Real Options and ExclusivityHow important is it that organizations have an exclusive right to exercise a real option? That is, can we really say that an option being considered has value if competitor
Session 7: Special Topic: Real Options
This Week's comments address the following subject areas:
Real Options: Introduction
Real Options Valuation: Other Examples
Capsim Performance Report I
SVA Assignment
Discussion Papers
Discussion Issues
1. Real Options: Introduction
There are many financial analysts and managers who believe that net present value is not the proper way to analyze investments, especially in the high tech area, including internal IT projects, ERP-Internet applications, or simply e-commerce initiatives. Since you have studied financial options before in the context of stock investments, you understand the main idea.
Here the valuation method is basically the same but it is now applied to capital investments (i.e. applied to real assets, thus real options). In your previous courses you may have been introduced to real options under the title of "Managerial Options." Here's the key point:
In conventional net present value or internal rate of return analyses, we assume a once-and-for-all go/ no go decision. In real options analysis, we allow for other decisions, including delay and phasing. This broadened range of allowable decisions has major consequences for our valuation.
REAL OPTIONS DEFINITION:
An option represents an action that one may choose to undertake, without the compulsion to do so. Visiting Disney World is an option, paying taxes is not.
Real options are opportunities that center on real (non-financial) assets. Real or financial options allow the option holder to take advantage of potential benefits while controlling risk. Options shift the possible distribution of future outcomes toward a (presumedly) more favorable pattern. Buy an option today and make a follow-up investment if the option looks to be worthwhile. If business doesn't go well, there is no need for further investment, and the loss is limited to the cost of the initial option.
What are some examples where real options might exist? Let's consider the e-commerce/ IT space. (You'll see that the examples are somewhat dated, but they represented new uses of real options methods at the time.)
(a) Chip Manufacturing - Consider the case of expanding the manufacturing capabilities of a new generation of chips. Suppose that with a bit more manufacturing capacity, a line for a new chip can be added.
It's not clear what the demand for the new chip will be. But installing new production capacity (beyond immediate requirements) creates the option to learn about the value of that type of chip. The upside to this product flexibility option could be large if it creates new markets. The costs of the option are limited to the cost of the extra capacity. The flexibility option allows the company to adapt manufacturing to respond to changing customer demand. What makes this option attractive is that it's generally cheaper to build in additional capacity in original construction than as an add-on later.
Options thinking highlights two key points. First, risk can be your friend. Greater market volatility need not translate into greater losses, because losses are limited to the initial investment. But greater volatility may produce greater gains because the option enables you to capture sudden market upswings. With greater volatility, you should be willing to pay more to acquire an option, everything else being equal.
Second, time is on your side. Options thinking shows the value of longer decision horizons. Two-year options allow you to change your mind several times and are more valuable than options that are only three months long. The real options approach creates a decision-making discipline that emphasizes learning and choice. For managers, the challenge is to transform this intuitive concept into a workable methodology.
Real options capture the value created by IT investments that deliver platforms of business flexibility in a disciplined manner. For example, let's look at an IT investment to support the chip company's growth. Suppose there is already enough computing capacity to grow the business another 25 percent.
Investing in even more computing capacity doesn't have many benefits. But a more valuable IT facility would allow the company to retain business flexibility, such as options to change the current product or to launch new products. For IT, those options would translate into building systems that are easily modified or extended in response to the company's product changes. For example, a proposed data warehouse might allow rapid application development, which enables the quick addition of new product data to the warehouse.
Or the warehouse might feature customized decision support, which would help analysts choose new products or variants faster. Such a data warehouse contributes to the product flexibility option and might thus be viewed as a worthwhile IT investment. If executives relied on traditional valuation tools that focused on incremental cost reductions or incremental increases in capacity, the benefits of the data warehouse would be less obvious.
The point here is that evaluating this investment in a traditional discounted cash flow framework will most likely fail to reveal its value creation potential. Evaluating it with real options bring the relevancy information to decision-makers.
(b) E-Commerce Penetration into New Markets - Scalability options create opportunities to adjust flexibly the scale of the business over time. Imagine a company whose strategy requires an aggressive market expansion into Europe and Asia, which will increase the flow of transactions through the supply chain management system significantly. However, the timing and size of the market expansion is uncertain.
