Chapter 23 Principles Principles of of Corporate Corporate Finance Finance Ninth Edition Real Options Slides by Matthew Will Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin
Dec 17, 2015
Chapter 23 PrinciplesPrinciples
ofof
CorporateCorporate
FinanceFinance
Ninth Edition
Real Options
Slides by
Matthew Will
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw Hill/Irwin
23-2
Topics Covered
The Value of Follow-On Investment Opportunities
The Timing OptionThe Abandonment OptionFlexible ProductionAircraft Purchase OptionsA Conceptual Problem
23-3
Corporate Options
4 types of “Real Options”1 - The opportunity to expand and make follow-up
investments.2 - The opportunity to “wait” and invest later.3 - The opportunity to shrink or abandon a project.4 - The opportunity to vary the mix of the firm’s output or production methods.
Value “Real Option” = NPV with option - NPV w/o option
23-4
Microcomputer Forecasts
1982 1983 1984 1985 1986 1987
After-tax operating cash flow (1) 100 159 295 185 0Capital investment (2) 450 0 0 0 0 0Increase in working capital (3) 0 50 100 100 -125 -125Net cash flow (1)-(2)-(3) -450 60 59 195 310 125
NPV at 20% = - $46.45, or about -$46 million
Year
Example – Mark I Microcomputer ($ millions)
23-5
Microcomputer Forecasts
)()()( 21 EXPVdNPdNOC
6761.1
900price) exercise(
3PV
million
dNdN
tdd
ttEXPVPd
12.55$]6761805[.}4673793[. Value Call
1805.)( 3793.)(
9134.606.3072.
3072.2/606.]606./691log[.
2//)](/log[
21
12
1
Example – Mark II Microcomputer Option
23-6
Microcomputer Forecasts
1982 ………. 1985 1986 1987 1988 1989 1990After-tax operating cash flow 220 318 590 370 0Increase in working capital 100 200 200 -250 -250Net cash flow 120 118 390 620 250Present Value @ 20% 467 807Investment, PV @ 10% 676 900Forecasted NPV in 1985 -93
Year
Example – Mark II Microcomputer ($ millions)
Forecasted cash flows from 1982
NPV(1982) =PV(inflows) -PV(investment)
= 467 – 676
= - $209 million
23-7
Microcomputer Forecasts
Example – Mark II Microcomputer (1985)
Distribution of possible Present Values
Expected value
($807)
Required investment
($900)
Present value in 1985
Probability
23-9
Option to Wait
Intrinsic Value + Time Premium = Option Value
Time Premium = Vale of being able to wait
Option Price
Stock Price
23-11
Timing Option Example
Possible cash flows and end-of-period values for the malted herring project are shown. The project costs $180 million, either now or later. The figures in parentheses show payoffs from the option to wait and to invest later if the project is positive-NPV at year 1. Waiting means loss of the first year’s cash flows. The problem is to figure out the current value of the option.
23-12
Timing Option Example
High demand generates $25 million and a value of $250 million at the end of the year. Low demand generates $16 million and no value.
375.
1200
)25025(return Total
12.
1200
)16016(return Total
High Demand Low Demand
Risk neutral return = 5%
23-13
Timing Option Example
The next step requires the calculation of the probability of there being a high demand for the malted herring project.
The option value is now determined as follows.
343. demandhigh of Prob
05.return Expected
(-.12)demand)high of Prob1(375.demand)high of Prob(return Expected
million 9.22$05.1
)0657(.)70343(. ValueOption
23-14
Option to Wait
Example – Development option
Wait
NPV<0 100 240
Hotel NPV>0
Cash flow from hotel
Cash flow Office Bldg
Office Bldg
NPV>0
240
100
23-15
Option to Abandon
Example - AbandonMrs. Mulla gives you a non-retractable offer to buy your company for $150 mil at anytime within the next year. Given the following decision tree of possible outcomes, what is the value of the offer (i.e. the put option) and what is the most Mrs. Mulla could charge for the option?
Use a discount rate of 10%
23-16
Option to AbandonExample - Abandon
Mrs. Mulla gives you a non-retractable offer to buy your company for $150 mil at anytime within the next year. Given the following decision tree of possible outcomes, what is the value of the offer (i.e. the put option) and what is the most Mrs. Mulla could charge for the option?
Year 0 Year 1 Year 2
120 (.6)
100 (.6)
90 (.4)
NPV = 145
70 (.6)
50 (.4)
40 (.4)
23-17
Option to AbandonExample - Abandon
Mrs. Mulla gives you a non-retractable offer to buy your company for $150 mil at anytime within the next year. Given the following decision tree of possible outcomes, what is the value of the offer (i.e. the put option) and what is the most Mrs. Mulla could charge for the option?
Year 0 Year 1 Year 2
120 (.6)
100 (.6)
90 (.4)
NPV = 162
150 (.4)
Option Value =
162 - 145 =
$17 mil
23-20
Option to Abandon
Example – Ms. East – Value
on2.695milli$3.803-1.108APV
.618change down of Prob
.382change up of Prob
06.29.2
)1(05.205.3return Expected
29.2$09.1
5.2
pp
millionPV
23-21
Tanker Example
Mothballing costs
Value if mothballed
Cost of reactivating
Value in operation
Tanker Rates
Value of Tanker
23-22
Aircraft Purchase Option
The option to purchase an aircraft provides the holder both the ability to obtain a lower price as well as receive the aircraft sooner. Both have value to the aircraft buyer, thus the option has value.
23-23
Aircraft Purchase Option
Value of aircraft purchase option—the extra value of the option versus waiting and possibly negotiating a purchase later. The purchase option is worth most when NPV of purchase now is about zero and the forecasted wait for delivery is long.
23-24
Real Option Barriers
Practical reasons exist why real options are not always feasible to use.
1. Valuation of real options can be complex and sometimes it is impossible to arrive at the “perfect” answer.
2. Real options do not always have a clear structure their path and cash flows.
3. Competitors also have real options, which an alter the value of your options by altering the underlying assumptions and environment that serves as the basis of your valuation.
Given these limitations, real options are not always the best approach when valuing projects.