Lecture 7

ROV: real option valuation

 Homework
1) Choosing a company
2) Description of the company's investment activity: investment potential,
main projects being implemented, main areas of investment, investment
financing. Key results of ongoing projects. Outline the specifics of the
company's investment activities
3) Description of the selected investment project. The purpose of the project,
the timing of the project, the main sources of funding. Creation of a
calculation model: income, expenses. The choice of the discount rate and its
justification. Calculation of project efficiency: key parameters of the
assessment. Identifying project risks and developing a risk management
policy
Provided 2 files:
– a presentation describing the company's investment policy and the main
results of the project
– Calculation file with a full description of all financial indicators and project
results You can also provide a description of the entire job with a project
report in a separate document

We send the finished documents in LMS- Projects

Deadline for sending: 12.12.2020
Using Option Pricing Methods to
Value Flexibility
 Options

Over the past decade or so, theoretical and computational advances have allowed finance
practitioners to adapt financial option pricing techniques to the valuation of investment decisions,
so-called real options.

Option pricing methods are superior to traditional DCF approaches because they explicitly
capture the value of flexibility.

It is not clear that option pricing will replace DCF techniques for valuing whole companies
except in limited circumstances.

An option gives its owner the right (but not the obligation) to buy or sell an asset at a
predetermined price (called the strike or exercise price) for a predetermined period of
time (called the life of the option). The right to take an action is flexibility. The necessity
of taking an action is inflexibility.

Call options give the right to buy, and put options the right to sell.

Options can be found on both the assets and the liabilities sides of the balance sheet.
 Underlying Theme: Searching for an Elusive Premium

• Traditional discounted cashflow models under estimate the value of investments, where
there are options embedded in the investments to
– Delay or defer making the investment (delay)
– Adjust or alter production schedules as price changes (flexibility)
– Expand into new markets or products at later stages in the process, based upon
observing favorable outcomes at the early stages (expansion)
– Stop production or abandon investments if the outcomes are unfavorable at early stages
(abandonment)

• Put another way, real option advocates believe that you should be paying a premium on
discounted cashflow value estimates.
• A real option exists in an investment project when there are future
possibilities for action when the solution of a current uncertainty is known.
For example, some of Amazon’s real options when it was only a company that
sold books were:
• New business options. zShops (a marketplace), AmazonAuctions (an
auction market) and its new
• businesses: Drugstore.com (beauty and health products), Ashford.com
(jewelry and gift items), Della.com (weddings and gifts), Pets.com (pets)
and Greenlight.com (automobiles). Several of these options were
exercised by acquisition. Between April 1998 and April 1999, Amazon
made 28 acquisitions.
• Expansion options. Amazon entered the European market in 1999.
• Growth options through new customers. Amazon started to sell music,
videos and DVDs in 1998; software,
• toys, electronic products and home products in 1999; kitchenware and
gardening products in 2000.
• Efficiency improvement options to increase the entry barriers. In 1999,
Amazon invested more than $300 million to improve its technological
infrastructure. It patented the procedure called “1-Click”. Free greeting
• service. Verification of e-mail order.
When is there an option embedded in an action?

An option provides the holder with the right to buy or sell a specified
quantity of an underlying asset at a fixed price (called a strike price or
an exercise price) at or before the expiration date of the option.

There has to be a clearly defined underlying asset whose value

changes over time in unpredictable ways.

The payoffs on this asset (real option) have to be contingent on an

specified event occurring within a finite period.
Payoff Diagram on a Call

Net Payoff

on Call

Strike

Price Price of underlying asset

 Example 1: Product Patent as an Option

PV of Cash Flows
from Project

Initial Investment in
Project

Present Value of Expected

Cash Flows on Product
Project's NPV turns
Project has negative positive in this section
NPV in this section
Example 2: Undeveloped Oil Reserve as an option

Net Payoff on
Extraction

Cost of Developing
Reserve

Value of estimated reserve

of natural resource
 Real Option Pricing Methods
Suppose you are deciding whether to invest $1,600 in a new project that makes
widgets. The cash flow per widget is $200 but will change to either $300 or $100 at
the end of the year with equal probability. After that it will stay at its new level forever.
Note that the expected future cash flow is $200, the weighted average of the risky
outcomes, $300 and $100. The cost of capital is 10 percent. Assuming that one widget
can be sold immediately, and one per year thereafter

The NPV approach discounts the

The NPV rule is the maximum
expected project cash flows at
(determined today) of the
the weighted average cost of
expected values
capital.

