Ch10 Real Options

Question 1

Real Options Essence

Answer 1

Real options apply financial option theory to real investment decisions. They represent the flexibility management has regarding a project

Question 2

Limits of Traditional Static NPV Analysis

Answer 2

Traditional Net Present Value (NPV) analysis assumes deterministic cash flows and a static decision-making process.
This approach breaks down under two conditions:
1. Uncertainty dissolves over time: Information increases over time about central project value drivers (e.g., GDP, commodity prices, competitor moves).
2. Managerial flexibility exists: Decision-makers have opportunities to adapt the investment strategy over time (e.g., defer, abandon, expand, contract)

Question 3

Real Options vs. Financial Options

Answer 3

◦ Similar to financial options, real options give the right, but not the obligation, to do something.
◦ The payoff from project flexibility is asymmetric, similar to options.
◦ This suggests option pricing theory (contingent claim analysis) is suitable for dealing with managerial flexibility.

Question 4

Call Option (Diagram)

Answer 4

Question 5

Put Option (Diagram)

Answer 5

Question 6

Influence on Call or Put Options

Answer 6

Question 7

Project Options

Answer 7

Option to Delay a Project: The right to defer investment and benefit from the resolution of uncertainty

Option to Expand a Project: Taking an initial project may provide the opportunity to take other valuable projects in the future

Option to Abandon a Project: The right to abandon a project for its salvage value, saving further losses, especially if cash flows underperform expectations

Question 8

Option to Abandon a Project

Answer 8

• This is similar to a Put option
• Example: Airbus investing in a joint venture with a negative static NPV could be made more valuable if the partner offers Airbus the option to sell its share back for a fixed amount (salvage value) within a certain period

Question 9

Option to Expand a Project

Answer 9

• This option to expand can make a project with a negative static NPV worthwhile.
• This is often referred to as a “strategic option”.
• Example: Investing in a Spanish Disney channel for Mexico (negative NPV initially) could give Disney the option to expand into Latin America if the market is successful

Question 10

Option to Delay a Project

Answer 10

• Exclusive rights like patents are valuable even if the project isn’t viable today, and their value increases with underlying business volatility
• This option allows waiting for market conditions to improve
• Example: A pharmaceutical patent gives the exclusive right to produce a drug for 17 years. Even if the project has a negative NPV today based on current cash flows and investment costs, the patent (the option to delay) has value

Question 11

Other Real Options

Answer 11

• option to contract operations
• the option to shut down and restart
• option to switch inputs/outputs

Question 12

Issue of DCF with Project Value

Answer 12

Standard Discounted Cash Flow (DCF) analysis underestimates project value by not accounting for managerial flexibility

Question 13

When are Real Options interesting

Answer 13

Real options are valuable when management can learn about uncertain parameters and act upon that information

Question 14

Managerial Flexibility and Firm Value

Answer 14

Increasing managerial flexibility can make firms more valuable

Question 15

Opportunities and Options

Answer 15

Care must be taken to ensure the option is exclusive to avoid overstating value; mere opportunities are not options

Question 16

Real Options Costs and Benefits

Answer 16

The cost of acquiring these rights (e.g., via R&D) must be weighed against their benefits