CHAPTER 2

Option Pricing with Application to

Real Options

1
Topics Covered

 Real options
 Decision trees
 Application of financial options to real
options

2
Real Options
 What is a real option?
 Real options exist when managers can influence the size and risk of
a project’s cash flows by taking different actions during the
project’s life in response to changing market conditions.
 Alert managers always look for real options in projects.
 Smarter managers try to create real options.
 What is the single most important
characteristic of an option?
 It does not obligate its owner to take any action. It merely gives
the owner the right to buy or sell an asset.

3
How are real options different
from financial options?
 Financial options have an underlying asset that is
traded--usually a security like a stock.
 A real option has an underlying asset that is not a
security--for example a project or a growth
opportunity, and it isn’t traded.
 The payoffs for financial options are specified in the
contract.
 Real options are “found” or created inside of
projects. Their payoffs can be varied.

(More...)
4
What are some types of
real options?
 Deferral or Investment timing options
 Expansion or Growth options
 Expansion of existing product line

 New products

 New geographic markets

 Contraction options
 Abandonment options
 Compound or Flexibility options
 Extension rights (natural gas pipe line transportation contracts)
 Switching options (temporary suspension)

5
Five Procedures for
Valuing Real Options
1.DCF analysis of expected cash flows,
ignoring the option.
2.Qualitative assessment of the real
option’s value.
3.Decision tree analysis.
4.Standard model for a corresponding
financial option.
5.Financial engineering techniques.
6
 Analysis of a Real Option:
Basic Project
 Initial cost = $70 million, Cost of Capital =
10%, risk-free rate = 6%, cash flows occur
for 3 years.

Annual
Demand Probability cash flow
High 30% $45
Average 40% $30
Low 30% $15
7
Approach 1: DCF Analysis
 E(CF) =.3($45)+.4($30)+.3($15)
= $30.
 PV of expected CFs = ($30/1.1) +
($30/1.12) + ($30/1.13)
= $74.61 million.
 Expected NPV = $74.61 - $70
= $4.61 million.
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Investment Timing Option
 If we immediately proceed with the
project, its expected NPV is $4.61
million.
 However, the project is very risky:
 If demand is high, NPV = $41.91 million.
 If demand is low, NPV = -$32.70 million.
_______________________________

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Investment Timing
(Continued)
 If we wait one year, we will gain
additional information regarding
demand.
 If demand is low, we won’t implement
project.
 If we wait, the up-front cost and cash
flows will stay the same, except they
will be shifted ahead by a year.
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Procedure 2:
Qualitative Assessment
 The value of any real option increases
if:
 the underlying project is very risky
 there is a long time before you must
exercise the option
 This project is risky and has one year
before we must decide, so the option to
wait is probably valuable.
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 Procedure 3: Decision Tree Analysis
(Implement only if demand is not low.)
Cost Future Cash Flows NPV this
a
0 Prob. 1 2 3 4 Scenario

-$70 $45 $45 $45 $35.70

30%
$0 40% -$70 $30 $30 $30 $1.79
30%
$0 $0 $0 $0 $0.00
Discount the cost of the project at the risk-free rate, since the cost is
known. Discount the operating cash flows at the cost of capital.
Example: $35.70 = -$70/1.06 + $45/1.12 + $45/1.13 + $45/1.13.

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Project’s Expected NPV if Wait
 E(NPV) =
[0.3($35.70)]+[0.4($1.79)] + [0.3 ($0)]

 E(NPV) = $11.42.