In this case, a real options analysis would help decision makers think through the timing of the e-commerce capacity expansion by linking the value of IT investments to the range of possible business outcomes and by identifying the critical levels of key business variables that trigger the next stage of expansion. The real options approach allows executives to value fully the flexibility created by alternative investment strategies and to trade off the value of extensibility against cost.
A traditional (e.g., NPV/DCF) analysis would look at this IT investment as an all-or-nothing proposition, rather than as a phased plan based on feedback and learning over time. Such a traditional valuation of the investment fails to see the value in the flexibility to scale up or not, depending upon the success of an aggressive marketing effort.
(c) Software Development tools for E-mail - Flexibility options allow a company easily and quickly to adapt product features or service offerings. In the IT world, new software development tools for e-mail allow mass customization of electronic commerce advertising and information and lead into personalized services. By investing in these packages, executives acquire an option that represents the opportunity to quickly effectively make follow-on investments that could not have been achieved without this new business platform. The follow-on integration of this software in customer relationship management subsystems provides further options to take advantage of wealth creating opportunities.
Examples (a), (b), and (c) are adapted from the June 15, 1999 Issue of CIO Enterprise Magazine ("Taking an Option on IT," by Martha Amram and John C. Henderson)
(d) Building a B2B Marketplace for Hewlett Packard - At HP, real-options thinking helped top managers decide to go ahead with a business-to-business e-marketplace project that, officials said, might not have survived a traditional cash flow analysis.
HP was looking for a way to improve inventory forecasting. Using real options, HP officials decided not to put together a traditional forecasting analysis system but to build a business-to-business marketplace where HP can either buy merchandise from suppliers on the spot market or sell excess inventory.
"The marketplace lets HP expand its options by enabling the company to mix traditional contracts with more dynamic spot trading with suppliers. The overall result will be more effective procurement processes," said Corey Billington, then director of strategic planning and modeling at HP, in Palo Alto, CA. It's worth noting, perhaps, that this case dates from before the four most recent CEOs of HP!
(e) IT Infrastructure - Consider a decision to build a network. The initial decision to fund the project provides some benefits. But it also gives a company the opportunity, not the obligation, to spend money to acquire other assets, such as a vertical-trading community.
The secondary benefit is possible only because of the initial investment. Real-options analysis weighs that potential benefit against the risks of choosing to forgo those investments.
In this case, the real-options approach acknowledges the uncertainty and volatility of business and IT decisions today. Therefore, companies can change their minds many times from today's plan and not lose their investment as they adjust their evolving investment strategy to changing conditions. The more dynamic and uncertain the environment, the greater this flexibility option is.
Examples (d) and (e) are adapted from the Jan. 10, 2000 issue of e-Week "Show Them the Money," by Beth Stackpole
(f) Amazon.com, an Increase in Scope - A good example of a company that has realized scope options is Amazon.com. It has moved from books to music to videos, and its recent acquisition of drugstore.com gives it an option to incorporate medical products. At the same time, it has incorporated auctions as a selling mechanism.
You are no doubt familiar with the concept of economies of scale. Economies of scope have to do with being able to do two disparate tasks more cheaply together than separately. The concept was developed by economists at Bell Labs circa 1980, when their employer sought to fight the attempts (later successful) to break up the original AT&T by showing how the single company (with potential competition via entry) could operate more cheaply than as independent companies.
(g) Microsoft Learning and Growth Options - In May of 1999, Microsoft invested $5bn in AT&T, then the US's largest cable provider. This investment kept Microsoft in the game of setting the standard for the operating system in television set-top boxes (through which viewers have access to the Internet and interactive television). Microsoft also collaborated with network television company NBC to produce MSNBC, an online news site and television channel that was launched in 1996. NBC bought out Microsoft's interest late in 2005, though Microsoft still shares some content ownership.
The bottom line is that the more dynamic, volatile, or uncertain the environment, the greater the value of a strategy that allows one to take advantage of opportunities or good "surprises" while protecting oneself from bad surprises. Looking for and identifying the real options existing in alternative decisions helps us position our organization pick the course of action that creates the most value.
Examples (f) and (g) derived from the September 20, 1999, issue of the Financial Times, "Real Options in the Digital Economy" by Nalin Kulatilaka and N. Venkatraman.
