Chapter 10 Real Options and Cross-Border Investment

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 10-1

Chapter 10Chapter 10Real Options and Cross-Border InvestmentReal Options and Cross-Border Investment

10.1 The Theory and Practice of Investment10.2 Market Entry and the Option to Invest10.3 Uncertainty and the Value of the Option to Invest10.4 Market Exit and the Abandonment Option10.5 The Multinational’s Entry into New Markets10.6 Options within Options10.7 Option Theory as a Complement to NPV10.8 Summary


The theory of investmentThe theory of investment

The conventional theory:Discount expected future cash flows at an appropriate risk-adjusted discount rate.

NPV = t [E[CFt] / (1+i)t]

include only incremental cash flows include all opportunity costs


Three investment puzzlesThree investment puzzles

Puzzle #1:MNC’s use of inflated hurdle rates

Puzzle #2: MNC’s failure to abandon unprofitable investments

Puzzle #3: MNC’s ‘negative-NPV’ investments into new and emerging markets


Puzzle #1: MNC’s use of inflated hurdle ratesPuzzle #1: MNC’s use of inflated hurdle rates

Market entry and the option to invest By exercising its option to invest, the firm is foregoing the

opportunity to invest at some future date.

Consequently, a project must be compared not only against other projects today but also against similar versions of itself initiated at some future date.

Because of the value of waiting for additional information, firms often demand hurdle rates that exceed investors’ required returns on investments into uncertain environments.


An example of the option to investAn example of the option to invest

Initial investment I0 = $20,000,000

(For simplicity, the present value of this initial investment is assumed to be PV(I) = $20,000,000 regardless of when investment is made.)

Price of Oil P0 = $20/bbl

P1 = either $30 or $10 with equal probability

E[P] = $20

Variable production cost V = $8 per barrels

E[production] = Q = 200,000 barrels per year

Discount rate i = 10%


The option to invest as a “now or never” decisionThe option to invest as a “now or never” decision

NPV = [ (E[P]-V) (Q) / i ] - I0

NPV(invest today)

= [($20 - $8) (200,000) / .1] - $20,000,000= $4,000,000 > $0

invest today (?)

(E[P]-V)(Q) (E[P]-V)(Q)

I0


Wait one year before deciding to investWait one year before deciding to invest

(E[P]-V)(Q)

I1

NPV0 = [(E[P]-V)(Q) / i]/ (1+i) PV(I1)

(E[P]-V)(Q)


The investment timing optionThe investment timing option

NPV(wait one yearP1=$30)

= (($30 $8)(200,000) /.1)/(1.1) $20,000,000= $20,000,000 > $0 invest if P1=$30


= (($10 $8)(200,000) /.1)/(1.1) $20,000,000= $16,363,636 < $0 do not invest if P1=$10

NPV(wait one year) = (½)($0) + (½)($20,000,000)= $10,000,000 > $0

wait one year before deciding to invest


The opportunity cost of investing todayThe opportunity cost of investing today

NPV = $4,000,000Invest now or never

Wait one yearNPV = $20,000,000

NPV = $16,363,636

E[P1] = $20/bbl

P1 = $10/bbl

P1 = $30/bbl

$0

NPV(wait one year)= ½($20,000,000)+ ½($0) = $10,000,000

NPV(invest today) =$4,000,000


The opportunity cost of investing todayThe opportunity cost of investing today

Option Value = Intrinsic Value + Time Value

NPV(wait one year) = NPV(invest today)+ Opportunity costof investing today

$10,000,000 = $4,000,000 + $6,000,000



A resolution of Puzzle #1:A resolution of Puzzle #1: Use of inflated hurdle rates Use of inflated hurdle rates

Financial managers facing this type of uncertainty have four choices:

• Ignore the timing option (?!)• Estimate the value of the timing option using option pricing

methods• Adjust the cash flows with a decision tree that captures as

many future states of the world as possible • Inflate the hurdle rate (apply a “fudge factor”) to

compensate for high uncertainty


The investment call optionThe investment call option

Option value = intrinsic value + time value

Intrinsic value = value if exercised immediately ($4 million in BP example) Time value = additional value if left unexercised ($6 million in BP example)

0

5

10

15

20

25

0 5 10 15 20 25 30 35 40

Value of an oil well

The value of BP’soption to invest

Time value

Intrinsic value

Option value


Call option value determinantsCall option value determinants

Increasing this determinant changes call option value

Option value determinant BP example in the indicated direction

Price of the underlying asset Poil

Exercise price of the option K $20 million Riskfree rate of interest RF 10%

Time to expiration of the option T one year Volatility of the underlying asset Poil

Option value = intrinsic value + time value

Intrinsic value = Asset value - exercise price = (Poil - K)

Time value = f(Poil, K, RF , T, Poil)


Exogeneous price uncertaintyExogeneous price uncertainty

Price of Oil: P1 = $35 or $5 with equal probability E[P1] = $20/bbl

NPV(invest today) = (($20$8)(200,000) /.1)/(1.1)$20,000,000 = $20,000,000 > $0 invest today (?)