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Decision Tree with Option to
Wait vs. Original DCF Analysis
 Decision tree NPV is higher ($11.42 million
vs. $4.61).
 In other words, the option to wait is worth
$11.42 million. If we implement project
today, we gain $4.61 million but lose the
option worth $11.42 million.
 Therefore, we should wait and decide next
year whether to implement project, based on
demand.
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The Option to Wait Changes
Risk
 The cash flows are less risky under the option
to wait, since we can avoid the low cash
flows. Also, the cost to implement may not
be risk-free.
 Given the change in risk, perhaps we should
use different rates to discount the cash flows.
 But finance theory doesn’t tell us how to
estimate the right discount rates, so we
normally do sensitivity analysis using a range
of different rates.
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Procedure 4: Use the existing
model of a financial option.
 The option to wait resembles a financial
call option-- we get to “buy” the project
for $70 million in one year if value of
project in one year is greater than $70
million.
 This is like a call option with an exercise
price of $70 million and an expiration
date of one year.
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Inputs to Black-Scholes Model
for Option to Wait
 X = exercise price = cost to implement
project = $70 million.
 rRF = risk-free rate = 6%.
 t = time to maturity = 1 year.
 P = current stock price = Estimated on
following slides.
 σ2 = variance of stock return =
Estimated on following slides.
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Estimate of P
 For a financial option:
 P = current price of stock = PV of all of stock’s
expected future cash flows.
 Current price is unaffected by the exercise cost
of the option.
 For a real option:
 P = PV of all of project’s future expected cash
flows.
 P does not include the project’s cost.
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 Step 1: Find the PV of future
CFs at option’s exercise year.
Future Cash Flows PV at
0 Prob. 1 2 3 4 Year 1

$45 $45 $45 $111.91

30%
40% $30 $30 $30 $74.61
30%
$15 $15 $15 $37.30

Example: $111.91 = $45/1.1 + $45/1.12 + $45/1.13.

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 Step 2: Find the expected PV
at the current date, Year 0.
PVYear 0 PVYear 1

$111.91
High
$67.82 Average $74.61
Low
$37.30
PV2004=PV of Exp. PV2005 = [(0.3* $111.91) +(0.4*$74.61)
+(0.3*$37.3)]/1.1 = $67.82.

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The Input for P in the
Black-Scholes Model
 The input for price is the present value
of the project’s expected future cash
flows.
 Based on the previous slides,
 P = $67.82.

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Estimating σ2 for the
Black-Scholes Model
 For a financial option, σ2 is the variance of the stock’s rate of
return.
 For a real option, σ2 is the variance of the project’s rate of
return.
 Three Ways to Estimate σ2
 Judgment.
 The direct approach, using the results from the scenarios.
 The indirect approach, using the expected distribution of the
project’s value.

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Estimating σ2 with Judgment
 The typical stock has 2 of about 12%.
 A project should be riskier than the firm
as a whole, since the firm is a portfolio
of projects.
 The company in this example has σ2 =
10%, so we might expect the project to
have σ2 between 12% and 19%.

23
Estimating σ2 with the
Direct Approach
 Use the previous scenario analysis to
estimate the return from the present
until the option must be exercised. Do
this for each scenario
 Find the variance of these returns,
given the probability of each scenario.

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Find Returns from the Present
until the Option Expires
PVYear 0 PVYear 1 Return

$111.91 65.0%
High
$67.82 Average $74.61 10.0%
Low
$37.30 -45.0%
Example: 65.0% = ($111.91- $67.82) / $67.82.

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Expected Return and Variance of
Return.
 E(Ret.)=0.3(0.65)+0.4(0.10)
+0.3(-0.45)
 E(Ret.)= 0.10 = 10%.

 2 = 0.3(0.65-0.10)2 + 0.4(0.10-0.10)2
+ 0.3(-0.45-0.10)2
 2 = 0.182 = 18.2%.
26
Estimating σ2 with the
Indirect Approach
 From the scenario analysis, we know the
project’s expected value and the variance
of the project’s expected value at the time
the option expires.
 The questions is: “Given the current value
of the project, how risky must its expected
return be to generate the observed
variance of the project’s value at the time
the option expires?”
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The Indirect Approach (Cont.)
 From option pricing for financial
options, we know the probability
distribution for returns (it is lognormal).
 This allows us to specify a variance of
the rate of return that gives the
variance of the project’s value at the
time the option expires.

