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Engineering Systems Analysis for DesignMassachusetts Institute of Technology
Richard de Neufville Real Options SDM Slide 1 of 31
Richard de NeufvilleProfessor of Engineering Systems and of
Civil and Environmental EngineeringMIT
Real Options
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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Outline
Motivational Example: Garage Case
General Perspective
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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Garage Case Topics
Value at Risk
Analyzing flexibility using spreadsheet
Parking garage case
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Value at Risk Concept
Value at Risk (VAR) recognizes fundamental reality: actual value of any design can only be known probabilistically
Because of inevitable uncertainty in – Future demands on system– Future performance of technology– Many other market, political factors
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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Value at Risk Definition
Value at Risk (VAR) definition:– A loss that will not be exceeded at some specified
confidence level– “We are p percent certain that we will not lose more
than V dollars for this project.”
VAR easy to see on cumulative probability distribution (see next figure)
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Look at distribution of NPV of designs A, B:– 90% VAR for NPVA is -$91– 90% VAR for NPVB is $102
CDF
0%
20%
40%
60%
80%
100%
-400 -200 0 200 400 600
NPV
Cu
mu
lati
ve
Pro
ba
bil
ity
NPVA NPVB 90% VAR for NPVA
90%VAR for NPVB 10% Probability
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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VAR and Flexibility
VAR is a common financial concept
It stresses downside losses, risks
However, designers also need to look at upside potential: “Value of Gain”
Flexible design provides value by both:– Decreasing downside risk– Increasing upside potential– See next figure
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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Sources of value for flexibility
Cumulative Probability
Value
Original distribution
Distribution with flexibility
Cut downside risks
Expand upside potential
Cut downside ; Expand Upside
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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Excel Analysis Sequence toillustrate value of flexibility
1: Examine situation without flexibility – This is Base case design
2: Introduce variability (simulation)a different design (in general)
3: Introduce flexibility=> a even different and better design
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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Parking Garage Case
Garage in area where population expands Actual demand is necessarily uncertain
Design Opportunity: Strengthened structure – enables future addition of floor(s) (flexibility)– costs more (flexibility costs)
Design issue: is extra cost worthwhile?
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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Parking Garage Case details
Demand– At start is for 750 spaces– Over next 10 years is expected to rise exponentially
by another 750 spaces– After year 10 may be 250 more spaces– could be 50% off the projections, either way;– Annual volatility for growth is 10%
Average annual revenue/space used = $10,000
The discount rate is taken to be 12%
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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Step 1: Set up base case
0 1 2 3 19 20Demand 750 893 1,015 1,688 1,696Capacity 1,200 1,200 1,200 1,200 1,200Revenue $7,500,000 $8,930,000 $10,150,000 $12,000,000 $12,000,000Recurring Costs
Operating cost $2,400,000 $2,400,000 $2,400,000 $2,400,000 $2,400,000Land leasing cost $3,600,000 $3,600,000 $3,600,000 $3,600,000 $3,600,000 $3,600,000
Cash flow $1,500,000 $2,930,000 $4,150,000 $6,000,000 $6,000,000Discounted Cash Flow $1,339,286 $2,335,778 $2,953,888 $696,641 $622,001Present value of cash flow $32,574,736Capacity costs for up to two levels $6,400,000Capacity costs for levels above 2 $16,336,320Net present value $6,238,416
Year
Demand growth as predicted, no variability
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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Optimal design for base case (no uncertainty) is 6 floors
-15
-10
-5
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5
10
2 3 4 5 6 7 8 9
Number of Floors
Exp
ecte
d N
PV
($,
Mil
lio
ns)
Traditional NPV Recognizing uncertainty
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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Step 2: Simulate uncertainty
0
100
200
300
400
500
600
-17.8 -15.6 -13.5 -11.3 -9.2 -7.0 -4.9 -2.7 -0.6 1.6 3.7 5.9 8.0
Fre
qu
en
cy
5-floor design
Simulated Mean
6-floor design
Deterministic
Result
Lower demand => Loss
Higher demand => Gain limited by garage size
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NPV Cumulative Distributions
0
0.1
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0.3
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1
-20 -15 -10 -5 0 5 10
Pro
bab
ilit
y
CDF for Result of
Simulation Analysis (5-
floor) Implied CDF for
Result of
Deterministic NPV
Analysis (6-floor)
Compare Actual (5 Fl) with unrealistic fixed 6 Fl design
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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Recognizing uncertainty => different design (5 floors)
-15
-10
-5
0
5
10
2 3 4 5 6 7 8 9
Number of Floors
Exp
ecte
d N
PV
($,
Mil
lio
ns)
Traditional NPV Recognizing uncertainty
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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Step 3: Introduce flexibility into design (expand when needed)
0 1 2 3 19 20Demand 820 924 1,044 1,519 1,647Capacity 800 800 1,200 1,600 1,600
Decision on expansion expandExtra capacity 400
Revenue $8,000,000 $8,000,000 $10,440,000 $15,190,000 $16,000,000Recurring Costs
Operating cost $1,600,000 $1,600,000 $2,400,000 $3,200,000 $3,200,000Land leasing cost $3,600,000 $3,600,000 $3,600,000 $3,600,000 $3,600,000 $3,600,000Expansion cost $8,944,320
Cash flow $2,800,000 -$6,144,320 $4,440,000 $8,390,000 $9,200,000Discounted Cash Flow $2,500,000 -$4,898,214 $3,160,304 $974,136 $953,734Present value of cash flow $30,270,287Capacity cost for up to two levels $6,400,000Capacity costs for levels above 2 $7,392,000Price for the option $689,600Net present value $12,878,287
Year
Including Flexibility => Another, better design:
4 Floors with strengthened structure enabling expansion
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Summary of design results from different perspectives
Why is the optimal design much better when we design with flexibility?
