TOPIC -Decision Trees and Real Options

NEW VENTURE STRATEGY AND REAL OPTIONS

LEARNING OBJECTIVES:

- Describe strategic alternatives in terms of real options

- Understand how to use decision trees to identify and evaluate real options

- An illustration of using real options in valuation

“Finance theory properly applied is critical to managing in an increasingly complex and risky
business climate... Option analysis provides a more flexible approach to valuing our
investments... To me all kinds of business decisions are options”
- Judy Lewent, CFO, Merck

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 TOPIC -Decision Trees and Real Options

Recognizing Real Options

• Real options capture the value of managerial flexibility to adapt decisions in response to
unexpected market developments.

• The real options method applies financial options theory to quantify the value of management
flexibility in a world of uncertainty.

• The real option method enables corporate decision-makers to leverage uncertainty and limit
downside risk.

• Strategic planning is not a one-shot exercise.

• Passage of time brings deviation from forecasts and new information.

• Opportunities to abandon expand, or redirect the venture are real options.

• Select the strategy that offers the highest expected value in light of the venture’s real options.

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Option Basics

• An option is the right, but not the obligation, to make a decision and take an action in the future

• The value of an option depends on

– market price of the underlying asset (assets you buy/sell)
– volatility of the price of the underlying asset
– time to option expiration
– time value of money

• The cost to acquire an option is called the “premium”

Call Option: is a right to buy a share of stock at some future date for a price that is established today,
in the stock market.

Put Option: carries the right to sell an underlying asset during a specified period at a specified
exercise price.

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Call Option on a Share of Amazon Stock

The right to buy a share of [Link] common stock anytime during next three months at a price
$110 is a call option with an exercise price of $110, where share of Amazon is underlying asset.

• A call option gains value if the market price of underlying asset rises and loses value if the price
of asset falls.
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• Suppose that Amazon is selling at expiration for $120 per share. The $110 call option would
yield a $10 payoff ($120-$110). If the price of Amazon goes to $150, the value of call option
increases, payoff in this example would be $40 ($150-$110).

• → Call option with lower exercise prices are more valuable than those with higher exercise
prices.

• Options limit downside risk. → Option risk is one sided → the more volatile the underlying
asset, the higher the value of an option. Suppose, over the next 3 months, Amazon is equally
likely to rise to $140 or to decline to $100. If the price rises to $140 → call option is in the
money and can be exercised to acquire the stock for a profit/saving of $30 per share. If price falls
to $100 → the call option is out of money and will not be exercised.

• Buying call option in this case limits the downside risk but preserves the potential for gain.
Moreover, because volatility increases with time to expiration → long-term options are more
valuable.

• Time value of money affects option values → buying an option works like borrowing??

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Put Option on a Share of Amazon Stock

A put option on Amazon at exercise price of $110

• If the owner of the put option decides to exercise, he receives the exercise price.

• A put on Amazon is more valuable if Amazon is selling for $80 than $90 → like call options, put
options are more valuable when the underlying asset is riskier.
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• Because the owner of put is effectively lending the exercise price without charging interest → a
put is less valuable if the cost of money (interest rate) is high (more interest income is forgone)

• Puts and calls can be used to allocate the risk of investing in the underlying asset → an investor
in Amazon who buys put option has reallocated the downside risk to the writer of the option.

Comparisons between Real and Financial Options

• Real options are similar to financial options

• Yet differ in important ways

– real option markets are not complete
– real options often are interdependent

• The real option premium

– may bear little relation to the value of the option
– for example, the value of an abandonment option depends on the next highest alternative
use of the asset

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 TOPIC -Decision Trees and Real Options

Some Common Types of Real Options

• Wait/Learn
• Expand or contract
• Switch inputs or outputs
• Abandon

Investment decision can be treated as the exercising of an option.

• Firm has option to invest.

• Need not exercise the option now — can wait for more information.
• If investment is irreversible (sunk cost), there is an opportunity cost of investing now rather than
waiting.
• Opportunity cost (value of option) can be very large.
• The greater the uncertainty, the greater the value of the firm’s options to invest, and the greater
the incentive to keep these options open.

Note that value of a firm is value of its capital in place plus the value of its growth options.

