International Institute of Planning &

Management

CIP Report

Topic: - What are the four main types of real options? Explain the

implications of real options in case of analyzing the project.

Submitted to: - Prof. Paresh Shah

Prepared By: - Siddharth Kothari

PGP/SS/08-10/B

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What are Real Options?

Real options are methods which quantify the value of management

flexibility in the uncertainty prevailing world. These options are said to be

the strategic options. They adapt to the decisions wherein they have to

response to uncertainty or unexpected market developments. Conceptually

saying, Real Options allows the management to determine and

communicate the strategic value of the project wherein investments have

been made. Traditional Methods like NPV etc. sometimes fails to determine

the economic value on investments in such an environment where there is

huge uncertainty and rapid change, and that is where Real Options are

useful. Identifying, managing and exercising Real Options can also be used

for creating the shareholders value which is compounded by their

investment portfolio. The real options method represents the new state-of-

the-art technique for the valuation and management of strategic

investments. The real option method enables corporate decision-makers to

leverage uncertainty and limit downside risk. A firm has always one or more

options to take strategic decisions during lifespan of a project. For example,

a natural resource firm can take decision to not extract the gold from the

mine if the price of the gold falls below the cost of extraction and vice versa .

These strategic options, which are known as real options, are typically

ignored in standard discounted cash flow (DCF) analysis where a single

expected present value is computed. These real options, however, can

significantly increase the value of a project by eliminating unfavorable

outcomes

Types of Real Options

There are basically four types of Real Options:-

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1) Abandonment or Shutdown Options

2) Investment Timing Options

3) Growth Options

4) Flexibility Options

1) Abandonment or Shutdown Options

In traditional business format, a project is said to run throughout its

lifetime but a firm may have option of ceasing the project anytime

during its life. This is called abandonment or shutdown options. This

option means the right to sell the cash flows over the remainder of the

projects life for some value. When the present value of the remaining

cash flows falls below the liquidation value, the asset may be sold.

Abandonment is effectively the exercising of a put option. These

options are particularly important for large capital intensive projects

such as nuclear plants, airlines, and railroads. They are also important

for projects involving new products where their acceptance in the

market is uncertain.

Example:

Suppose your resource management company has a two-year lease

over a small copper deposit and is deciding whether or not to mine

the deposit. At the end of the lease, all rights to the property revert to

the government. It is known that the deposit contains eight million

pounds of copper. Mining would involve a one-year development

phase that would cost $1.25 million immediately. The company would

then pay all extraction costs to a subcontractor, in advance, at a rate

of 85 cents per pound. This amounts to a cash payment of $6.8 million

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one year from now. Your company would then sell the rights to the

copper recovered (8 million pounds) to a third party at the spot price

of copper one year from now. Copper prices follow a process such that

percentage price changes are normally distributed with mean 7% and

standard deviation 20%, and the current price is 95 cents per pound.

What is the expected NPV of mining if the required return for copper

mining projects is 10% and the riskless rate of interest is 5%?

Answering the above question may tell whether we have an option to

abandoned or shut down the project

2) Investment Timing Options

When there is more uncertainty about the future cash flows and this

increased uncertainty makes the firm more or less willing to invest in

the project today, this is investment timing options. This option talks

about the time of the investment of the project whether it right time

to invest or not.

These are the following questions which one may ask in the option

What is the NPV of doing Project X today?

What is the NPV of Project X in 5 year if the market is strong?

What is the NPV of Project X in 3 year if the market is weak?

What is the expected NPV of Project X if any firm waits 6 and half

months to decide whether to undertake the project?

What is the value of this investment timing option?

3) Growth Options

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The value of the firm can exceed the market value of the projects

currently in place because the firm may have the opportunity to

undertake positive NPV projects in the future. Standard capital

budgeting techniques involve establishing the present value of these

projects based on anticipated implementation dates. However, this

implicitly assumes that the firm is committed to go ahead with the

projects. Since management need not make such a commitment, they

retain the option to exercise only those projects that appear to be

profitable at the time of initiation. The value of these options should

be considered in valuing the firm. Growth options are particularly

valuable in infrastructure-based or strategic industries. For example,

in the high-tech and software industries (where there are significant

first-mover advantages) valuable growth options can be obtained

through R&D expenditure and by creating strategic links with other

industry players -- even though these activities may appear to be

negative NPV investments when viewed in isolation.

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4) Flexibility Options

Choice of capital structure can affect value of project. Like operating

flexibility, financial flexibility can be measured by the value of the

financial options made available to the firm by its choice of capital

structure. Interaction between financial and operating options can be

strong -- especially for long-term investment projects with a lot of

uncertainty. The option valuation framework is particularly useful to

the corporate strategist because it provides an integrative analysis of

both operating and financial options associated with the combined

investment and financing decisions.

