FNCE20005 Corporate Financial Decision Making

• Real Options
• Decision Tree Analysis
• Real Options
• Valuing Real Options
• Readings:
• Fundamentals of Corporate Finance – Chapter 24 (Options and Capital
Budgeting)
• Corporate Finance – Chapter 7.3 & 7.4
7.1 Decision Tree Analysis
• In a typical NPV analysis, we only consider the initial decision to invest at t=0. However, projects can
involve multiple decisions a sequence over time. Also, the NPV implicitly compares the project to
the cost of capital – we may want to directly compare against alternative projects.
• These considerations can be incorporated through a decision tree analysis.
• It is necessary to obtain estimates of the probability of an event occurring and the cash-flows
associated with the event.
• If there is more than one decision to make, the rollback procedure is used
• Rollback procedure
• Also known as backward induction in game theory.
• Involves assessment of the most distant decision first. Once this decision is analyzed, next
most distant decision is assessed. The procedure is repeated until we reach today’s decision.
7.2 Decision Tree Analysis: Example
• Company needs to expand its operations and has choice of expanding domestically or overseas
• Expansion overseas would require $3m while domestic expansion would require $0.5m
• Chances of success are 30% overseas and 80% domestically
• At the end of next year:
• Success (failure) overseas will result in $10m ($2m)
• Success (failure) domestically will generate $3m ($1m)
• Opportunity cost of capital is 10% p.a.
• Should the company expand overseas or domestically?
7.3 Decision Tree Analysis: Example
• Decision tree
7.4 Decision Tree Analysis: Example

0.3 × 10 + 0.7 × 2
𝑁𝑃𝑉𝑂𝑣𝑒𝑟𝑠𝑒𝑎𝑠 = −3=1
1.1
0.8 × 3 + 0.2 × 1
𝑁𝑃𝑉𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 = − 0.5 = 1.86
1.1

• Decision is to expand domestically

7.5 Decision Tree Analysis: Another Example
• Assume you are a professional karaoke singer trying to decide whether you should spend the last 2
years before you retire in Australia or whether you should travel to Japan for the last two years of
your career.
• If you remain in Australia then you will sign a contract that guarantees earnings over the next 2
years of $15,000 p.a.
• If you choose to go to Japan, then there is a 20% chance of success in the first year. If you are a
success in the first year, then you will continue to succeed in the following year. If you are a failure
in the first year, then you have the option to spend $5,000 on advertising to relaunch your
international career. If you spend this money, the probability of success for the following year is
increased to 50%, whereas if you don’t spend the money, the probability of success remains at 20%.
• Success in Japan is expected to generate a net cash flow of $25,000 p.a. whilst failure generates a
net cash flow of only $10,000 p.a. If you choose to go to Japan, then you must buy an airplane
ticket today that will cost you $3,000.
• The opportunity cost of capital is 10% p.a.
7.6 Decision Tree Analysis: Another Example
• Go to Japan or not? The analysis should first focus on the later decision, whether to buy ads
7.7 Decision Tree Analysis: Another Example
• Another example
• NPV(Ads) = $10,909, NPV(No Ads) = $11,818
• We should choose not to advertise.
• Now we calculate whether to go to Japan.
• NPV(Japan) = $21,545, NPV(Australia) = $26,033
• We should choose to stay in Australia.
• Advantages of decision tree analysis is that it forces you to think about future decisions and lets
that guide your current decisions through rollback for backward induction. The disadvantage of
decision tree analysis is that it can get complex very quickly.
FNCE20005 Corporate Financial Decision Making
• Real Options
• Decision Tree Analysis
• Real Options
• Valuing Real Options
• Readings:
• Fundamentals of Corporate Finance – Chapter 24 (Options and Capital
Budgeting)
• Corporate Finance – Chapter 7.3 & 7.4
7.8 Real Options
• What are real options?
• Financial options that are traded in the market are not the only options that exist. For
corporations, we have what are called real options.
• Real options refer to discretionary/strategic opportunities or options "embedded" in a firm’s real
investment project
• Any strategic flexibility to wait and see, invest further, shrink or abandon the project, or switch
it to another in response to new information
• Here, two important points are
• These options are a right, but not an obligation
• The option exercise decisions can be optimally made to maximize project value after receiving
new information in the future
7.9 Real Option Illustration
• A new mineral – Debranium – is discovered at Newport Beach, California.
• You estimate that the present value of the extraction costs are $100 million and the present value of
the revenues are $80 millon.
• The US government puts out to tender the right to extract the Debranium.
• What would you bid for that right?
• (a) 0 (b) > 0 (c) < 0 (d) need more information
• Standard NPV analysis:
• NPV = PV(Inflows) − PV(Outflows) = $80 m − $100 m = − $20 m
• So does that mean that you wouldn’t pay $1 for the right – but not the obligation – to
extract Debranium?
7.10 Standard NPV vs. Real Option Analysis
• Standard NPV analysis is static
• Treats each project decision as a “now-or-never” decision
• Only based on the information available now
• Real option analysis is dynamic
• Captures management’s flexibility to adapt its future actions in response to future market
conditions
• Expands project value by assuming that at each stage in the future, management will actively
improve its upside potential while limiting downside losses
7.11 Standard NPV vs. Real Option Analysis
• For example:
• Standard NPV analysis: Decide now and
hope for the best.

