17 - 1

CHAPTER 17
Option Pricing with Applications to
Real Options

Financial options
Black-Scholes Option Pricing Model
Real options
Decision trees
Application of financial options to
real options
 17 - 2
What is a real option?

Real options exist when managers can

influence the size and risk of a projects
cash flows by taking different actions
during the projects life in response to
changing market conditions.
Alert managers always look for real
options in projects.
Smarter managers try to create real
options.
 17 - 3

What is a financial option?

An option is a contract which gives

its holder the right, but not the
obligation, to buy (or sell) an asset at
some predetermined price within a
specified period of time.
 17 - 4

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.
 17 - 5

Option Terminology

Call option: An option to buy a

specified number of shares of a
security within some future period.
Put option: An option to sell a
specified number of shares of a
security within some future period.
Exercise (or strike) price: The price
stated in the option contract at which
the security can be bought or sold.
 17 - 6

Option price: The market price of

the option contract.
Expiration date: The date the
option matures.
Exercise value: The value of a call
option if it were exercised today =
Current stock price - Strike price.
Note: The exercise value is zero if
the stock price is less than the
strike price.
 17 - 7

Covered option: A call option

written against stock held in an
investors portfolio.
Naked (uncovered) option: An
option sold without the stock to
back it up.
In-the-money call: A call whose
exercise price is less than the
current price of the underlying
stock.
 17 - 8

Out-of-the-money call: A call

option whose exercise price
exceeds the current stock
price.
LEAPs: Long-term Equity
AnticiPation securities that are
similar to conventional options
except that they are long-term
options with maturities of up to
2 1/2 years.
 17 - 9

Consider the following data:

Exercise price = $25.

Stock Price Call Option Price
$25 $ 3.00
30 7.50
35 12.00
40 16.50
45 21.00
50 25.50
 17 - 10
Create a table which shows (a) stock
price, (b) strike price, (c) exercise
value, (d) option price, and (e) premium
of option price over the exercise value.

Price of Strike Exercise Value

Stock (a) Price (b) of Option (a) - (b)
$25.00 $25.00 $0.00
30.00 25.00 5.00
35.00 25.00 10.00
40.00 25.00 15.00
45.00 25.00 20.00
50.00 25.00 25.00
 17 - 11

Table (Continued)

Exercise Value Mkt. Price Premium

of Option (c) of Option (d) (d) - (c)
$ 0.00 $ 3.00 $ 3.00
5.00 7.50 2.50
10.00 12.00 2.00
15.00 16.50 1.50
20.00 21.00 1.00
25.00 25.50 0.50
 17 - 12

Call Premium Diagram

Option
value
30
25
20
15
10 Market price

5
Exercise value

5 10 15 20 25 30 35 40 45 50
Stock Price
 17 - 13

What happens to the premium of the

option price over the exercise
value as the stock price rises?
The premium of the option price over
the exercise value declines as the stock
price increases.
This is due to the declining degree of
leverage provided by options as the
underlying stock price increases, and
the greater loss potential of options at
higher option prices.
 17 - 14
What are the assumptions of the
Black-Scholes Option Pricing Model?
The stock underlying the call option
provides no dividends during the call
options life.
There are no transactions costs for
the sale/purchase of either the stock
or the option.
RRF is known and constant during the
options life.
(More...)
 17 - 15

Security buyers may borrow any

fraction of the purchase price at the
short-term risk-free rate.
No penalty for short selling and sellers
receive immediately full cash
proceeds at todays price.
Call option can be exercised only on
its expiration date.
Security trading takes place in
continuous time, and stock prices
move randomly in continuous time.
 17 - 16

What are the three equations that

make up the OPM?

V = P[N(d1)] - Xe -r t[N(d2)].
RF

ln(P/X) + [rRF + (2/2)]t

d1 = .
t
d2 = d1 - t.
 17 - 17

What is the value of the following

call option according to the OPM?
Assume: P = $27; X = $25; rRF = 6%;
t = 0.5 years: 2 = 0.11
V = $27[N(d1)] - $25e-(0.06)(0.5)[N(d2)].
ln($27/$25) + [(0.06 + 0.11/2)](0.5)
d1 =
(0.3317)(0.7071)
= 0.5736.
d2 = d1 - (0.3317)(0.7071) = d1 - 0.2345
= 0.5736 - 0.2345 = 0.3391.
 17 - 18

N(d1) = N(0.5736) = 0.5000 + 0.2168

= 0.7168.
N(d2) = N(0.3391) = 0.5000 + 0.1327
= 0.6327.
Note: Values obtained from Excel using
NORMSDIST function.

V = $27(0.7168) - $25e-0.03(0.6327)
= $19.3536 - $25(0.97045)(0.6327)
= $4.0036.
 17 - 19

What impact do the following para-

meters have on a call options value?