Example: Precious Metal Mining

Four silver production sites, each with different layout and extraction

technologies.

The price of silver has been very volatile. To value firm based upon

forecasts of silver prices (traditional NPV approach) could grossly

underestimate the value.

Value is enhanced by:

(i) Operational flexibilities

(ii) Switching options (shut down, reopening, abandonment).

Insight can be gained into the opening-up and shutting-down decision.

If the mine is already open, it might be optimal to keep it open even

when the marginal revenue from a ton of output falls below the

marginal cost of extraction. Intuitively, the fixed cost of closing an

operation might be needlessly incurred if the price rose in the future.

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The logic is just the opposite for the closing-down decision. Due to the

cost of reopening the mine, the optimal decision might be to keep it

closed until the commodity price rises substantially above the

marginal cost of production

Implication of real options in case of analyzing the project.

When we analyze any project, Real options plays an important role in

quantifying the real value of the investment done in any project. Real

Options are the new techniques used for the accurate valuation and

management of investments done strategically. In today’s world where the

uncertainty level is very high and there are rapid changes in the economic

environment, the traditional formats like NPV etc cannot help to identify the

real or accurate value of the investment in project and that is where Real

Options are used as to accurately measure or quantify the value of the

investment.

Suppose if NPV of any investment in the particular project is negative then

a firm will cancel the project but it is not the case and if the NPV of

investment of same project is Positive then the firm will accept the project

because they assume that there will be positive cash flows when NPV is

positive, but this is also not the case. This is where the Real Options comes

into picture because while calculating the NPV all factors are not

considered which may affect the NPV of the project, whereas Real Options

measures or considers each and every factor related to the project and then

the decision is made which is known as strategic decision and the option is

known as Strategic Option.

Rationale Implications of Real options

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Strategic Considerations/Options

In many acquisitions or investments, the parent firm believes that the

transaction will give it competitive advantages in the future. These

competitive advantages have a higher range and may be as follows:

Entry into another market:

Technological Updation

Big Brand Image etc.

The above competitive advantages are not taken into consideration while

measuring actual value of the project as they can affect the real value of

the project. But a Real option takes everything into consideration

Research, Development and Test Market Expenses

Some firms spends a lot in R & D and test marketing but they cannot

evaluate the actual expenses incurred in R & D or test marketing and even

if they evaluate these expenses they assume that they will have profits in

future with the experiments but there is possibility that the research or test

marketing may turn into scrap because of uncertainty of economy or

market.

Multi-Stage Projects/ Investments

While entering into new venture or new investment, it may happen that

investment is done in various stages. By doing this a firm can reduce the

downside risk and here come Real Options as a tool to measure the value of

project accurately as it will be done in various stages and by doing this we

can have a option to go for another stage or not.

There may be two possibilities which are:

It may happen that the projects which were not looking worth for full

investment can seems to be good looking by investing in various

stages.

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It may also happen that the projects which seems worth on full

investment may seem time wasting after some stages

Financial Flexibility

Looking one option as financial flexibility, it generates valuable insights on

when financial flexibility will be most valuable. But there are some instances

which can be argued and are as under:

If the business has higher returns or margins like any IT firm, other

things remaining equal, then there will be more financial flexibility as

they hold more cash reserves and can easily excess debt tool and if it

is vice versa than firm with low margins or returns will have less

financial flexibility. And the value is generated according to that.

Since a firm’s ability to fund these reinvestment needs is determined

by its capacity to generate internal funds, other things remaining

equal, financial flexibility should be worth less to firms with large and

stable earnings, as a percent of firm value. Firms that have small or

negative earnings, and therefore much lower capacity to generate

internal funds, will value flexibility more.

Firms with limited internal funds can still get away with little or no

financial flexibility if they can tap external markets for capital – bank

debt, bonds and new equity issues. Other things remaining equal, the

greater the capacity (and willingness) of a firm to raise funds from

external capital markets, the less should be the value of flexibility.

This explains why private or small firms, which have far less access to

capital, will value financial flexibility more than larger firms. The existence

of corporate bond markets can also make a difference in how much

flexibility is valued. In markets where firms cannot issue bonds and have to

depend entirely upon banks for financing, there is less access to capital and

a greater need to maintain financial flexibility.

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Conclusion

Option pricing theory has wide applicability in corporate finance. Real

options can find out or measure the real value of any investment in the

project. Certain factors which comes out after the real option implication

proves to be very important and crucial and needs an eagle eye to value any

investment. I came to know that Identifying, managing and exercising Real

Options can also be used for creating the shareholders value which is

compounded by their investment portfolio. The real options method

represents the new state-of-the-art technique for the valuation and

management of strategic investments. The real option method enables

corporate decision-makers to leverage uncertainty and limit downside risk.

A firm has always one or more options to take strategic decisions during

lifespan of a project.

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