NPV? Decision Trees? Real
Options?
EST581
F. Phillips
A running example
• An opportunity requires an investment of $10,000
now, with an assured first-year cash flow of $6,000.
The second-year cash flow is uncertain with a 50-50
chance of either a $15,000 gain or a $5,000 loss.
• The project can be abandoned at the end of the first
year if new information uncovered during this period
suggests that the second-year payoff will not be
favorable.
• Dropping the project at that time involves no salvage
value or penalty.
• The cost of capital is 10%.
Decision tree for the example
QuickTime™ and a
decompressor
are needed to see this picture.
NPV for the example
NPV = -$10,000 + 6,000/1.10 + 5,000/(1.10)2 = -$413
• Negative NPV => Do not make this investment.
Traditional method of adding a “risk
premium” to the discount rate:
If risk premium = 5%
Then
Risk-adjusted NPV = -$10K + $6K/1.15 + $5K/(1.15)2 = -$1,001.89
Much worse than before. Notice the formula applies the risk premium
many times - thus
• overstating the project risk, and
• causing management to reject some good projects.
The NPV didn’t let us use the option of
abandoning the project after we got the
additional information. What if it did allow it?
NPV(ABANDON) = -$10,000 + 6,000/1.10
NPV(KEEP) = -$10,000 + 6,000/1.10 + 15,000/(1.10)2
NPV(OPTION) = 0.5*NPV(KEEP) + 0.5*NPV(ABANDON) =
$1,600. => Make the investment.
Traditional DCF analyses may understate the attractiveness of
new product market ventures which typically have high levels of
uncertainty associated with early time periods.
Why decision trees are more flexible than
NPV
NPV- Pro’s and Con’s
• Pros
– Simple and understandable
– Easily compare alternative projects/investments
– Thus, easy to implement in companies
• Cons
– Can’t allow for contingencies
– Tends to overstate risks
– Can’t address concerns of multiple constituents
Decision Trees: Pro’s and Con’s
• Pros
– Allows for contingent actions
– More realistic choice of projects or investments
– Adaptable to concerns of (small # of) constituents.
• Cons
–
–
–
–
Only good for discrete choices
More complex than NPV
Requires more organizational buy-in than NPV.
Thus, most uses are personal or entrepreneurial.
Options.
Hmm, they sound good.
Let’s learn more about them.
An Introduction to Options
• Option - A right to make a decision in the future
• Elements of an option
–
–
–
–
An underlying asset
Exercise price (strike price)
Expiration date
European or American form
• Basic options
– Call option
– Put option
• Financial options
• Real options
• Complex options
– Contingencies - Option created by some earlier action
– Interdependencies - Options with interdependent values
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4
Example of a financial option
The Structure of a Call Option
Underlying Asset
Expiration
Value
Value
of Asset
Call before
Expiration
E
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Value of Underlying Asset
Chapter 4
Realized Returns on Options
Buy a Call
Write a Call
Gain
Loss
Gain
Loss
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4
Simple (Financial) Options:
Features
• A bet on the rise or fall of a single stock.
• The option may be:
• To buy a certain number of shares at a certain price and
certain date (“put”)
• To sell a certain number of shares at a certain price and
certain date (“call”)
• The bet is made by one investor or fund manager.
• I.e., rather simple.
Kinds of Continuous Options
• Simple Financial Options
• Put
• Call
• Complex Options (Rainbow Options)
A single option linked to two or more underlying assets. In order for
the option to pay off, all the underlying assets must move in the
intended direction. (www.investopedia.com)
• Real Options
Adapted from ©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4
The Black-Scholes Option
Pricing Model
This will not
be on the exam.
Terminology
• “Real option” refers to treating a contingent
operations management decision using the same
reasoning as for a financial option.
• (Kind of implies that finance isn’t real, ha ha.)
• Some people call decision trees a real option
technique. However,
• In this class we reserve the term “real options” for
analysis of situations where choice variables (time,
money, etc.) are continuous rather than discrete.
– Analyzed with variations of the Black-Scholes formula.