• Real option analysis: Wait for uncertainty

to be resolved and then decide.
7.12 Four Types of Real Options
• Option to delay making an investment (a timing option) comparable to call options

• Option to expand operations by making follow-up investments (a growth option)

• Option to abandon the project (an exit option) comparable to put options

• Option to vary output or production methods (a flexibility option)

7.13 Option to Delay (Timing)
• Firms often have the right to determine the timing of their investment in a project
• Advantage: delaying provides the chance to respond to new market information (e.g., market
demand or new technology)
• Disadvantage: delaying may reduce the PV of cash flows (due to firm missing early cash flows or
due to competitors’ moving first etc.)
• This option may not come without costs as the firm may need to maintain access to market
information or obtain a license/patent so that it can act in the future
• Example:
• Biogen, a bio-technology firm, is considering the production of Avonex, a drug to treat
multiple sclerosis, whose revenues are uncertain. It can produce the drug now or obtain a
patent that enables it to decide (whether to produce or not) over the life of the patent. The
production cost is assumed to be constant over time.
• What is the embedded real option here? With the patent, the firm has exclusive rights to the
product for a specific period (within the life of the patent), so that it can delay taking the
project until a later date without losing the opportunity (so, option to delay)
7.14 Option to Expand (Growth)
• Taking a project today may allow a firm to expand its operations later if the original project is
successful not a lot of exclusivity

• Examples
• Why did Virgin Airlines enter the Australian market when their initial routes weren’t profitable?
→ What is the problem with this real option?
• Why might a U.S. company open a store in China even though the NPV of that store is
negative?
7.15 Option to Abandon (Exit)
• A firm may sometimes have the option to abandon the project if it turns out to be unsuccessful
• This option exists when
• a firm retains the right to abandon a project and realize salvage values associated with the
project’s assets; or
• there is a “get-out” clause if things don’t go to plan
• Example
• Airbus is considering a joint venture with Learjet to produce a small commercial airplane.
Learjet, which is eager to enter into the deal, offers to buy Airbus’s entire share of the venture
anytime over the next five years for $400 million if Airbus decides to get out of the venture.
7.16 Option to Vary (Flexibility)
• A flexibility option arises when a firm can revise its operating decisions for a fixed cost in response
to market conditions
• Examples
• Option to alter production rate → Respond to changes in demand
• Option to differentiate/alter production → Switch product lines
• Option to switch inputs/technology → Ability to incorporate more efficient production
processes
FNCE20005 Corporate Financial Decision Making
• Real Options
• Decision Tree Analysis
• Real Options
• Valuing Real Options
• Readings:
• Fundamentals of Corporate Finance – Chapter 24 (Options and Capital
Budgeting)
• Corporate Finance – Chapter 7.3 & 7.4
7.17 Valuing Real Options
• Main idea of real option analysis
• NPV with real option = NPV without real option + Value of real option
• What can be wrong with the standard NPV rule?
• NPV without real option not sufficient to warrant investment
• e.g., Delay the investment decision if NPV with real option > NPV without real option > 0
when there is an option to delay investment
• NPV without real option < 0 not sufficient to reject investment if the value of real option is
large enough
7.18 Valuing Real Options
• To measure the value of real option opportunities, work with decision-tree analysis
• Valuation using methods like the Black-Scholes model or the binomial model relies on
assumptions that are too different from the situation surrounding real options
• Decision tree maps a sequence of decisions and their uncertain consequences over time
• Value the project both with and without the real option
• A decision tree without the option typically provides a benchmark for the project’s value
• Difference in valuations with and without the option gives you the approximate value of the real
option embedded in your project
7.19 Financial Option Pricing
• You can also try and utilize models developed for pricing financial options to value “real options”
• Basic financial option pricing techniques are the Binomial model and the Black-Scholes type models