Perspective Simulation Option Embedded Design Estimated Expected NPVDeterministic No No 6 levels $6,238,416
Recognizing Uncertainty Yes No 5 levels $3,536,474
Incorporating Flexibilty Yes Yes4 levels with strengthened
structure$10,517,140
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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Sources of value for flexibility:
0
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5-Floor Design 4-Floor Design
1) Minimize exposure to downside risk
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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Sources of value for flexibility:
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
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90.0%
100.0%
-20 -15 -10 -5 0 5 10 15 20 25 30 35
Pro
bab
ility
CDF for NPV
with Flexibility
CDF for NPV
without Flexibility
Mean for NPV
without Flexibility
Mean for NPV
with Flexibility
2) Maximize potential for upside gain
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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Comparison of designswith and without flexibility
Wow! Everything is better! How did it happen?
Root cause: change the framing of the problem
• recognize uncertainty ; add in flexibility thinking
Design Design with Flexibility Thinking Design without Flexibility thinking Comparison(4 levels, strengthened structure) (5 levels)
Initial Investment $18,081,600 $21,651,200 Better with optionsExpected NPV $10,517,140 $3,536,474 Better with optionsMinimum Value -$13,138,168 -$18,024,062 Better with optionsMaximum Value $29,790,838 $8,316,602 Better with options
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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Summary from Garage Case
Sources of value for flexibility– Cut downside risk– Expand upside potential
VAR chart is a neat way to represent the sources of value for flexibility
Spreadsheet with simulation is a powerful tool for estimating value of flexibility
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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“Options” Embody Idea of Flexibility
An “Option” provides a formal way of defining flexibility
An “Option” has a specific technical definition
Semantic Caution:– The technical meaning of an “option” is…
much more specific and limited than … ordinary meaning of “option” in conversation... where “option” = “alternative”
Pay careful attention to definition that follows!
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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Technical definition of an Option An Option is... A right, but not an obligation…
– “Exercise”, that is “use” only if advantageous– Asymmetric returns -- “all gain, no pain”– Usually acquired at some cost or effort
to take some action…– to grow or change system, buy or sell something, etc, etc,
now, or in the future... – May be indefinite – But can be for a limited time after which option expires
for a pre-determined price (the “strike” price). – Cost of action separate from cost of option
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Financial Options
Focus first on financial options because – Consequences easiest to present– This is where options and valuation developed
Financial Options– Are tradable assets (see quotes finance.yahoo.com)– Sold through exchanges similar to stock markets– Are on all kinds of goods (known as “underlying
assets”)•Stocks, that is, shares in companies•Commodities (oil, meat, cotton, electricity...)•Foreign exchange, etc., etc.
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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Real Options
“Real” because they refer to project and systems– Contrast with financial options that are contracts
Real Options are focus of interest for Design– They provide flexibility for evolution of system
Projects often contain option-like flexibilities– Rights, not obligations (example: to expand garage)– Exercise only if advantageous
These flexibilities are “real” options
Let’s develop idea by looking at possibilities…
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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Real Options are Everywhere
Examples:
Lease equipment with option to buy at end of lease– Action is to buy at end of lease (or to walk away)– Lease period defined up-front (typically 2-3 years)– Purchase price defined in lease contract
Flexible manufacturing processes– Ability to select mode of operation (e.g. thermal power by
burning either gas or oil)– Switching between modes is action– Continuous opportunity (can switch at any time)– Switching often entails some cost (e.g.: set-up time)
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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Real Options “IN” and “ON” projects Those “real” because, in contrast to financial options, they
concern projects, they are “ON” projects– E.g.: the option to open a mine– These do not concern themselves with system design– Most common in literature
Those “real” because they concern the design elements of system, they are “IN” projects
– EX: options for staging of system of communication satellites– These require detailed understanding of system– Most interesting to system designers
Financialoptions
Options ON projects
Options INprojects
Real Options
These needknowledgeof system
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Real Options “ON” projects These are financial options, but on technical things
They treat technology as a “black box”
Example: Antamina Copper– option to open the mine after a two-year exploration period– Uncertainty concerns: amount of ore and future price
=>uncertainty in revenue and thus in value of mine– Option is a Financial Call Option (on Mine as asset)
Differs from normal Financial Option because– Much longer period -- financial option usually < 2 years– Special effort needed to model future value of asset, it can’t
be projected simply from past data (as otherwise typical)
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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Real Options “IN” projects
These create options by design of technical system
They require understanding of technology
Example: Communications Satellites– Designers can create options for expansion of capacity
by way they configure original satellites– Technical skill needed to create and exercise option
Differ from other “real” Options because– Special effort needed to model feasible flexibility within
system itself (e.g.: modeling of ‘trade space” for design of communication satellites)
Engineering Systems Analysis for DesignMassachusetts Institute of Technology
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Summary Options embody formal concept of flexibility Options are not “alternatives” 4 step Mantra “right, but not obligation, to act…” “Calls” for opportunities, “puts” for downside risks
OPTIONS MAY HAVE GREAT VALUE
Options are Financial and “Real” Many “real” options available to system designers “Real” Options “ON ” and “IN” systems