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Indirect Estimate of σ2
 Here is a formula for the variance of a
stock’s return, if you know the
coefficient of variation of the expected
stock price at some time, t, in the
future:
1n(CV2 + 1)
σ2 =
t
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 From earlier slides, we know the
value of the project for each scenario
at the expiration date.
 Expected PV and PV:
PVYear 1  E(PV)=.3($111.91)+.4($74.61)
+.3($37.3)
 E(PV)= $74.61.
$111.91
High  PV = [.3($111.91-$74.61)2
+ .4($74.61-$74.61)2 + .3($37.30-
Average $74.61 $74.61)2]1/2
 PV = $28.90.
Low
 Expected Coefficient of Variation,
$37.30 CVPV (at the time the option expires)
 CVPV = $28.90 /$74.61 = 0.39.
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 Now use the formula to
estimate σ2.

 From our previous scenario analysis, we

know the project’s CV, 0.39, at the time
it the option expires (t=1 year).

1n(0.392 + 1)
σ2 = = 14.2%
1

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The Estimate of σ2
 Subjective estimate:
 12% to 19%.
 Direct estimate:
 18.2%.
 Indirect estimate:
 14.2%
 For this example, we chose 14.2%, but we
recommend doing sensitivity analysis over a
range of σ2.

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 Black-Scholes Inputs: P=$67.83; X=$70;
rRF=6%; t = 1 year; 2=0.142.

V = $67.83[N(d1)] - $70e-(0.06)(1)[N(d2)].
d1 = ln($67.83/$70)+[(0.06 + 0.142/2)](1)
(0.142)0.5 (1).05
= 0.2641.
d2 = d1 - (0.142)0.5 (1).05= d1 - 0.3768
= 0.2641 - 0.3768 = - 0.1127.
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 Black-Scholes Value

N(d1) = N(0.2641) = 0.6041

N(d2) = N(- 0.1127) = 0.4551
V = $67.83(0.6041) - $70e-0.06(0.4551)
V = $40.98 - $70(0.9418)(0.4551)
V = $10.98.
Note: Values of N(di) obtained from Excel using
NORMSDIST function.
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Step 5: Use financial
engineering techniques.
 Although there are many existing models
for financial options, sometimes none
correspond to the project’s real option.
 In that case, you must use financial
engineering techniques, which are
covered in later finance courses.
 Alternatively, you could simply use
decision tree analysis.
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Other Factors to Consider When
Deciding When to Invest
 Delaying the project means that cash
flows come later rather than sooner.
 It might make sense to proceed today if
there are important advantages to
being the first competitor to enter a
market.
 Waiting may allow you to take
advantage of changing conditions.
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 A New Situation: Cost is $75
Million, No Option to Wait
Cost Future Cash Flows NPV this
Year 0 Prob. Year 1 Year 2 Year 3 Scenario

$45 $45 $45 $36.91

30%
-$75 40% $30 $30 $30 -$0.39
30%
$15 $15 $15 -$37.70

Example: $36.91 = -$75 + $45/1.1 + $45/1.1 + $45/1.1.

37
Expected NPV of New
Situation
 E(NPV) = [0.3($36.91)] + [0.4(-$0.39)]
+ [0.3 (-$37.70)]
 E(NPV) = -$0.39.

 The project now looks like a loser.

38
 Growth Option: Can replicate the original
project after it ends in 3 years.

 NPV = NPV Original + NPV Replication

= -$0.39 + -$0.39/(1+0.10)3
= -$0.39 + -$0.30 = -$0.69.
 Still a loser, but you would implement
Replication only if demand is high.

Note: the NPV would be even lower if we separately discounted

the $75 million cost of Replication at the risk-free rate.

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 Decision Tree Analysis

Cost Future Cash Flows NPV this

Year 0 Prob. 1 2 3 4 5 6 Scenario

$45 $45 -$30 $45 $45 $45 $58.02

30%
-$75 40% $30 $30 $30 $0 $0 $0 -$0.39
30%
$15 $15 $15 $0 $0 $0 -$37.70
Notes: The Year 3 CF includes the cost of the project if it is optimal to
replicate. The cost is discounted at the risk-free rate, other cash
flows are discounted at the cost of capital.
40
Expected NPV of Decision Tree
 E(NPV) = [0.3($58.02)]+[0.4(-$0.39)]
+ [0.3 (-$37.70)]
 E(NPV) = $5.94.

 The growth option has turned a losing

project into a winner!