It also makes the implicit The decision rule is to take the

assumption that the project maximum of the discounted
should be undertaken expected cash flows or zero
immediately or not at all (meaning don't do the project)
1 variant

2 variant: uncertainty
When Is Managerial Flexibility Valuable?
 The value of an option

The value of an option increases as the variability in the value of the

underlying risky asset (the cash flow per unit) increases.

the market value of the underlying asset on which the option is contingent

the exercise price of the option

the time remaining until the maturity of the option

the volatility of the underlying asset

the risk-free rate of interest

Option Value Is Determined by Six Variables
When does the option have significant economic value?

• For an option to have significant economic value, there has to be a

restriction on competition in the event of the contingency. In a perfectly
competitive product market, no contingency, no matter how positive, will
generate positive net present value.

• At the limit, real options are most valuable when you have exclusivity - you
and only you can take advantage of the contingency. They become less
valuable as the barriers to competition become less steep.
 Exclusivity: Putting Real Options to the Test

• Product Options: Patent on a drug

– Patents restrict competitors from developing similar products
– Patents do not restrict competitors from developing other products to treat
the same disease.
• Natural Resource options: An undeveloped oil reserve or gold mine.
– Natural resource reserves are limited.
– It takes time and resources to develop new reserves
• Growth Options: Expansion into a new product or market
– Barriers may range from strong (exclusive licenses granted by the government
- as in telecom businesses) to weaker (brand name, knowledge of the market)
to weakest (first mover).
 Taxonomy of Options
Abandonment option. The option to abandon (or sell) a project—the right to abandon an
open pit coal mine—is formally equivalent to an American put option on a stock. If the
bad outcome occurs at the end of the first period, the decision maker may abandon the
project and realize the expected liquidation value. Then, the expected liquidation (or
resale) value of the project may be thought of as the exercise price of the put. A project
that can be liquidated is worth more than the same project without the possibility of
abandonment.

Option to defer development. The option to defer an investment to develop a property is

formally equivalent to an American call option on the stock. The owner of a lease on an
undeveloped oil reserve has the right to acquire a developed reserve by paying a lease-
on-development cost. The owner can defer the development process until oil prices rise.
In other words, the managerial option implicit in holding an undeveloped reserve is a
deferral option. The expected development cost may
be thought of as the exercise price of the call.
Option to expand or contract. The option to expand the scale of a project is formally
equivalent to an American call option on the stock. Management may choose to build
capacity in excess of the expected level of output so that it can manufacture at a
higher rate if the product is more successful than was anticipated. The expansion
option gives management the right, but not the obligation, to make additional follow-
on investment (for example, to increase the production rate) if project conditions turn
out to be favorable.

Option to extend or shorten. It is possible to extend the life of an asset or a contract

by paying a fixed amount of money—an exercise price. Conversely, it is possible to
shorten the life of an asset or a contract. The option to extend is a call, and the option
to shorten is a put. Real estate leases often have clauses that are examples of the
option to extend or shorten the lease.

Option to scope up or scope down. Scope is the number of activities covered in a

project. Its optionality is expressed in terms of the ability to switch among alternative
courses of action at a decision point in the future. Scope is like diversification—it is
sometimes preferable to be able, at a higher exercise cost, to chose among a wide
range of alternatives. Buying the option to have greater scope is a call.
Switching options. The option to switch project operations is a portfolio of options that consists of
both calls and puts. Restarting operations when a project is shut down is equivalent to an American
call option. Shutting down operations when unfavorable conditions arise is equivalent to an
American put option. The cost of restarting (or shutting down) operations may be thought of as the
exercise price of the call (or put). A project whose operation can be turned on and off (or switched
between two distinct locations, and so on) is worth more than the same project without the
flexibility to switch.

Compound options. These are options on options. Phased investments are a good example. You
may have a factory that can be built as a sequence of real options, each contingent on those that
precede it. The project can be continued at each stage by investing a new amount of money (an
exercise price). Alternatively, it might be abandoned for whatever it can fetch.

