Economics of strategy
Lecture 1: Introduction to Real Options
Firms need to make some kind of investment to get a competitive advantage. All investments are
surrounded by uncertainty.
3 Basic questions:
• How do you view uncertainty when making (investment) decisions?
• How can the value of firms be high when they don’t make any profit at all?
• Why do firms invest in R&D when the NPV of doing so is negative?
Market Value
- Market capitalization (P) = net present value (NPV) of earnings from assets in place (a.i.p) +
present value of growth opportunities (PVGO)
- PVGO = P – NPV a.i.p.
- P = Stock price x Number of stocks outstanding
- NPV of earnings from a.i.p. is hard to estimate
Alternative estimate of option value: Tobin’s Q = P / book value of equity
- Merely looking at current earnings multiples underestimates market value
Examples of NPV
- Supporse the firms appropriate discount rate = 15%
- The firm can invest now $10,000,000
Calculated expected NPV: suppose that the firm is risk-neutral
Consider scenario 1: cash flow is
$9,000,000 with probability 0.5
$13,000,000 with probability 0.5
ExpectedNPV = $11,000,.15 - $10,000,000 (what you invest) < 0 so don’t invest
1
,Adjust NPV for uncertainty: decision trees
1)Expected NPV with most likely scenario and discount rate of 10%
2)Expected NPV taking into account market uncertainty
3)expected NPV taking into account all uncertainties
2
,4)Expanded NPV, taking into account option value
Comparison
NPV 1: Most likely $ –2.27m
NPV 2: Market uncertainty $ -1.78m
NPV 3: All uncertainties $ -1.03m
Expanded NPV $ 0.51m
if the outcome isn’t excellent you would probably not invest.
Real Options are rights, not obligations, to undertake some actions in the future. Actions should be
conditional on outcomes and the greater the uncertainty, the more extreme the range of outcomes
Investment rule is to invest when value exceeds cost by option value of waiting
Two examples of real options timing option and growth option
ZIE SCHRIFT
Net Present Value Method
- Most commonly used instrument for investment appraisal
- Cash-Flow method that calculates the NPV of a project over the project’s lifetime
- Decision rule: project can be started if project NPV > 0
- Correct when there is no uncertainty (now-or-never decision for timing options) or when
investment is irreversible
- Prioritization: project with highest NPV, next highest and so on
Prioritization is choosing the project with highest NPV, next highest and so on
- S > X option is in the money NPV > 0 Option value ~ NPV
- S < X option is out of the money NPV < 0 Option value = 0
Irreversibility
• Almost all investments are at least partially irreversible
• Investment irreversible when sunk costs are involved
3
, • Sunk costs cannot be recouped later
• Lemon’s problem
Real option analogy with financial options
S Current Stock Price Current Project Value
X Exercise Price of the Option Investment Cost
Stock Dividend Yield Value that is lost by waiting to invest
r Risk-Free Interest Rate Risk-Free Interest Rate
Stock Volatility Volatility of Project Value
T Time to Expiration of the Option Time to Expiration of the Investment
Given this analogy, why not use option pricing instruments?
• Famous Black and Scholes option pricing formula for a European call option...
• Call option: right to buy the underlying asset
• European: No exercise before maturity date of the option.
Pros and Cons of the Black-Scholes Formula
Cons
- Underlying asset of the option is not traded on financial markets, real options are proprietary, so
main assumption of the derivation violated
- Managerial Blackbox, not easy to explain to top management
Pros
- Able to deal with managerial flexibility and irreversibility
- Can incorporate competitive behavior standard calculation methods available
Lecture 2: Corporate Real Options
We have seen that:
- There is a difference between a firm’s value and the net present value of earnings from assets in
place
- The difference is attributed to a firm’s real options
- R&D generate new products; these are important growth options
- Apart from growth option, there are timing options
Overview of Common Real Options
- Timing: the option to delay an investment or divestment (=process of selling subsidiary assets,
investments, or divisions of a company in order to maximize the value of the parent company)
until more market information becomes known (e.g. when to start with the exploration of an
oilfield)
- Growth: the option to grow when an initial investment is made, and a strategic position is
acquired (e.g. market introduction options derived from R&D or the options embedded in a brand-
name to launch new products under the same brand)
- Operating: the option to abandon, to temporarily shut down, contract and expand capacity, to
switch input and/or output factors, which hedges the downside risk of an investment or captures
some upside potential (e.g. the option to shut down production if price drops below variable costs)
4
Lecture 1: Introduction to Real Options
Firms need to make some kind of investment to get a competitive advantage. All investments are
surrounded by uncertainty.