Financial Options Real Options

• Short maturity • Long maturity
• Underlying assets are financial assets – • Underlying assets are real assets
stocks, commodities (project cash flows)
• Underlying market price drives value; • Management’s forecasts and degree of
Limited opportunity to manipulate flexibility affect value
• Marketable and traded in exchanges and • Not traded, are firm-specific
OTC • Not comparable with other
• Well established trading and pricing options/assets in the market
conventions • Not clear how rigorously firms value real
options
7.20 Valuing Real Options: Example – Option to Delay
• Consider a project to produce baby toys
• PV of project CFs in year 1 will be either $150 or $80 with equal probability
• We have the following two choices:
• Investing in the project now with investment costs of $95; or
• Acquiring the right to wait a year when PV of project CFs becomes certain and decide whether
to invest, but a fee is required for the right, and the investment costs in year 1 will be $100
• Assume the firm’s risk-adjusted discount rate is 15% p.a., risk-free rate is 5% p.a., and ignore all
other factors
7.21 Valuing Real Options: Example – Option to Delay
• Static” NPV analysis (now-or-never decision)
• PV of expected project CFs

0.5 × $150 + 0.5 × $80

= = $100
1.15
Investment costs = $95
NPV without real option = $100 - $95 = $5.

• According to the static NPV analysis, one should invest now because NPV without real option is
greater than zero.
7.22 Valuing Real Options: Example – Option to Delay
• “Dynamic” NPV analysis
0.5×$50+0.5×$0
• NPV with real option = 1.15
= $21.74

• PV with real option = NPV with real option – NPV without real option = $21.74 - $5
= $16.74 > 0
• So, delay the investment decision for a year as long as the fee for the right is less than $16.74 (i.e.,
maximum amount we’re willing to pay for the right today)
7.23 Valuing Real Options: Example2 – Option to Abandon
• Victoria Airways enters domestic airline market
• This investment requires initial investment of $6 million
• If demand is high (with 30% chance) then cash flow will be $2m per annum in perpetuity
• If demand is low (with 70% chance) then cash flow per annum equals $0.5m in perpetuity
• Firm retains right to abandon operations after 1 year of flying and sell all assets for $10m
• Required rate of return on the project is 10% p.a
7.24 Valuing Real Options: Example2 – Option to Abandon
• First, draw the decision tree
7.25 Valuing Real Options: Example2 – Option to Abandon
• Step 1 – Assess the most distant decision first
• Scenario 1: High demand → Exercise the abandonment option?
$2𝑚
• 𝑃𝑉𝐶𝑜𝑛𝑡𝑖𝑛𝑢𝑒 = = $20 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
0.10

• 𝑃𝑉𝐴𝑏𝑎𝑛𝑑𝑜𝑛 = $10 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

• If demand is high in first year, do not exercise abandonment option
• Scenario 2: Low demand → Exercise the abandonment option?
$0.5𝑚
• 𝑃𝑉𝐶𝑜𝑛𝑡𝑖𝑛𝑢𝑒 = = $5 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
0.10

• 𝑃𝑉𝐴𝑏𝑎𝑛𝑑𝑜𝑛 = $10 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

• If demand is low in first year, exercise abandonment option
• Approximate value of abandonment option?
$2𝑚 $0.5𝑚+$10𝑚
• 𝑁𝑃𝑉𝑤𝑖𝑡ℎ 𝑅𝑂 = −$6𝑚 + 0.3 + 0.7 = $6.68𝑚
0.10 1.10

$2𝑚 $0.5𝑚
• 𝑁𝑃𝑉𝑤𝑖𝑡ℎ𝑜𝑢𝑡 𝑅𝑂 = −$6𝑚 + 0.3 + 0.7 = $3.5𝑚
0.10 0.10

• Approximate present value of the real option = $3.18m

7.26 Valuing Real Options
• NPV with real option = NPV without real option + Value of real option
• Dynamic NPV analysis vs. Financial option pricing techniques
• Standard discounting may not be suited for all dynamic NPV analyses
• Financial option pricing techniques ignore the fundamental differences between financial and
real options
• Our main approach for real option analysis is to approximate pricing using dynamic NPV analysis
with decision trees
• Albeit not exact, this provides approximation for real-options problems
• Decision trees can only include discrete range of outcomes
• Value of real options depends on accurate estimates of future cash flows. For non-exclusive real
options, the cash flows associated with the option may be much smaller than expected due to
increased competition when the market conditions are better.
• Option to expand airline routes vs. option to extract minerals.