Rainbow options. Multiple sources of uncertainty produce a rainbow option. Most research and
development programs have at least two sources of uncertainty—technological and product-market
uncertainty. The latter is represented by the evolution of the uncertain price of the product from a
value that is relatively well known today, to less certain values that are affected by the state of the
economy as well as other uncertain influences in the future. Thus, product- market uncertainty
increases through time. Technological uncertainty, on the other hand, is reduced over time by
conducting research until we learn what the product is and what its capabilities are. A similar type
of rainbow option is exploration and development of natural resources like oil reserves.
 Options Pricing: Black-Scholes Model
The Black-Scholes model is used to calculate the theoretical price of European
put and call options, ignoring any dividends paid during the option's lifetime.
While the original Black-Scholes model did not take into consideration the
effects of dividends paid during the life of the option, the model can be
adapted to account for dividends by determining the ex-dividend date value
of the underlying stock.

The model makes certain assumptions, including:

• The options are European and can only be exercised at expiration
• No dividends are paid out during the life of the option
• Efficient markets (i.e., market movements cannot be predicted)
• No commissions
• The risk-free rate and volatility of the underlying are known and constant
• Follows a lognormal distribution; that is, returns on the underlying are
normally distributed.
 Determinants of option value

• Variables Relating to Underlying Asset

– Value of Underlying Asset; as this value increases, the right to buy at a fixed price (calls)
will become more valuable and the right to sell at a fixed price (puts) will become less
valuable.
– Variance in that value; as the variance increases, both calls and puts will become more
valuable because all options have limited downside and depend upon price volatility for
upside.
– Expected dividends on the asset, which are likely to reduce the price appreciation
component of the asset, reducing the value of calls and increasing the value of puts.

• Variables Relating to Option

– Strike Price of Options; the right to buy (sell) at a fixed price becomes more (less)
valuable at a lower price.
– Life of the Option; both calls and puts benefit from a longer life.

• Level of Interest Rates; as rates increase, the right to buy (sell) at a fixed price in the future
becomes more (less) valuable.
 The Normal Distribution
d N(d) d N(d) d N(d)
-3,00 0,0013 -1,00 0,1587 1,05 0,8531
-2,95 0,0016 -0,95 0,1711 1,10 0,8643
-2,90 0,0019 -0,90 0,1841 1,15 0,8749
-2,85 0,0022 -0,85 0,1977 1,20 0,8849
-2,80 0,0026 -0,80 0,2119 1,25 0,8944
N(d1) -2,75 0,0030 -0,75 0,2266 1,30 0,9032
-2,70 0,0035 -0,70 0,2420 1,35 0,9115
-2,65 0,0040 -0,65 0,2578 1,40 0,9192
-2,60 0,0047 -0,60 0,2743 1,45 0,9265
-2,55 0,0054 -0,55 0,2912 1,50 0,9332
-2,50 0,0062 -0,50 0,3085 1,55 0,9394
-2,45 0,0071 -0,45 0,3264 1,60 0,9452
-2,40 0,0082 -0,40 0,3446 1,65 0,9505
-2,35 0,0094 -0,35 0,3632 1,70 0,9554
-2,30 0,0107 -0,30 0,3821 1,75 0,9599
-2,25 0,0122 -0,25 0,4013 1,80 0,9641
-2,20 0,0139 -0,20 0,4207 1,85 0,9678
-2,15 0,0158 -0,15 0,4404 1,90 0,9713
d1 -2,10 0,0179 -0,10 0,4602 1,95 0,9744
-2,05 0,0202 -0,05 0,4801 2,00 0,9772
-2,00 0,0228 0,00 0,5000 2,05 0,9798
-1,95 0,0256 0,05 0,5199 2,10 0,9821
-1,90 0,0287 0,10 0,5398 2,15 0,9842
-1,85 0,0322 0,15 0,5596 2,20 0,9861
-1,80 0,0359 0,20 0,5793 2,25 0,9878
-1,75 0,0401 0,25 0,5987 2,30 0,9893
-1,70 0,0446 0,30 0,6179 2,35 0,9906
-1,65 0,0495 0,35 0,6368 2,40 0,9918
-1,60 0,0548 0,40 0,6554 2,45 0,9929
-1,55 0,0606 0,45 0,6736 2,50 0,9938
-1,50 0,0668 0,50 0,6915 2,55 0,9946
-1,45 0,0735 0,55 0,7088 2,60 0,9953
-1,40 0,0808 0,60 0,7257 2,65 0,9960
-1,35 0,0885 0,65 0,7422 2,70 0,9965
-1,30 0,0968 0,70 0,7580 2,75 0,9970
-1,25 0,1056 0,75 0,7734 2,80 0,9974
-1,20 0,1151 0,80 0,7881 2,85 0,9978
-1,15 0,1251 0,85 0,8023 2,90 0,9981
-1,10 0,1357 0,90 0,8159 2,95 0,9984
-1,05 0,1469 0,95 0,8289 3,00 0,9987
-1,00 0,1587 1,00 0,8413
 Example
• Stocks mine reliably estimated at 1 million ounces of production capacity – 50 thousand .
ounces per year .
• It is expected that gold prices are rising annually by 3%.
• The company owns the rights to the mine for 20 years.
• The costs for the opening of the mine and the start of production ( development costs ) are
equal to 10 million USD .
• Average production costs amount to about $ 250 . Per ounce .
• Expected increase in operating costs of 5% per year.
• The standard deviation of the price of gold - 20 % , it is assumed that the instability of the
price will not be changed
• Current price of gold is $ 375 per ounce
• r rf= 9%
 Solution

