Real options

Flexibility adds value to an investment:

• For example, if an investment can be staggered, then future costs can be avoided if the market turns out to be less attractive than originally expected.
• The core to this value lies in reducing downside risk exposure but keeping upside potential open - i.e. in making probability distributions asymmetric.

Financial options are an example where this flexibility can be valued.

• A call option on a share allows an investor to wait and see what happens to a share price before deciding whether to exercise the option and will thus benefit from favourable price movements without being affected by adverse movements.

Real options theory attempts to classify and value flexibility in general by taking the ideas of financial options pricing and developing them:

• A financial option gives the owner the right, but not the obligation, to buy or sell a security at a given price. Analogously, companies that make strategic investments have the right, but not the obligation, to exploit these opportunities in the future.
• As with financial options most real options involve spending more up front (analogous to the option premium) to give additional flexibility later.

Conventional investment-appraisal techniques typically undervalue flexibility within projects with high uncertainty. High uncertainty within a NPV context will result in a higher discount rate and a lower NPV. However, with such uncertainty any embedded real options will become more valuable.

Different types of real option

There are many different classifications of real options. Most can be summarised under the following generic headings:

Options to delay/defer

The key here is to be able to delay investment without losing the opportunity, creating a call option on the future investment.

For example, establishing a drugs patent allows the owner of the patent to wait and see how market conditions develop before producing the drug, without the potential downside of competitors entering the market.

Options to switch/redeploy

It may be possible to switch the use of assets should market conditions change.

For example, traditional production lines were set up to make one product. Modern flexible manufacturing systems (FMS) allow the product output to be changed to match customer requirements.

Similarly a new plant could be designed with resale and/or other uses in mind, using more general-purpose assets than dedicated to allow easier switching. For example, when designing a plant management can choose whether to have higher or lower operating gearing. By having mainly variable costs, it is financially more beneficial if the plant does not have to operate every month.

Options to expand/contract

It may be possible to adjust the scale of an investment depending on the market conditions.

For example, when looking to develop their stadiums, many football clubs face the decision whether to build a one- or a two-tier stand:

• A one-tier stand would be cheaper but would be inadequate if the club's attendance improved greatly.
• A two-tier stand would allow for much greater fan numbers but would be more expensive and would be seen as a waste of money should attendance not improve greatly.

Some clubs (e.g. West Bromwich Albion in the UK) have solved this problem by building a one-tier stand with stronger foundations and designed in such a way (e.g. positioning of exits, corporate boxes,etc.) that it would be relatively straightforward to add a second tier at a later stage without knocking down the first tier. Such a stand is more expensive than a conventional one-tier stand but the premium paid makes it easier to expand at a later date when (if) attendance grows.

Options to abandon

If a project has clearly identifiable stages such that investment can be staggered, then management have to decide whether to abandon or continue at the end of each stage.

Valuing real options

Introduction

Valuing real options is a complex process and currently a matter of some debate as to the most suitable methodology. One approach is to use the Black-Scholes model:

The Black-Scholes equation is well suited for simple real options, those with a single source of uncertainty and a single decision date. To use the model we need to identify the five key input variables as follows:

Exercise price

For most real options (e.g. option to expand, option to delay), the capital investment required can be substituted for the exercise price.These options are examples of call options.

For an option to abandon, use the salvage value on abandonment. This is an example of a put option.

Share price

The value of the underlying asset is usually taken to be the PV of the future cash flows from the project (i.e. excluding any initial investment). This could be the value of the project being undertaken for a call option (e.g. option to expand, option to delay), or the value of the cash flows being foregone for a put option (option to abandon). 

Time to expiry

This is straightforward if the project involves a single investment.

Volatility

 The volatility of the underlying asset (here the future operating cash flows) can be measured using typical industry sector risk. 

Many writers continue to use the risk-free rate for real options.However, some argue that a higher rate be used to reflect the extra risks when replacing the share price with the PV of future cash flows.

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