1. REAL
OPTIONS

2. WHAT IS A REAL OPTION?
• A situation in which an investor is able to choose
between two different investments where both choices
involve tangible assets. The investor may choose
between assets;
like land or inventory; financial instruments like
stocks and bonds are not involved in a real option.
• Real options, as a discipline, extends from its
application in corporate finance, to decision making
under uncertainity in general, adapting the techniques
developed for financial options to "real-life" decisions.
• It should be noted that a real option has nothing to do
with an option contract.

3. • Real option applies option valuation
techniques to capital budgeting decisions.
• Real options represent a company’s rights to
make chronological decisions in a capital project.
• Real options increase the NPV of a project
because a firm would not rationally exercise an
option which lowers value.
• They are referred to as "real" because they
usually pertain to tangible assets such as capital
equipment, rather than financial instruments.
Taking into account real options can greatly affect
the valuation of potential investments.

4. TYPES OF REAL OPTIONS

5. TYPES OF REAL OPTIONS
• Options relating to project size; where the project’s scope
is uncertain, flexibility as to the size of the relevant facilities
is valuable, and constitutes optionality.
1. Option to expand
2. Option to contract
3. Option to expand or contract (Switching option)
• Options relating to project life and timing; they refer to
the option to exercise only those projects that appear to
be profitable at the time of initiation.
1. Initiation or deferment options
2. Option to abandon (Termination option)
3. Sequencing options

6. • Options relating to project operation; management may
have flexibility relating to the product produced and /or
the process used in manufacture.This flexibility constitutes
optionality.
1. Output mix options (product flexibility)
2. Input mix options (process flexibility)
3. Operating scale options (Intensity options)

7. Five Procedures for Valuing
Real Options
1. Discounted cash flows
analysis of expected cash
flows, ignoring the option.
2. Qualitative assessment of
the real option’s value.
3. Decision tree analysis.
4. Standard model for a
corresponding financial
option.
5. Financial engineering
techniques.

8. Analysis of a Real Option: A Numerical
Example
• Initial cost = $70 million, Cost of Capital =
10%, risk-free rate = 6%, cash flows occur for 3
years.
Annual
Demand Probability Cash Flow
High 30% $45
Average 40% $30
Low 30% $15

9. Procedure 1: DCF Analysis
• Expected(CF)=Probability1 xcash flows1+
Probability2 xcash flows2 +Probability3 xcash
flows3
=0.3($45)+0.4($30)+0.3($15)
= $30
• PV of expected CFs = ($30/1.1) + ($30/1.12) +
($30/1/13) = $74.61 million.
• Expected NPV = PV of expected CFs- Initial cost
= $74.61 - $70
= $4.61 million.

10. Investment Timing Option
• Project’s expected NPV is $4.61 million.
• However, the project is very risky.Now,we
should find Present Value of expected CFs in
the high and low demand.

11. Investment Timing Option
– High Demand
PV of CFs = ($45/1.1) + ($45/1.12) + ($45/1.13)
= $111.91
NPV = $111.91 - $70 = $41.91
– Low Demand
PV of CFs=($15/1.1) + ($15/1.12) + ($15/1.13)
= $37.30
NPV = $37.30 - $70 = - $32.70

12. Investment Timing Option
• If we wait one year, we will gain additional
information regarding demand.
• If demand is low, we won’t implement project.
• If we wait, the up-front cost and cash flows
will stay the same, except they will be shifted
ahead by a year.

13. Procedure 2: Qualitative Assessment
• The value of any real option increases if:
– the underlying project is very risky
– there is a long time before you must exercise the
option
• This project is risky and has one year before
we must decide, so the option to wait is
probably valuable.

14. Procedure 3: Decision Tree Analysis
(Implement only if demand is not low.)
C ost F utur e C a sh F low s N P V th is
a
2001 P r ob . 2002 2003 2004 2005 S c e n a r io
-$ 7 0 $45 $45 $45 $ 3 5 .7 0
30%
$0 40% -$ 7 0 $30 $30 $30 $ 1 .7 9
30%
$0 $0 $0 $0 $ 0 .0 0
Discount the cost of the project at the risk-free rate, since the cost is
known. Discount the operating cash flows at the cost of capital.
Example: $35.70 = -$70/1.06 + $45/1.12 + $45/1.13 + $45/1.14.

15. • Use these scenarios, with their given
probabilities, to find the project’s expected
NPV if we wait.
• E(NPV) = 0.3($35.70)+0.4($1.79) + 0.3
($0)
= $11.42.