V= CIF*e –yt *N(d1)- COF*e –rt *N(d2)

!"# %!
!" !$#
#$%#&# & ∗%
d1= d2=d1- 𝜎 ∗ 𝑡^ 0,5
(∗% ),+

,
y= ln (1+ % )
CIF- income of the project- P spot
COF- CAPEX/ OPEX- P strike
 , ,
• y= ln(1+ % ) = ln (1+-) )= 0,05
,,).!"
• CIF= [(50 000*375$) * (1- )] / (0,09-0,03)= 211,79
,,)/!"
,,)+!"
• COF= [(50 000*250$) * (1- )] / (0,09-0,05) +10 mln=
,,)/!"
174,55
&'',)* -,&!∗&-
!" ')+,,,
#),)/∗-)#),)+# & ∗%
• d1= ),-∗-)
,
"$ = 2,73
• d2= 2,71- 0,2 *200,5= 1,83

• N(2,73)= 0,9965
• N(1,83)=0,9641
• V= 211,79*e –0,05*20 *0,9965- 174,55*e –0,09*20 *0,9641= 49,82
• NPV= 211,79- 174,55= 37,24
 Event Trees
The lattice that models the values of the underlying risky asset is called an event tree.
It contains no decision nodes and simply models the evolution of uncertainty in the
present value of the underlying risky asset. Suppose we are studying a project that has
a present value (PV ) of $100, volatility of 15 percent per year, and an expected rate of
return of 12 percent per year. The risk-free rate is 8 percent per year, and the cash
outflow necessary to undertake the project, if we invest in it immediately, is $105.

A geometric tree
has multiplicative
up-and down
two types of event
single source of movements that
tree—geometric
uncertainty model a log-
or arithmetic
normal
distribution of
outcomes
 Three Basic Questions

• When is there a real option embedded in a decision or an asset?

• When does that real option have significant economic value?
• Can that value be estimated using an option pricing model?
• Up movement= u= e 𝜎 𝑇 =𝑒 0,15* 1 = 1,1618
! !
• Down movement= d= = = 0,8607
" !,!$!%
u 1,16
d 1/1,1618 0,86
Option 1: a risk rate
q (e 0,12 – d)/ (u-d)=e 0,12-0,8607)/ (1,16-0,86) 0,8612

1-q 0,1388
PV [0,8612*(212) +0,1388*(157)]/ (1+12%) 182 единицы

Option 2: a risk-free rate

q (1+ r rf - d)/ (u-d) = (1+8%-0,8607) / (1,1618- 0,7283
0,8607)
PV [0,7283*212+(1-0,7283)*157]/ (1+8%) 182 единицы