions
• Lognormality
• The rate of return on the underlying
  asset is lognormally distribution.
• Example
• A non-dividend paying stock sells for 100
  and moves up to 110 after one year. The
  logarithmic return is ln(1.10) 9.53
• The model typically assume the
  logarithmic return follows a normal distribution,
  which means the return itself follows a
  lognormality distribution
• Randomness
• Prices are randomness to assure that
  markets are competitiveness that allows pricing
  models to work. No one participant can dominate
  all the others.
• Known and constant volatility
• The volatility in standard option-pricing
  models is not directly observe and easy to
  obtain.
• Also, the models are sensitive to the
  volatility.

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• Minor Assumptions
• Known and constant risk-free rate
• Option-pricing models generally assume a
  known and constant risk-free rate.
• No taxes and transaction costs
• It facilitates the capture of most essential
  elements of the economic process being modeled.
• American-style option
• The option is the one that can be exercised
  before expiration. It offers more flexibility.

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• Difficulty of Estimating Inputs
• Market Value of the Underlying Asset
• Sometimes, the estimating for appropriate
  discount rate, the life of a project may be
  difficult.
• Exercise Price
• The amount of money can be received or paid in
  the future are difficult to determine.
• Time to Expiration
• A company cant know how long it can keep a
  project before abandoning it to claim a salvage
  value.
• Volatility
• The option prices are very sensitive to the
  estimate of volatility. But it is very difficult
  to observe in financial option-pricing
  application.

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• Risk-Free Rate
• The value of an option is not so
  sensitive to estimate of the risk-free rate.
• It is acceptable to obtain an estimate of
  the risk-free rate by estimating the rate on a
  default-free zero-coupon security.
• Example
• A real option expires in 275 days
• Let the bid and ask discount rates on US
  government zero-coupon bonds (Treasury Bills) for
  maturity be 4.52 and 4.54
• We spilt the difference and assume a rate
  of 4.53

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• Example

The price of one year bill
If the T-bill price is 96.54 per 100 par, the
annual rate is
The continuous compounded rate is (in order to
use in Black-Schole Model)
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Nontradability of the Underlying Asset

• Assumption in the area of real options analysis
  underlying asset can be bought and sold in a
  liquid market.
• When using binomial approach, the ability to
  trade the asset and the option in such a manner
  that no arbitrage opportunity exists is the glue
  that binds the models together.

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Assumptions of Hedging, Tradability, and Risk
Neutral Valuation

• r Risk-free rate (5)
• u Holding period return on the stock if it goes
  up (150)
• d Holding period return on the stock if it goes
  down (50)
• Stock price 100

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Option price calculation
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Risk-adjusted discount rate and probability of
outcomes

• If the probability of up move is 0.6, then
  Risk-adjusted discount rate k 0.1.
• If k 0.12, then q0.62.

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Risk-adjusted discount rate and probability of
outcomes (cont.)

• If k is risk-free rate, then
• q plays the same role as p in the
  option-valuation problem. Option-pricing models
  are often said to use risk neutral valuation.

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Consistency of All Approaches

• No one assume investors are risk neutral. Rather,
  risk neutral valuation is simple and imposes only
  light demands.
• Risk neutral valuation is not a different
  approach that obtains different numbers from a
  standard risk-adjusted approach.(Feinstein 1999)

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Example

• Invest 9 in a project
• If the outcome is good, invest 18 and begin to
  generate 10 a year forever.
• If the outcome is bad, invest 18 and begin to
  generate 3 a year forever.
• Probability of good outcome is 0.6 and bad
  outcome is 0.4
• Discount rate is 25

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Example (cont.)

• The market value of the project is
• The market value of the project at time 1 is

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Example (cont.)

• The value of the project at time 0 is
• NPV is
• Up factor
• Down factor
• The risk neutral probability is

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Example (cont.)

• Option value 11.28
• According to Feinsteins approach, the overall
  discount rate is a blend of 25 and 5. So the
  weighted discounted rate is
• The correct project value is
• 11.28

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Summary

• One source of difficulty in applying real options
  valuation is the assumption may or may not be
  appropriate in the case of real options
  (lognormality distribution of the value of the
  underlying asset, randomness of prices)
• The estimation of inputs, such as the volatility
  of the value of the underlying asset, the
  exercise price, the time to expiration, is more
  challenging for real options than for fincial
  options.