2. Real Options Valuation: Other Examples
One of the most important financial tasks that managers undertake in their search to increase shareholder value in an uncertain environment is the evaluation of investment opportunities. One of the key issues of these investments is the resources that will be acquired for the express purpose of generating future cash flows.
Investment opportunities are identified during the company's strategic planning process. Shareholder value is created when the present value of the cash coming into the company is greater than the value of the present value of the cash that is being paid for the resources associated with an investment.
Growth option: A computer firm buys a software company rather than develop competing software. For example, IBM did this with Lotus Development Corporation. The transaction created a major tax benefit as well -- IBM wrote off most of the acquisition cost as "in process Research and Development", applying the financial accounting standard, FAS 2, to tax calculations.
Among other high-tech companies, Cisco applies this technique -- it buys companies instead of doing basic research. This strategy may lead to a better range of technologies than might have turned up in-house (with its internal political pressures), likely at lower costs. Remember, Cisco is only buying technological ideas that have demonstrated "proof of concept"!
Firms with opportunities to pursue Internet initiatives have a very high potential to capitalize on growth in future demand, but, at the same time, there is a significant amount of technological risk and uncertainty.
Insurance Option and Risk: By the late 1960s, life insurance companies were signing up baby boomers for whole life insurance, which entitled policy holders to borrow against the cash value of the policy at a fixed and predetermined rate of interest -- let's say it was 8%. Essentially this policy clause provided a lifelong option to borrow at a rate of 8%.
In the late 1970s and early 1980s, interest rates soared to double digits. The baby boomers could borrow at 8% and earn 12% on their money. The insurance companies had had no idea of the value of the options that they gave away -- until they had to borrow at 12% to lend to policyholders at 8%, a failure to recognize uncertainty and the associated option value.
Options involve uncertainty about the future and help management teams respond to changing situations as uncertainties are resolved.
If management cannot change the structure of an investment (i.e., if the investment decision is made up front without considering some sort of phased investments), the investment is not an option -- it is a bet, regardless of how many Net Present Value models are run as justification.
Sources of real option value:
Early capture of market share
High entry costs
Technical expertise
Advertising
Brand names/ trademarks
Patents
Rights to develop land
Leases
Options to purchase equipment (e.g., airplanes)
Claims on capacity
Risk versus uncertainty:
Risk is generally represented as a random variable with a known probability distribution. For example, risk is frequently measured by the variance or standard deviation of an asset's value.
Uncertainty is a random variable with an unknown probability distribution. We may not even know the possible outcomes.
This distinction is generally attributed to Frank Knight, a University of Chicago economist. His classic book on the subject, Risk, Uncertainty, and Profit, was published in 1921.
To try to convert uncertainty into risk for analytic purposes, we use subjective probabilities. These probabilities may well be wrong -- seriously so, if one remembers the faulty models used to value sub-prime mortgage-based derivative securities.
Former Secretary of Defense Donald Rumsfeld has an interesting way of distinguishing between risk ("known unknowns") and uncertainty ("unknown unknowns"). Regardless of one's views of his performance in office, he did come up with many useful catch-phrases.
Managerial flexibility: Managerial flexibility allows one to capitalize on changes in uncertainty and risk over time by either phasing the investment, investing only in specific circumstances, or deciding to walk away from the investment because circumstances have become unfavorable.
Managerial flexibility is, thus, used to take advantage of upside risk and mitigate downside risk (i.e., by not investing everything up front) for the firm.
This flexibility is not captured in traditional NPV models.
Examples:
A. Oil Company
Ability to Wait: Waiting allows a manager to see the change in oil prices, for example:
If oil product prices increase (good uncertainty) then the manager makes a decision to expand a refinery with less probability of incurring a loss.
If product prices decrease (bad uncertainty) then the manager can make a decision not to add the refinery unit or units.
Similar considerations apply on the production side as well as refining. A play may have value beyond the current price of oil if the reservoir permits enhanced recovery if the price of oil should increase to justify the enhancement. An analyst at Amoco Production Company ran this case when I was there.
This model has actually been in operation for a long time and used to drive the price of South African gold mining stocks. Production costs at all mines have long been well-known to investors, and the price of gold has always been volatile. If the metal price were to rise above the production cost at any specific mine, that mine's stock would, in effect, become an "in the money" option. Therefore, these mines had value even when they were not producing.
