Chapter 32
Chapter 32
Chapter 32
Chapter 32
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Valuing Flexibility
1
Valuation Using Real Options
Slides 11-14
Real Option Valuation (ROV)
Part 2 If the project contains substantial market risk (i.e. beta greater than zero), decision
trees will be biased upwards because they underestimate the cost of capital.
Replicating portfolios allow us to value the option accurately.
Slide 16-23
An Exploration of Risk
Part 3 A number of factors, such as market risk, can affect the valuation process. We will
explore situations in which it may be more appropriate to use one of either the
Decision Tree Analysis or Real Option Valuation.
2
Decision Tree Analysis (DTA)
3
Product Testing
• What if you had the ability to test the product’s potential over the
next year before making the investment? What would the net
present value be after the test is completed?
4
Building a Decision Tree
• What if you had the ability to test the product’s potential over the
next year before making the investment? What is the present
value of the test before the test is completed?
Good Results
25
max 0, 350
.05
Value Today? Test
Bad Results
5
max 0, 350
.05
5
Valuing the Test Itself
• If this test costs $60 million and delays a full product launch by
a year, should we perform the test?
6
Why the Difference in Values?
• Note that the ‘standard’ NPV is the maximum, decided today, of the
expected discounted cash flows or zero:
• Real options are most valuable whenever you face a decision that is costly
to reverse, such as a large initial investment (i.e. sunk cost).
7
A Slight Alteration: A Practice Example
• One of your scientists has a brilliant idea. With a slight alteration in the
compound, you can reduce research and development costs from $350
million to $275 million. Unfortunately, this makes any testing (of the
compound) more expensive. The cost of testing will rise from $60 to
$85 million.
• If both compounds are available, would you change your investment &
testing strategy?
8
Valuation Using Real Options
Slides 11-14
Real Option Valuation (ROV)
If the project contains substantial market risk (i.e. beta greater than zero), decision
trees will be biased upwards because they underestimate the cost of capital.
Replicating portfolios allow us to value the option accurately.
Slide 16-23
An Exploration of Risk
Part 3 A number of factors, such as market risk, can affect the valuation process. We will
explore situations in which it may be more appropriate to use one of either the
Decision Tree Analysis or Real Option Valuation.
9
Using the Tools of Financial Options
– What was the strike price? Project Value using Standard NPV
10
Real Options Valuation (ROV)
25 25
p = 50%
Vu max 0, 350
.05 .05
V0
5 5
1 - p = 50%
Vd max 0, 350
.05 .05
11
Step 2: The Replicating Portfolio
• To value the call option, we can not use discounted cash flow, as we do not
know the appropriate cost of capital for the option. Therefore, we use
replicating portfolios.
• Since there are two states of the world, we need two assets to replicate the
payoff structure of the call option. As the second asset, we use a risk free
bond.
N(500)+B(1.05) = 150
Continuing
the same
example: N(100)+B(1.05) = 0
Value of Value of option
underlying payoff in down
asset in down state
state
12
Step 3: Valuing the Call Option
• Because both have identical payoffs, the value of the real option
equals the value of the replicating portfolio.
• Today’s value of the replicating portfolio equals N shares of the
underlying asset (S) financed by $b in risk free bonds.
13
Valuation Using Real Options
Slides 11-14
Real Option Valuation (ROV)
Part 2 If the project contains substantial market risk (i.e. beta greater than zero), decision
trees will be biased upwards because they underestimate the cost of capital.
Replicating portfolios allow us to value the option accurately.
Slide 16-23
An Exploration of Risk
A number of factors, such as market risk, can affect the valuation process. We will
explore situations in which it may be more appropriate to use one of either the
Decision Tree Analysis or Real Option Valuation.
14
Modeling Market Based Risk
15
Analyzing Market Risk vs. Technological Risk
16
Using DTA to Solve for Option Value
• What if you had the ability to test the product’s potential over the
next year before making the investment? What is the net
present value after the test is completed?
Good Results
75
max 0, 350 150
.15
75
max 0, 15 350 0
.15
17
Using ROV to Solve for Option Value
• To value the call option, we can not use discounted cash flow, as we do not
know the appropriate cost of capital. Therefore, we use replicating portfolios.
• Since there are two states of the world, we need two assets to replicate the
payoff structure of the call option. As the second asset, we use a risk free
bond.
18
Valuing the Call Option
• Because they have identical payoffs, the value of the real option
equals the value of the replicating portfolio.
• Today’s value of the replicating portfolio equals N shares of the
underlying asset (S) financed by $B in risk free bonds.
19
The Intuition Behind the Valuation Difference
20
When to Use DTAs versus ROV Models
21
Complex Real Option Models
Success
1–p= 85%
Stop
22