Current stock price: Call option

value increases as the current
stock price increases.
Exercise price: As the exercise
price increases, a call options
value decreases.
 17 - 20

Option period: As the expiration date

is lengthened, a call options value
increases (more chance of becoming
in the money.)
Risk-free rate: Call options value
tends to increase as rRF increases
(reduces the PV of the exercise price).
Stock return variance: Option value
increases with variance of the
underlying stock (more chance of
becoming in the money).
 17 - 21

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
isnt traded.

(More...)
 17 - 22

How are real options different from

financial options?
The payoffs for financial options are
specified in the contract.
Real options are found or created
inside of projects. Their payoffs can
be varied.
 17 - 23

What are some types of

real options?
Investment timing options
Growth options
Expansion of existing product line
New products
New geographic markets
 17 - 24

Types of real options (Continued)

Abandonment options
Contraction
Temporary suspension
Flexibility options
 17 - 25
Five Procedures for Valuing
Real Options
1. DCF analysis of expected cash flows,
ignoring the option.
2. Qualitative assessment of the real
options value.
3. Decision tree analysis.
4. Standard model for a corresponding
financial option.
5. Financial engineering techniques.
 17 - 26

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
 17 - 27

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
 17 - 28

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.*
_______________________________________
* See Ch 17 Mini Case.xls for calculations.
 17 - 29

Investment Timing (Continued)

If we wait one year, we will gain

additional information regarding
demand.
If demand is low, we wont 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.
 17 - 30

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.
 17 - 31
Procedure 3: Decision Tree Analysis
(Implement only if demand is not low.)
Cost Future Cash Flows NPV this
2001 Prob. 2002 2003 2004 2005 Scenarioa

-$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.
See Ch 17 Mini Case.xls for calculations.
 17 - 32
Use these scenarios, with their given
probabilities, to find the projects
expected NPV if we wait.

E(NPV) = [0.3($35.70)]+[0.4($1.79)]
+ [0.3 ($0)]
E(NPV) = $11.42.
 17 - 33
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.
 17 - 34
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 doesnt tell us how to
estimate the right discount rates, so we
normally do sensitivity analysis using a
range of different rates.
 17 - 35
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.
 17 - 36
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.
2 = variance of stock return =
Estimated on following slides.
 17 - 37
Estimate of P
For a financial option:
P = current price of stock = PV of all of
stocks expected future cash flows.
Current price is unaffected by the
exercise cost of the option.
For a real option:
P = PV of all of projects future
expected cash flows.
P does not include the projects cost.
 17 - 38
Step 1: Find the PV of future CFs at
options exercise year.
Future Cash Flows PV at
2002 Prob. 2003 2004 2005 2006 2003

$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.

See Ch 17 Mini Case.xls for calculations.
 17 - 39
Step 2: Find the expected PV at the
current date, 2002.
PV2002 PV2003

$111.91
High
$67.82 Average $74.61
Low
$37.30
PV2002=PV of Exp. PV2003 = [(0.3* $111.91) +(0.4*$74.61)
+(0.3*$37.3)]/1.1 = $67.82.
See Ch 17 Mini Case.xls for calculations.
 17 - 40
The Input for P in the Black-Scholes
Model
The input for price is the present
value of the projects expected future
cash flows.
Based on the previous slides,
P = $67.82.
 17 - 41
Estimating 2 for the Black-Scholes
Model
For a financial option, 2 is the
variance of the stocks rate of return.
For a real option, 2 is the variance of
the projects rate of return.
 17 - 42

Three Ways to Estimate 2

Judgment.
The direct approach, using the
results from the scenarios.
The indirect approach, using the
expected distribution of the projects
value.
 17 - 43

Estimating 2 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 2 =
10%, so we might expect the project to
have 2 between 12% and 19%.
 17 - 44

Estimating 2 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.
 17 - 45
Find Returns from the Present until the
Option Expires
PV2002 PV2003 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.
See Ch 17 Mini Case.xls for calculations.
 17 - 46
Use these scenarios, with their given
probabilities, to find the 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%.
 17 - 47

Estimating 2 with the Indirect Approach

From the scenario analysis, we know

the projects expected value and the
variance of the projects 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 projects
value at the time the option expires?
 17 - 48

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 projects value at the
time the option expires.
 17 - 49
Indirect Estimate of 2
Here is a formula for the variance of a
stocks return, if you know the
coefficient of variation of the
expected stock price at some time, t,
in the future:
ln[ CV 1]
2

2
t
We can apply this formula to the real
option.
 17 - 50
From earlier slides, we know the value
of the project for each scenario at the
expiration date.
PV2003

$111.91
High
Average $74.61
Low
$37.30
 17 - 51
Use these scenarios, with their given
probabilities, to find the projects
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.
 17 - 52
Find the projects expected coefficient
of variation, CVPV, at the time the option
expires.