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 TOPIC -Decision Trees and Real Options

Real Options and Valuation1

Imagine you are the CEO of a company that designs, creates and sells computer games. A film
studio is about to start shooting a major action thriller film. It will reach box office in one year
from now. The film company have contacted you offering the right to develop and market a
game based on the film (with film clips and voice-overs from the principal actors). You would
have to pay £10m now for this. From previous experience you estimate that there is a 50:50
chance of the film being a success or a box office flop. If it is successful, the present value of all
the future cash flows for the game will amount to £50m. if, however, it is a flop the high cost of
development and promotion will mean a present value of all future cash flows associated with
the will be negative £50m.

Should you pay £10m now for the game rights?

1 Based on Arnold, Glen, “Corporate Financial Management”, Chapter 6 of 5th edition.

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Conventional NPV calculation

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Options approach

• You are purchasing an option to develop the game, without the obligation to do so.

• You can abandon the whole plan in one year’s time when you have some vital information
→ how the film performs at the box office after the release.

• If it is a failure then do not invest any more than the original £10m and save yourself the
£50m (negative PV in failure case).

• With this flexibility built in, your cash flows in future are +£50m if film is well received,
and Zero if it is hammered by the critics and the audiences stay away (each of which has a
50% chance of occurring).

• The important rule is that we don’t view the project as a take-it-now-in-its-entirety-or-

forget-it deal but rather consider the possibility of future managerial choices.

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The value of Option to abandon is;

+£15m – (-£10m) = £25m

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Welcoming risk

• In real options analysis (contrary to traditional NPV analysis), uncertainty provides value
because the opportunity to exercise the option to take action later becomes all more
precious.

• Let’s double the range of PV of cash flows after the initial investment. There is now a 50%
chance of +£100m and 50% chance of -£100m.

• The expected NPV under the traditional analysis remains at -£10m but the range of
outcomes has increased (risk has risen)

Film is a success (–£10m + £100m)0.5 = +£45m

Film is a failure (–£10m – £100m)0.5 = –£55m
––––––––
Crude NPV = –£10m
––––––––

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 TOPIC -Decision Trees and Real Options

• The options perspective shows the more volatile cash flows to be more valuable than the less
volatile ones → managers can avoid the downside risk by simply abandoning the project if new
information turns out to be negative.

Film is a success (–£10m + £100m)0.5 = £45m

Film is a failure (–£10m + 0)0.5 = –£5m
––––––––
Option perspective NPV = £+40m
––––––––

• Uncertainty can therefore be a good thing, if you hold an option to exploit the change in
circumstances as time goes on.

• Don’t sacrifice options lightly or cheaply

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Why look at investment decisions this way? What’s wrong with the standard NPV rule?

• With uncertainty and irreversibility, NPV rule is often wrong — very wrong. Option theory
gives better answers.

Option theory emphasizes uncertainty and treats it correctly. (NPV rule often doesn’t.)
Helps to focus attention on nature of uncertainty and its implications.

• Managers ask: “What will happen (to oil prices, to electricity demand, to interest rates,...)?”
Usually, this is the wrong question. The right question is: “What could happen (to oil
prices, to...), and what would it imply?”

• Managers often underestimate or ignore the extent of uncertainty and its implications.

• Option theory forces managers to address uncertainty

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 TOPIC -Decision Trees and Real Options

Strategic Planning and Decision Trees

• Decision trees
– are a good way to conceptualize strategic alternatives that involve real options
– impose discipline on the evaluation process
– are used to evaluate connections between decisions today and the future value of the
venture
– incorporate both decisions and uncertain events
– use probabilities to estimate conditional NPVs

Decision Tree Techniques

– Focus on the most important choices

– Reason forward to construct the tree
– Keep track of what is known and unknown at each node
– Evaluate choices recursively, starting at the last decision point
– Prune the tree
– Select the branch of the tree with the highest expected NPV

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 TOPIC -Decision Trees and Real Options

An illustration2

• Entrepreneur is considering investing in a new restaurant

• Uncertain demand can be high, moderate, or low
• The decision:
– build a large restaurant ($750,000)
– build a small restaurant ($600,000)
– don’t build
• Entrepreneur invests $400,000
• Outside investor provides the balance and gets one percent of the equity for each $10,000
invested