B. Shipping Oil from New Developments
This is a very current issue. The U.S. is now producing a LOT of oil in areas that had no production ten years ago (or more recently). Most of these areas are shale developments -- the Bakken in North Dakota and Eagle Ford in southeast Texas are the most well-known (the Marcellus in Pennsylvania and Utica in Ohio and Pennsylvania are both primarily natural gas plays).
The issue is transporting the oil produced in these areas to various refining centers. Pipelines do not currently exist. Oversimplifying a bit, shippers can make long-term shipment commitments to pipeline companies, which will then build and operate the lines, or they can ship via rail on what is essentially a spot basis. For discussion purposes, let's assume that shipment via pipeline might cost $5/ barrel, while the rail tariff might be $13/ barrel.
So, why is there a preference for rail and some reluctance to commit to a pipeline? Essentially, the additional $8/ barrel represents an option premium. The locus of U.S. refining is changing -- most of New York Harbor (which goes as far south as Delaware City) is or has shut down, and one would hate to be committed to shipping crude volumes to unprofitable markets.
[Side notes: The problem is that crude costs at New York Harbor have been higher than on the Gulf Coast. The East Coast refineries import crudes priced according to Brent benchmarks -- Brent is a light sweet crude from the North Sea. The Gulf Coast benchmark, however, is West Texas Intermediate, a roughly similar crude that is priced well below Brent because of large inventories at Cushing, Oklahoma. Pure economics would suggest piping crude from Cushing to Houston, then shipping it by tanker to New York Harbor. Some crude is shipped to eastern Canada on this basis, but intracoastal shipping, per the Jones Act of 1920, must take place in U.S. ships manned by U.S. crew, and Jones Act shipping is sufficiently expensive as to preclude crude arbitrage within the U.S.]
C. Manufacturer
A manufacturer (e.g., Intel) is trying to decide whether to build a new $100 million high-tech plant with uncertain demand for the product. (Note: world scale plants -- in most process industries -- cost over $1 billion these days, so $100 million is a quite modest sum.)
If the only choice is build the plant or not build the plant, it is a bet not an option and fits into the NPV method.
If the choice is that the manufacture can spend $10 million now for a small facility, and then $100 million in a year to expand the facility if justified, then it is an option.
The problem now becomes how to measure whether the $10 million option is worthwhile. If demand can be predicted with accuracy, then the option has little value and evaluating the project using NPV is appropriate. If demand is highly uncertain, then the option has value and we need to determine how much value there is in waiting or phasing the investment and compare that to spending a $100 million now to build the facility. The kinds of valuable options this project may have can be identified by reviewing the value in managerial flexibility.
TYPES OF MANAGERIAL FLEXIBILITY:
Deferring the investment
Expanding the investment (expand scope)
Contracting the investment size
Temporarily shutting down
Abandon the investment (or limit the scope)
Switching the use of the investment to other application
Defaulting on the investments preplanning costs
Flexibility is most important with those decisions where there is not a clear highly positive or negative NPV, where managerial ability to respond is high, and where there is a strong chance of obtaining new information by waiting.
Real option business valuation requires:
Identification of all real options
Categorizing them
Valuing them
Determine if they are interrelated
Recalculating their combined value
NPV forecasts future cash inflows and outflows, discounts them at a risk-adjusted rate (the weighted average cost of capital), and then nets the positive present values with negative present values to estimate the NPV. Negative NPV results in the rejection of the project.
THIS METHOD DOES NOT CAPTURE MANAGERIAL FLEXIBILITY related to the above menu of possible actions. Such flexibility represents a change of plans that is not captured in the scenarios.
There are other valuation methods that are used commonly, but that are less intuitive and may require making assumptions that cannot be validated in a straightforward manner. Black-Scholes can be applied, and there are binomial and other methods as well.
3.Capsim Performance Report I: DUE by midnight, the last day of this week. See the attached description of Capsim Performance Reports requirements for details.
4. SVA Assignment (see introductory discussion in Week 5) is due by 11:59 PM, the last day of Week 8. Notes, the assignment description, and a template for your model are attached.
5. Discussion Papers - Completed discussion papers are due at 11:59 PM, the last day of Weeks 7 and 8.
6. Discussion Issues: See the posted issues raised for this week's discussion