= (($35$8)(200,000) /.1)/(1.1)$20,000,000 = $29,090,909 > $0 invest if P1=$35


= (($5$8)(200,000) /.1)/(1.1)$20,000,000 = $25,454,545 < $0 do not invest if P1=$5 ( NPV=0)

NPV(wait one year) = (½)($0)+(½)($29,090,909) = $14,545,455 > $0




The effect of uncertainty over the future price of oil

P1 = $30 or $10Option value = Intrinsic value + Time value$10,000,000 = $4,000,000 + $6,000,000

P1 = $35 or $5Option value = Intrinsic value + Time value$14,545,455 = $4,000,000 + $10,545,455

The time value of the investment optionincreases with exogeneous price uncertainty.


A resolution of Puzzle #2:A resolution of Puzzle #2:Failure to abandon unprofitable investmentsFailure to abandon unprofitable investments

Why do firms remain in unprofitable markets even though they are losing money?

Market exit - the option to disinvest By abandoning a losing venture today, the firm is

foregoing the opportunity to abandon at a future date. A part of the exercise price of the abandonment option

is the opportunity cost of exiting today rather than at a future date.

Firms retain losing ventures because of the option value of waiting for additional information.


The abandonment optionThe abandonment option

Cost of disinvestment PV(I) = $2,000,000Assume the present value of abandoning the oil well is $2 million regardless of when the well is abandoned

Price of Oil P0 = $10/bbl;

P1 = either $15 or $5 with equal probability

Variable production cost V = $12 per barrels

Expected production Q = 200,000 barrels per year

Discount rate i = 10%


The abandonment option The abandonment option

NPV(now or never) = (($10$12) (200,000)/.1)$2,000,000 = $2,000,000 > $0 abandon today (?)


The abandonment option The abandonment option

NPV(abandon in one yearP1=$15)

= (($15$12) (200,000)/.1)/(1.10)$2,000,000 = $7,454,545 < $0 ( NPV=0)

do not abandon given P1=$15

NPV(abandon in one yearP1=$5)

= (($5$12) (200,000)/.1)/(1.10)$2,000,000 = +$10,727,273 > $0

abandon in one year given P1=$5

NPV(wait one year)= (½) ($0) + (½) ($10,727,273)= $5,363,636 > $0

wait one year before deciding


The abandonment optionThe abandonment option

NPV = $2,000,000Exit today

Wait one yearNPV = $7,454,545

NPV = $10,727,273

E[P1] = $10/bbl

P1 = $5/bbl

P1 = $15/bbl

$0

NPV(wait one year)= ½($10,727,273) + ½($0) = $5,363,636

NPV(exit today) =$2,000,000


The opportunity cost of abandoning todayThe opportunity cost of abandoning today

Option Value = Intrinsic Value + Time Value

NPV(wait one year) = NPV(exit today)+Opportunity costof exiting today

$5,363,636 = $2,000,000 + $3,363,636

wait one year before deciding to abandon


Hysteresis: Entry-exit decisions in combinationHysteresis: Entry-exit decisions in combination

Cross-border investments often have different thresholds for investment and disinvestment.

– Cross-border investments are often not undertaken until the expected return is well above the required return.

– Once invested, cross-border investments are frequently left in place well after they have turned unprofitable.

This is called “hysteresis” - the failure of a phenomenon to reverse itself as its underlying cause is reversed.


A resolution of Puzzle #3: A resolution of Puzzle #3: Entry into emerging markets Entry into emerging markets

Firms often make investments into emerging markets even though further investment does not seem warranted according to the “accept all positive-NPV projects” rule.

The value of growth options Negative-NPV investments into emerging markets are often out-of-

the-money call options entitling the MNC to make further investments should conditions improve.

If conditions worsen, the MNC can avoid making a large sunk investment.

If conditions improve, the MNC can choose to expand its investment.

Vfirm = Vassets-in-place + Vgrowth options


Why DCF failsWhy DCF fails

Option volatility - Options are inherently riskier than the underlying asset on which they are based.

Changing option volatility - Option volatility changes with changes in the value of the underlying asset.

Returns on options are not normally distributed.

-3 -2 -1 0 1 2 3

Option value

Value of the underlying asset

Exercise price


The option pricing alternativeThe option pricing alternative

Option pricing methods circumvent problems with the opportunity cost of capital by constructing a replicating portfolio that mimics the payoffs on the option.

Costless arbitrage then ensures that the value of the option equals the value of the replicating portfolio.


The option pricing alternativeThe option pricing alternative

Option pricing works well for financial options– low transactions costs facilitate arbitrage– observable prices

Option pricing is more difficult for real options– higher transactions costs impede arbitrage– the price of the underlying asset (such as a factory

or product line) is usually unobservable

Chapter 10 Real Options and Cross-Border Investment

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Transcript of Chapter 10 Real Options and Cross-Border Investment