– large restaurant  investor gets 35% equity

– small restaurant  investor gets 20% equity
– entrepreneur retains balance of the equity

2 Based on Chapter 4, Smith and Bliss, Entrepreneurial Finance: Strategy, Valuation and Deal Structure
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Total restaurant PV conditional on size and demand

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Evaluating the Venture as an Accept-Reject Decision

• Consider the project as a simple accept-reject decision with mutually exclusive alternatives
• Invest in large restaurant
• Invest in small restaurant
• Don’t invest

• Decision tree notation:

• Squares represent decision points
• Circles represent uncertainty
• Each state has an associated probability
• Triangles in the figure are terminal nodes

With a one-time accept/reject decision, the entrepreneur cannot anticipate the level of
product demand that will be realized. The investment decision and choice of level of
investment are made in light of existing uncertainty by maximizing expected NPV.

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 TOPI 7-Decision Trees and Real Options

30.0% 30.0%
High Dem and
$975,000 $575,000 = - $400,000 + 0 .6 5 x $1,500,000
Chance
Large Restaurant
-$ 4 0 0 , 0 0 0 $191,500
50.0% 50.0%
Moderate Demand
$520,000 $120,000 = - $400,000 + 0 .6 5 x $800,000
20.0% 20.0%
Low Demand
$195,000 -$ 2 0 5 , 0 0 0 = - $400,000 + 0.65 x $300,000
30.0% 0.0%
High Dem and
$640,000 $240,000 = - $400,000 + 0 .8 0 x $800,000
Chance
Small Restaurant
-$ 4 0 0 , 0 0 0 $176,000
50.0% 0.0%
Moderate Demand
$640,000 $240,000 = - $400,000 + 0 .8 0 x $800,000
20.0% 0.0%
Low Demand
$320,000 -$ 8 0 , 0 0 0 = - $400,000 + 0.80 x $400,000
Decision
A c c e p t - Reject
$191,500
30.0% 0.0%
High Dem and
$0 $0
Chance
D o Not Enter
$0 $0
50.0% 0.0%
Moderate Demand
$0 $0
20.0% 0.0%
Low Demand
$0 $0

P r e p ar ed u s i n g PrecisionTree ®, Palisade Corporation.

Source: Fig 4.3 Smith and Bliss
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 TOPIC -Decision Trees and Real Options

Entrepreneur’s NPV – Large Restaurant

Conditional PVs of entrepreneur:

PVEntrep. (Large/High) = 65% X $1,500,000 = $975,000

PVEntrep. (Large/Moderate) = 65% X $800,000 = $520,000
PVEntrep. (Large/Low) = 65% X $300,000 = $195,000

Expected PV of entrepreneur:

E(PVEntrep. |Large) = 30% X $975,000 + 50% X $520,000 + 20% X $195,000

= $591,500

Expected NPV of entrepreneur:

E (NPVEntrep. |Large) = -$400,000 + $591,500 = $191,500

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Entrepreneur’s NPV – Small Restaurant

Conditional PVs of entrepreneur:

PVEntrep. (Small/High) = 80% X $800,000 = $640,000
PVEntrep. (Small/Moderate) = 80% X $800,000 = $640,000
PVEntrep. (Small/Low) = 80% X $400,000 = $320,000

Expected PV of entrepreneur:
E(PVEntrep. |Small) = 30% X $640,000 + 50% X $640,000 + 20% X $320,000
= $576,000

Expected NPV of entrepreneur:

E(NPVEntrep. |Small) = -$400,000 + $576,00 = $176,000

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Base Case Decision

E (NPVEntrep. | Build Large) = $191,500

E (NPVEntrep. |Build Small) = $176,000

E (NPVEntrep. |Do not Build) = $ 0

 Build large

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 TOPIC -Decision Trees and Real Options

The Wait/Learn Option

• Suppose the entrepreneur can wait to learn more about demand

• Waiting is a call option on building the optimal size restaurant

• BUT waiting increases likelihood of competitor entry

– reduces large restaurant PV to $1,300,000

– reduces small restaurant PV to $700,000

Not investing today may preserve an option to wait until more information is known
about the true state of demand.