– Can give some good approximate solutions, but...
– ... Assumptions of B-S model do not always hold in
operational situations.
Complex Enterprise Decisions
• Opportunities to alter input sourcing, change output mix, or
redirect exports to new markets are common in settings of
• multiple markets
• with fluctuating currency values.
• Example: With the devaluation of SE Asian currencies in
1997, Japanese automakers shifted subsidiaries in
Thailand and Indonesia
• from production of autos for the local markets
• to production of parts for developed-country markets.
• This flexibility is a major rationale for value creation via the
“multinational corporation” model.
Real Options - Some Examples
• Defer - Investing now eliminates the option to defer
(learning).
• Expand - An option to defer part of the scale of investment.
• Contract - The flexibility to reduce the rate of output.
• Abandon - Stop investing, and liquidate existing assets.
• Staging - Substitute a series of small investments for one
large.
• Switching - Re-deploy resources or change inputs
(terminate).
• Change Scope - Expand or contract scope.
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4
Option
Examples:
More
Detail
Description
Examples
Defer
To wait before taking an action
until more is known or timing is
expected to be more favorable
When to harvest a stand of trees,
introduce a new product, or replace
an existing piece of equipment
Expand or
contract
To increase or decrease the
scale of a operation in response
to demand
Adding or subtracting to the daily
flights on an airline route or adding
memory to a computer
Abandon
To discontinue an operation and
liquidate the assets
Discontinuing a research project,
closing a store, or resigning from
current employment
Stage
investment
To commit investment in stages
Staging of research and
giving rise to a series of valuations development projects or financial
and abandonment options
commitments to a new venture
Switch inputs
or outputs
To alter the mix of inputs or
outputs of a production process
in response to market prices
The output mix of refined crude oil
products or substituting coal for
natural gas to produce electricity
Grow
To expand the scope of activities
to capitalize on new perceived
opportunities
Extending brand names to new
products or marketing through
existing distribution channels
©2000, Entrepreneurial Finance, Smith and Kiholm Smith
Chapter 4
So, why is NPV still so widely
(and exclusively) used?
Survey of High Tech Execs
Survey Scores: Reasons Why Your Company Does Not Use the ΤOptionsΥMethod of
Valuing Projects or the Decision Analysis Approach (DAA)Σ
• Perfect information for project evaluations at future points is rarely available (or difficult
to obtain).
74
• Operations executives do not like to discontinue their own projects at a future point of
evaluation.
70
• All possible ‘options’ cannot be anticipated.
69
• M ore convenient to obtain complete project funding now, rather than compete for partial
funding with other projects in the future.
65
• Conservative decision making avoids choosing ‘options’ or alternatives that involve large
downside risks.
59
• Exi stence of entry and exit barriers will not permit project expansion or discontinuance
based on DAA.
58
•Employee turnover/re-adjustment problems makes future project expansion/discontinuance
difficult.
54
• Process of evaluating a project at each future decision point may incur high er costs.
• Project valuation is generally performed by financial rather than operations executives.
• DAA is more complex than ROI/NPV.
49
Discuss
The acquisition of a fleet of buses (for example) has
one value to the acquiring company if later decisions
about maintenance are made in a certain way, e.g., if
the oil is changed at certain intervals,
and a different lifetime value if the oil is changed less
frequently or not at all.
If the return on fleet acquisition is allowed to depend
on reliable mechanics changing the oil regularly,
why are other kinds of project selections made
without depending on reliable executives to make the
subsequent decisions that maximize the project’s
value?
Sources for this lecture
Ted Fu
FDI and New Venture Strategy:
Real Option / Strategic Decision Trees Analysis
Compiled by Ted Fu
July 1, 2002
Adapted from
Luenberger: Investment Science
Smith: Entrepreneurial Finance
Click: International Financial Management
The Evolution of
Decision Analysis
By
Ali Abbas
[email protected]
Lecturer
Department of Management Science and Engineering
Stanford University
F. Phillips, Market-Oriented Technology Management
Springer, 2001.