Real Options

USING OPTION PRICING METHODS TO VALUE FLEXIBILITY

Value of Flexibility

  • The flexibility provided by the option to defer can be calculated as follows:

    • NPV computed using only event nodes: -$6

    • Value with the option to defer: $22.97

    • Therefore, the worth of the option to defer is:

    • Option Value = $22.97 - (-$6) = $28.97

Superiority of Option-Pricing Approach

  • The option-pricing approach is demonstrated to be superior to:

    • Naive application of the NPV technique

    • Decision Tree Analysis (DTA)

  • It effectively combines decision nodes with risk-adjusted comparables, allowing for better evaluation of decisions involving flexibility.

Taxonomy of Asset Options

  • Ordinary NPV analysis tends to understate a project's value by not capturing:

    • Operating flexibility

    • Strategic factors such as follow-on investments

Categories of Asset Options

  1. Abandonment Option

    • Equivalent to an American Put Option.

    • Example: The right to abandon a coal mine.

    • Decision tree: If a bad outcome occurs, the decision maker can abandon to realize expected liquidation value.

    • Expected liquidation value acts as the exercise price of the put option.

    • Significant because it sets a lower bound on project value; hence, a project with abandonment options is worth more than one without.

  2. Option to Defer Development

    • Equivalent to an American Call Option.

    • Example: Owner of a lease on undeveloped oil reserves can defer development until better conditions arise.

    • Development cost is the exercise price, and revenue minus depletion forms opportunity cost for deferral.

    • A project that can defer development is hence more valuable than one that cannot.

  3. Option to Expand

    • Also equivalent to an American Call Option.

    • Example: Building excess production capacity to respond to successful products.

    • Decision complexity: it can be exercised at various times, making evaluation difficult.

    • A project with the possibility to expand is worth more than one without this flexibility.

  4. Option to Contract

    • Equivalent to an American Put Option.

    • Example: Modular projects that allow for future output contraction.

    • It provides flexibility to reduce scale in unfavorable conditions, adding value to the project.

  5. Switching Options

    • This is a general form that combines both call and put options.

    • Example: Restarting operations after shutdown (call) versus shutting down operations during unfavorable conditions (put).

    • The costs of starting and shutting down operations are considered exercise prices.

    • Projects capable of dynamic operations (switching) are worth more than those without this flexibility.

Asset Options in Practice

  • Real-world case studies illustrate different asset options and their value.

  • Limitations exist where option value depends on market prices of commodities like oil, coal, etc.

Case Histories

  1. Oilco:

    • Focus on deferral options and expansion possibilities.

    • Conventional NPV underestimated the value significantly due to lack of flexibility considerations.

    • Extension of operations (deferment and expansion) from $1,299 million (base NPV) to $1,540 million, an increase of 21%.

  2. Kryptonite Mining:

    • Market value of equity estimated at $1,000 million, with conventional NPV analysis only reaching $1,160 million.

    • Valuation with option-pricing methods reached 116% of the current market value through operational flexibilities.

    • Shut-down and re-open decisions were optimized based on the established price ranges ($1.75 to $2.25 per ounce).

  3. Drug & Company (Pharmaceutical R&D):

    • Valuation considered four stages of drug development with varying probabilities of success.

    • Traditional NPV value: $18.3 million

    • With staged abandonment option, OPM valuation rose to $33.5 million (increasing value by 83%).

  4. MINCO (Mineral Lease):

    • Initial NPV analysis showed values 50% lower than anticipated bids due to lack of deferral options.

    • Deferral option had the potential to double the NPV, showcasing the importance of flexibility in valuation.

    • Mean reversion significantly affects the realism of price models over time.

Conclusion

  • Overall, it's evident that asset options can substantially influence business value.

  • However, optimal management of these options is crucial to capitalize on their available benefits.