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Source: Fig 4.4 Smith and Bliss

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 TOPIC -Decision Trees and Real Options

Conditional NPV of entrepreneur with waiting:

NPVEntrep. (Wait/High/Build Large) = $445,000
NPVEntrep. (Wait/Moderate/Build Small) = $160,000

NPVEntrep. (Wait/Low/Don’t Build) = $0

Expected NPV of entrepreneur with waiting:

E(NPVEntrep. |Wait) = 30% X $445,000 + 50% X $160,000 + 20% X $0

= $213,500

Compare to base case (accept/reject) NPV = $191,500

 Option value = $213,500 - $191,500 = $22,000

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Expansion Option

• Entrepreneur can build small now, learn about demand, and then decide whether to expand

– PV of large restaurant is $1.4 million if demand is high

• Expansion costs $200,000 (total cost is $800,000)

• $200,000 for expansion comes from investor

– less uncertainty means better terms for entrepreneur

– one percent equity for each $20,000 invested (10%) for expansion

– total investor share is 30% with expansion

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 TOPIC -Decision Trees and Real Options

Chance
Large Restaurant
-$400,000 + $191,500
30.0%
Expand
$980,000 $580,000 = -$400,000 + 0.70 x $1,400,000
30.0% Decision
High Demand
$0 $580,000
0.0%
Do Not Expand
$640,000 $240,000 = -$400,000 + 0.80 x $800,000
Chance
Small Restaurant
-$400,000 $278,000
0.0%
Expand
$560,000 $160,000 = -$400,000 + 0.70 x $800,000
50.0% Decision
Moderate Demand
$0 $240,000
50.0%
Do Not Expand
$640,000 $240,000 = -$400,000 + 0.80 x $800,000
0.0%
Expand
$210,000 -$190,000 = -$400,000 + 0.70 x $300,000
20.0% Decision
Low Demand
-$80,000
20.0%
Do Not Expand
$320,000 -$80,000 = -$400,000 + 0.80 x $400,000
Decision
Initial Choice
$278,000
Chance
Do Not Enter
$0 + $0

Prepared using PrecisionTree ®, Palisade Corporation.

Source: Fig 4.5 Smith and Bliss
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Expansion Option

NPVEntrep. (Small/High/Expand) = $580,000

NPVEntrep. (Small/Moderate/Don’t Expand) = $240,000

NPVEntrep. (Small/Low/Don’t Expand) = -$80,000

E(NPVEntrep. |Small) = 30% X $580,000 + 50% X $240,000 + 20% X -$80,000

E(NPVEntrep. |Small/Expansion Option) = $278,000

Base case NPV = $191,500

Value of expansion option = $278,000 - $191,500

= $86,500

Expansion vs. Wait/Learn = $278,000 - $213,500

= $64,500

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Abandonment Option

• Restaurant can be converted to office space

– PV of large restaurant as office $600,000
– PV of small restaurant as office $300,000

• No value for small restaurant

– lowest PV as restaurant is $400,000

NPVEntrep. (Large/Low/Abandon) = -$400,000 + (65% X $600,000)

= -$10,000

E(NPVEntrep. |Large/Abandon Option) = 30% X $575,000 + 50% X $120,000 + 20% X -

$10,000
= $230,500

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Value of the abandonment option if we build the large restaurant

NPVEntrep. (Large/Low/Abandon) = -$400,000 + (65% X $600,000)

= -$10,000

E(NPVEntrep. |Large/Abandon Option) = 30% X $575,000 + 50% X $120,000 + 20% X -

$10,000
= $230,500

E(NPVEntrep. |Small/Expansion Option) = $278,000

Best choice: build small with expansion option

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STAGED FINANCING IS OFTEN USED BY VC DUE TO INFORMATION

ASYMMETRY

- Even following a bad interim state, entrepreneurs (who presumably have more information
and may still believe the project is worthwhile to pursue) can prevent abandonment of the
venture by the lenders by renegotiating more appropriate second stage financing terms

- The flexibility to actively revalue the terms of financing deal to better match the evolution
of operating project risk, whether increasing or decreasing, as the project moves into its
various stages creates value, compared to a passive alternative where the financing terms
are irrevocably committed to from the outset under less complete information.

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