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Financial Option Analysis:
Inputs
 X = exercise price = cost of implement
project = $75 million.
 rRF = risk-free rate = 6%.
 t = time to maturity = 3 years.

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 Estimating P: First, find the value
of future CFs at exercise year.

Cost Future Cash Flows PV at Prob.

Year 0 Prob. 1 2 3 4 5 6 Year 3 x NPV

$45 $45 $45 $111.91 $33.57

30%
40% $30 $30 $30 $74.61 $29.84
30%
$15 $15 $15 $37.30 $11.19

Example: $111.91 = $45/1.1 + $45/1.12 + $45/1.13.

43
 Now find the expected PV at
the current date, Year 0.
PVYear 0 Year 1 Year 2 PVYear 3

$111.91
High
$56.05 Average $74.61
Low
$37.30
PVYear 0=PV of Exp. PVYear 3 = [(0.3* $111.91) +(0.4*$74.61)
+(0.3*$37.3)]/1.13 = $56.05.
44
The Input for P in the Black-
Scholes Model
 The input for price is the present value
of the project’s expected future cash
flows.
 Based on the previous slides,
P = $56.05.

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 Estimating σ2: Find Returns from the
Present until the Option Expires

Annual
PVYear 0 Year 1 Year 2 PVYear 3 Return

$111.91 25.9%
High
$56.05 Average $74.61 10.0%
Low
$37.30 -12.7%
Example: 25.9% = ($111.91/$56.05)(1/3) - 1.
46
Expected Return and Variance of
Return
 E(Ret.)=0.3(0.259)+0.4(0.10)+0.3(-
0.127)
 E(Ret.)= 0.080 = 8.0%.

 2 = 0.3(0.259-0.08)2 + 0.4(0.10-0.08)2
+ 0.3(-0.1275-0.08)2
 2 = 0.023 = 2.3%.
47
Why is σ2 so much lower than in
the investment timing example?
 σ2 has fallen, because the dispersion of
cash flows for replication is the same as
for the original project, even though it
begins three years later. This means
the rate of return for the replication is
less volatile.
 We will do sensitivity analysis later.

48
Estimating σ2 with the Indirect
Method
From earlier slides, we know the value of the project
for each scenario at the expiration date.

PVYear 3

$111.91
High
Average $74.61
Low
$37.30 49
Project’s Expected PV and PV

 E(PV)=.3($111.91)+.4($74.61)
+.3($37.3)
E(PV)= $74.61.
 PV = [.3($111.91-$74.61)2
+ .4($74.61-$74.61)2
+ .3($37.30-$74.61)2]1/2
PV = $28.90.
50
Now use the indirect formula
to estimate σ2.

 CVPV = $28.90 /$74.61 = 0.39.

 The option expires in 3 years, t=3.

1n(0.392 + 1)
σ2 = = 4.7%
3

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 Black-Scholes Inputs: P=$56.06; X=$75;
rRF=6%; t = 3 years; 2=0.047.

V = $56.06[N(d1)] - $75e-(0.06)(3)[N(d2)].
d1 = ln($56.06/$75)+[(0.06 + 0.047/2)](3)
(0.047)0.5 (3).05
= -.1085.
d2 = d1 - (0.047)0.5 (3).05= d1 - 0.3755
= -0.1085 - 0.3755 = - 0.4840.
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 Black-Scholes Value

N(d1) = N(-0.1085) = 0.4568

N(d2) = N(- 0.4840) = 0.3142

V = $56.06(0.4568) - $75e(-0.06)(3)(0.3142)
= $5.92.
Note: Values of N(di) obtained from Excel using
NORMSDIST function.
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Total Value of Project with
Growth Opportunity
 Total value =
NPV of Original Project + Value of
growth option

=-$0.39 + $5.92
= $5.5 million.

54
Sensitivity Analysis on the Impact of
Risk (using the Black-Scholes model)
 If risk, defined by σ2, goes up, then
value of growth option goes up:
 σ2 = 4.7%, Option Value = $5.92
 σ2 = 14.2%, Option Value = $12.10
 σ2 = 50%, Option Value = $24.08
 Does this help explain the high value
many dot.com companies had before
2002?
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