Overview of Chapter 13

In this lecture, we will cover options:

Financial options
Real options and valuing them
Trigger values
Abandon options
Scale-up options
Options and continuous uncertainties
Financial theory vs. real option valuation
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 Option Basics
Option: the right, not the obligation, to choose an
action in the future
• Real option: an option based on an underlying asset that is
not traded on financial markets
• Financial option: option based on asset traded on financial
markets (e.g., stock)
Exercise window: the time period during which the
option can be exercised
Option premium: the price of the option to be paid
• May be action or commitment rather than a cash outlay
Exercise price: the price to exercise the option, not
including the premium
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 Option Basics
To value an option, define the attributes of the option:
• What is the option premium? What action must we
value to estimate the premium?
• What is the exercise price? What action must we value
to estimate the price?
• What is the exercise date? What is the window in which
we can exercise the option?
• What are the related uncertainties?
• What is the value of the underlying asset?

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 Financial Options: A Brief Tutorial
The standard approach to valuing a financial option
is based on what the option price must be to be
consistent with the asset price.
Arbitrage-free value: If the option were not priced
consistent with the asset, arbitrageurs could trade
shares of the option and shares of the asset in such
a way that they are guaranteed to make money,
without risk, contrary to the efficient market
hypothesis.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 Financial Options: A Brief Tutorial

Key factors that play a role in valuing financial options:

The volatility of the underlying stock
Whether dividends are paid by the stock
The risk-free discount rate
The two basic approaches to valuing financial options:
Black-Scholes model – formula approach
Monte Carlo simulation – uses distributions

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 Financial Options: A Brief Tutorial

Two kinds of options:

• Call: right to buy an asset (stock) sometime in the future
• Put: right to sell an asset (stock) sometime in the future
Let’s assume:
• Current Stock Price = $85
• Exercise Price = $90
• Risk Free Rate = 5%
• Volatility = 20%.

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 Real Options

Real options in business strategy may be thought of

as something that adds flexibility.
Flexibility comes from choosing an alternative that
enables a downstream decision.
• Can be represented as an additional decision node later
in a decision tree
• Enables the creation of future option opportunities

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 Real Options
Aspects of options that lead to the creation of higher
value:
Greater uncertainty in the variable(s) related to
exercising the option
A longer window in which to exercise the option
A lower exercise price
Higher value for the underlying asset
More range of action in exercising the option
Exclusive value
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 An Approach to Valuing Real Options
Three steps for valuing real options:
1. Estimate what the underlying opportunity, excluding
the option, is worth (because it is not traded) with a
decision tree or a spreadsheet simulation
2. Estimate the value of the opportunity with the option
included
3. Calculate the value of the option itself as the
difference between the value of the opportunity with
the option and the value without it

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 An Approach to Valuing Real Options
This approach to valuing real options can be applied to:
Simple and complex options
Any value model and uncertainty structure that fits
the situation
Discrete uncertainties
• Decision trees
Continuous uncertainties
• Spreadsheet models and Monte Carlo simulation

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 Continuous Uncertainties and Discrete Choices
Going beyond simple options with discrete uncertainties and
discrete choices, causes complexity to increase dramatically.
With continuous distributions, uncertain quantities can take
on any value within some range.
Uncertainties may be interrelated.
As the window of time increases, modeling the dynamics of
the variables can require complicated structures.
Especially challenging is the task of projecting how
downstream decisions will be made in the face of many
dynamically varying variables is especially challenging.
Monte Carlo simulation can meet all these challenges.

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 A Trigger Value for Deciding
In a financial option (e.g., call option), the decision to
exercise the option is triggered by the actual price
exceeding the exercise price.
In a real option, we can decide to exercise however we
wish; we want to make that decision the best way we
can. Determining the trigger may:
• Take effort to identify what variable or variables are related
to ultimate value
• Require more work to choose the optimal set point for when
to pull the trigger

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 A Trigger Value for Deciding
We decide that the variables Price, Unit Volume, Unit
Cost, Operating Cost and Cash Flow will provide us
with the most valuable information for making option
triggering decisions.
• Correlation analysis shows Cash Flow as the best variable.
Also, we decide that by the end of year 2 we will know
about the path that will have been taken by these
variables.
Thus, we will make our decisions in year 2 as to
whether to exercise the options.

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 Valuing the Scale-Up Option
Based on the previous simulation and additional
refinement:
•
an expected NPV of $65,000.
• Since the optimal threshold for Cash Flow Year 2 is a
negative number, it is advisable to continue to operate,
even if the business is still losing money at the end of
year 2.
• However, if Cash Flow Year 2 is less than -$150,000 the
project should be abandoned.