3 Basic questions:
• How do you view uncertainty when making (investment) decisions?
• How can the value of firms be high when they don’t make any profit at all?
• Why do firms invest in R&D when the NPV of doing so is negative?
Market Value
- Market capitalization (P) = net present value (NPV) of earnings from assets in place (a.i.p) +
present value of growth opportunities (PVGO)
- PVGO = P – NPV a.i.p.
- P = Stock price x Number of stocks outstanding
- NPV of earnings from a.i.p. is hard to estimate
Alternative estimate of option value: Tobin’s Q = P / book value of equity
- Merely looking at current earnings multiples underestimates market value
Examples of NPV
- Supporse the firms appropriate discount rate = 15%
- The firm can invest now $10,000,000
Calculated expected NPV: suppose that the firm is risk-neutral
Consider scenario 1: cash flow is
$9,000,000 with probability 0.5
$13,000,000 with probability 0.5
ExpectedNPV = $11,000,.15 - $10,000,000 (what you invest) < 0 so don’t invest
1
,Adjust NPV for uncertainty: decision trees
1)Expected NPV with most likely scenario and discount rate of 10%
2)Expected NPV taking into account market uncertainty
3)expected NPV taking into account all uncertainties
2
,4)Expanded NPV, taking into account option value
Comparison
NPV 1: Most likely $ –2.27m
NPV 2: Market uncertainty $ -1.78m
NPV 3: All uncertainties $ -1.03m
Expanded NPV $ 0.51m
if the outcome isn’t excellent you would probably not invest.
Real Options are rights, not obligations, to undertake some actions in the future. Actions should be
conditional on outcomes and the greater the uncertainty, the more extreme the range of outcomes
Investment rule is to invest when value exceeds cost by option value of waiting
Two examples of real options timing option and growth option
ZIE SCHRIFT
Net Present Value Method
- Most commonly used instrument for investment appraisal
- Cash-Flow method that calculates the NPV of a project over the project’s lifetime
- Decision rule: project can be started if project NPV > 0
- Correct when there is no uncertainty (now-or-never decision for timing options) or when
investment is irreversible
- Prioritization: project with highest NPV, next highest and so on
Prioritization is choosing the project with highest NPV, next highest and so on
- S > X option is in the money NPV > 0 Option value ~ NPV
- S < X option is out of the money NPV < 0 Option value = 0
Irreversibility
• Almost all investments are at least partially irreversible
• Investment irreversible when sunk costs are involved
3
, • Sunk costs cannot be recouped later
• Lemon’s problem
Real option analogy with financial options
S Current Stock Price Current Project Value
X Exercise Price of the Option Investment Cost
Stock Dividend Yield Value that is lost by waiting to invest
r Risk-Free Interest Rate Risk-Free Interest Rate
Stock Volatility Volatility of Project Value
T Time to Expiration of the Option Time to Expiration of the Investment
Given this analogy, why not use option pricing instruments?
• Famous Black and Scholes option pricing formula for a European call option...
• Call option: right to buy the underlying asset
• European: No exercise before maturity date of the option.
Pros and Cons of the Black-Scholes Formula
Cons
- Underlying asset of the option is not traded on financial markets, real options are proprietary, so
main assumption of the derivation violated
- Managerial Blackbox, not easy to explain to top management
Pros
- Able to deal with managerial flexibility and irreversibility
- Can incorporate competitive behavior standard calculation methods available
Lecture 2: Corporate Real Options
We have seen that:
- There is a difference between a firm’s value and the net present value of earnings from assets in
place
- The difference is attributed to a firm’s real options
- R&D generate new products; these are important growth options
- Apart from growth option, there are timing options
Overview of Common Real Options
- Timing: the option to delay an investment or divestment (=process of selling subsidiary assets,
investments, or divisions of a company in order to maximize the value of the parent company)
until more market information becomes known (e.g. when to start with the exploration of an
oilfield)
- Growth: the option to grow when an initial investment is made, and a strategic position is
acquired (e.g. market introduction options derived from R&D or the options embedded in a brand-
name to launch new products under the same brand)
- Operating: the option to abandon, to temporarily shut down, contract and expand capacity, to
switch input and/or output factors, which hedges the downside risk of an investment or captures
some upside potential (e.g. the option to shut down production if price drops below variable costs)
4