CVPV = $28.90 /$74.61 = 0.39.

 17 - 53

Now use the formula to estimate 2.

From our previous scenario analysis,

we know the projects CV, 0.39, at the
time it the option expires (t=1 year).

ln[ 0.39 1]
2

2
14.2%
1
 17 - 54
The Estimate of 2
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 2.
 17 - 55

Use the Black-Scholes Model:

P = $67.83; X = $70; rRF = 6%;
t = 1 year: 2 = 0.142

V = $67.83[N(d1)] - $70e-(0.06)(1)[N(d2)].
ln($67.83/$70)+[(0.06 + 0.142/2)](1)
d1 =
(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.
 17 - 56

N(d1) = N(0.2641) = 0.6041

N(d2) = N(- 0.1127) = 0.4551

V = $67.83(0.6041) - $70e-0.06(0.4551)
= $40.98 - $70(0.9418)(0.4551)
= $10.98.

Note: Values of N(di) obtained from Excel using

NORMSDIST function. See Ch 17 Mini Case.xls for details.
 17 - 57
Step 5: Use financial engineering
techniques.
Although there are many existing
models for financial options,
sometimes none correspond to the
projects 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.
 17 - 58

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.
 17 - 59
A New Situation: Cost is $75 Million,
No Option to Wait
Cost Future Cash Flows NPV this
2002 Prob. 2003 2004 2005 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.

See Ch 17 Mini Case.xls for calculations.
 17 - 60

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.

 17 - 61

Growth Option: You 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.
 17 - 62
Decision Tree Analysis
Cost Future Cash Flows NPV this
2002 Prob. 2003 2004 2005 2006 2007 2008 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 2005 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. See Ch 17 Mini Case.xls
for all calculations.
 17 - 63

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!
 17 - 64

Financial Option Analysis: Inputs

X = exercise price = cost of

implement project = $75 million.
rRF = risk-free rate = 6%.
t = time to maturity = 3 years.
 17 - 65
Estimating P: First, find the value of
future CFs at exercise year.
Cost Future Cash Flows PV at Prob.
2002 Prob. 2003 2004 2005 2006 2007 2008 2005 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.

See Ch 17 Mini Case.xls for calculations.
 17 - 66
Now find the expected PV at the
current date, 2002.
PV2002 2003 2004 PV2005

$111.91
High
$56.05 Average $74.61
Low
$37.30

PV2002=PV of Exp. PV2005 = [(0.3* $111.91) +(0.4*$74.61)

+(0.3*$37.3)]/1.13 = $56.05.
See Ch 17 Mini Case.xls for calculations.
 17 - 67
The Input for P in the Black-Scholes
Model
The input for price is the present
value of the projects expected future
cash flows.
Based on the previous slides,
P = $56.05.
 17 - 68
Estimating 2: Find Returns from the
Present until the Option Expires
Annual
PV2002 2003 2004 PV2005 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.
See Ch 17 Mini Case.xls for calculations.
 17 - 69
Use these scenarios, with their given
probabilities, to find the 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%.
 17 - 70
Why is 2 so much lower than in the
investment timing example?
2 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.
 17 - 71
Estimating 2 with the Indirect Method
From earlier slides, we know the
value of the project for each scenario
at the expiration date.
PV2005

$111.91
High
Average $74.61
Low
$37.30
 17 - 72
Use these scenarios, with their given
probabilities, to find the projects
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.
 17 - 73
Now use the indirect formula to
estimate 2.
CVPV = $28.90 /$74.61 = 0.39.
The option expires in 3 years, t=3.

ln[ 0.39 1]
2

2
4.7%
3
 17 - 74

Use the Black-Scholes Model:

P = $56.06; X = $75; rRF = 6%;
t = 3 years: 2 = 0.047

V = $56.06[N(d1)] - $75e-(0.06)(3)[N(d2)].
ln($56.06/$75)+[(0.06 + 0.047/2)](3)
d1 =
(0.047)0.5 (3).05
= -0.1085.
d2 = d1 - (0.047)0.5 (3).05= d1 - 0.3755
= -0.1085 - 0.3755 =- 0.4840.
 17 - 75

N(d1) = N(0.2641) = 0.4568

N(d2) = N(- 0.1127) = 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. See Ch 17 Mini Case.xls for
calculations.
 17 - 76
Total Value of Project with Growth
Opportunity

Total value = NPV of Original Project +

Value of growth option
=-$0.39 + $5.92
= $5.5 million.
 17 - 77
Sensitivity Analysis on the Impact of
Risk (using the Black-Scholes model)
If risk, defined by 2, goes up, then
value of growth option goes up:
2 = 4.7%, Option Value = $5.92
2 = 14.2%, Option Value = $12.10
2 = 50%, Option Value = $24.08
Does this help explain the high value
of many dot.com companies?