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 Comparison: Real Option and Financial Theory

In a financial option (e.g., call option), the decision to

exercise the option is triggered by the actual price
exceeding the exercise price.
In a real option, we can decide to exercise however
we wish; we want to make that decision the best way
we can. Determining the trigger may:
• Take effort to identify what variable or variables are related
to ultimate value
• Further work to choose the optimal set point for when to pull
the trigger

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 Summary

In this chapter, you have learned about real options.

Real options are an important part of strategic
business decision-making.
• Real option valuation transforms the decision-making
process from an intuitive “gut feeling” approach to a
clearly articulated quantitative analysis of the value
added.
• Real option valuation, compared to financial theory, is
more complicated and closer to the “real world.”

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 LAC LEMAN FESTIVAL DE LA MUSIQUE (Synopsis)

The organizers of a music festival may use video from the Friday
concert to create a DVD to sell to those who come to the Saturday
concert. Attendance on Saturday is uncertain, as is the percentage
of those who attend on Saturday that will buy the DVD.
Is this a good idea?
If so, how many DVDs should be burned early Saturday morning and
offered for sale at that evening’s performance?
By that time, Friday attendance is known, along with whether it rained
on Friday, and there is a forecast for whether it will rain on Saturday.
Historical information on these variables may help us to predict
Saturday attendance; along with the results of a marketing survey,
such analysis will help us make better purchasing decisions.

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 LAC LEMAN FESTIVAL DE LA MUSIQUE (Synopsis)

Written Submission
Part A: Provide a complete forecast for attendance at Saturday
night’s performance using case Exhibit 1 only. Note: a complete
forecast acknowledges the uncertainty with a probability
distribution.

Part B: If 4,500 DVDs are produced on Saturday for the concert

later Saturday evening, what is the risk profile of profit
(including all costs related to the DVD project)? Also, make a
recommendation for how many DVDs to order from the
production company. Provide a risk profile for the profit that will
result.

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 SPRIGG LANE (Synopsis)
Tom Dingledine, the president of a natural-resources exploration company, has
to decide
whether to invest in a new gas-well-drilling opportunity. He already has a
spreadsheet that projects the most likely scenario for the well and calculates
the net present value (NPV) and internal rate of return (IRR).
Dingledine, however, has discussed six uncertainties with another investor; he
now needs to incorporate them into the analysis.
He has prepared a spreadsheet for two downside scenarios: in the first, gas
cannot be produced after the well is drilled; in the second, gas can be
produced but all other uncertainties are at their one-percentile worst possible
values.
A potential investor, Henry Ostberg, wants to know what the chances are that
the gas well willresult in a loss of value.

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 SPRIGG LANE (Synopsis)

Written Submission
Based on the base-case scenario and the two alternative
downside possibilities, is this investment economically
attractive? Also, what benefit can Monte Carlo simulation add to
Dingledine’s understanding of the economic benefits of the
Bailey prospect?

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 APPSHOP, INC. (Synopsis)

A regional director of a consulting firm must decide how to compete for a

major consulting contract.
Appshop can take a level-payment contract, a lower-level payment with
a prospective bonus for high performance, or bid on an RFP where a
significant reward is given contingent on the client’s savings.

Written Submission
Appraise the risk of the alternatives, and recommend what Eric Clark
should choose. Suppose Clark’s specific secondary incentive is to keep
blended revenue per hour above 150. How does that affect your view of
the risk.

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 CALAMBRA OLIVE OIL (Synopsis)

Frank Lockfeld, president and founder of Calambra Olive Oil, is

discussing over dinner with friends the order-quantity decision he is
facing. Lockfeld’s newly launched venture—to bring high quality,
vintage-dated California olive oil to market—has been selling product for
only three months, and has sold only 24 cases to date. Nevertheless,
even though the first-year marketing experiment has barely begun,
Lockfeld must decide by month’s end how many gallons of oil to order
for the next (1994 vintage) year.

Written Submission
How many gallons should Lockfeld order? Then, how would you
describe the situation Lockfeld is facing? Can you graphically depict it?
How and why?
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 [Link] (Synopsis)

A potential investor in a new on-line sheet-music business is ready to

deny funding based on simple expected monetary value. Further
reflection identifies potential downstream options. Two options are
important in the case of partial, but incomplete, success: to abandon the
business idea and sell the technology, or to switch to new technology
and keep the Web site.

Written Submission
Provide a description of any other contingent opportunities (generic) that
would add value to this business? Should Bernard invest in the
business? Does Bernard have reasonable cutoff levels to trigger action
on each of the ideas in the initial discussion question? What kinds of
assessment tools would you use to support your answers?
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.