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Chapter 6 Empirical Evidence on the Use and
Accuracy of Real Options Valuation
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Paddock, Siegel, and Smith (1988) Option
Valuation of Claims on Real Assets The Case of
Offshore Petroleum Leases

• Real options model for valuing offshore oil and
  gas leases in a federal sale of 21 tracts in the
  Gulf of Mexico.
• Real options were not able to explain the bids as
  well as one might have hoped.
• Real options theory was not very well-known in
  1988.
• Data provided by the government were not too good
  to carry out analysis.
• Winners curse tendency for the highest bidder
  to pay more than fair

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Quigg (1993) Empirical Testing of Real
Option-Pricing Models

• Market prices of 2,700 land transactions in
  Seattle during 1976-1979.
• Market prices reflect a premium for the option to
  wait to invest (optimal development) that has a
  mean value of 6 of the land value.
• Supports the belief that investors either use
  real options models or trade in such a manner
  that their valuations are consistent with those
  of real options models.

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Berger, Ofek, and Swary (1996) Investor
Valuation of the Abandonment Option

• Whether investors price the option to abandon a
  firm at its exit value.
• This option is priced as an American put, whose
  value increases with exit value.
• Significant relationship between a companys
  market value and its estimated exit value,
  suggesting that investors take the option to exit
  into account when valuing companies.
• The more likely the option will be exercised, the
  more valuable is the option.

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Hayn (1995) The Information Content of Losses

• Hypothesizes that because shareholders have a
  liquidation option, losses are not expected to
  perpetuate. They are thus less informative than
  profits about the firms future prospects.
• The results are consistent with the hypothesis.
• Investors do not respond to losses to the same
  magnitude that they do to profits.
• Option to liquidate is valued by investors.

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Moel and Tufano (2002) When Are Real Options
Exercised? An Empirical Study of Mine Closings

• The flexibility that mining firms have to open
  and close mines.
• The overall pattern of closures is well predicted
  by real option theory.
• Closures are influenced by the price and
  volatility of gold, firms operating costs,
  proxies for closing costs, and the size of
  reserves.
• Fail to capture aspects of firm-level decision
  making.
• Divisions within a firm share a common destiny
  and decision about particular units are
  influenced by the performance of the other parts
  of the firm.

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Clayton and Yermack (1999) Major League
Baseball Player Contracts An Investigation of
the Empirical Properties of Real Options

• Contracts negotiated between professional
  baseball players and teams to investigate the use
  of real options in a commercial setting.
• Baseball contracts feature options in diverse
  forms, and they found that these options have
  significant effects on player compensation.
• As predicted by theory, players receive higher
  guaranteed compensation when they allow teams to
  take options on their future services, and lower
  salaries when they bargain for options to extend
  their own contracts.
• The apparent value of options decreases as a
  function of the "spread" between option exercise
  price and annual salary and increases as a
  function of the time until exercise.

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Howell and Jagle (1997) Laboratory Evidence on
How Managers Intuitively Value Real Growth Options

• Asked managers series of questions on growth
  options from some investment case studies, asked
  other questions related to their personal
  situations and the kinds of investment decisions
  they make in their work.
• Skilled managerial decision makers agree only
  approximately with real option theory.
• They tend on average to value growth options in
  an erratic way.
• Overvaluation seems to be a function of
  Industry, being lowest in the oil industry, and
  it is also a function of (Business) Experience
  and Position being highest for more senior
  people.
• The result can be interpreted in two ways
• This limited sample of managers is not
  sufficiently knowledgeable about real options
  models.
• Real options models are simply not used in
  practice.
• Small sample size is a major limitation of this
  study (82 managers)

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Busby and Pitts (1997) - Real options in
practice an exploratory survey of how finance
officers deal with flexibility in capital
appraisal

• Dissatisfaction with discounted cash flow
  techniques has lead to a growing literature
  focusing on the value of managerial flexibility
  in handling real asset investments, a subject
  area known as real options.
• An exploratory survey of senior finance officers
  in industrial firms, examining the significance
  that real options assumed in their investment
  decisions, whether their firms had established
  procedures for assessing real options, and
  whether their intuitions were consistent with
  what theory prescribes.
• There was wide variation between individual
  decision-makers in their perception of real
  options.
• Few firms have procedures to assess options in
  advance.
• Very few decision-makers seemed to be aware of
  real option research but, mostly, their
  intuitions agreed with the qualitative
  prescriptions of such work.

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Chapter 7 Summary and Conclusions
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• Companies are often highly misvalued in the
  market
• Corporate investment decisions are typically made
  using standard discounted cash flow (DCF)
  techniques, which are not equipped to accommodate
  real options
• Discounted cash flow techniques that attempt to
  capture flexibility are not adequate
• The valuation of financial options has benefited
  from years of study, evolving from the binomial
  and BlackScholes models.
• A number of limitations and difficulties arise in
  applying real options

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• Real options models oftentimes do not meet the
  assumptions inherent in the models
• The estimation of inputs in real options models
  is particularly challenging
• The models are based on the idea that one can
  trade the underlying asset and the option to form
  a risk-free hedge or trade a combination of the
  underlying asset and risk free bonds to replicate
  the payoffs of the option
• Empirical research has provided some, but very
  limited, support for the real-world applicability
  of real options models

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Thank you