Using Real Options in Project Evaluation.doc

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Using Real Options in Project Evaluation

Jerry Flatto, North Carolina A&T University

Introduction

One of the primary responsibilities of management is the allocation of availableresources in their organization Unfortunately, there are never enough availableresources to go aroun! to perform all the tas"s an! pro#ects !esire! Therefore,management has to !eci!e $hich pro#ects $ill be pursue!

To evaluate competing pro#ects, the ma#ority of organizations use some form of%uantitative analysis techni%ue Among the common techni%ues use! are net presentvalue, internal rate of return, an! paybac"

This article $ill !iscuss the concept of real options $hich can be use! to e'pan! youre'isting analysis metho!s ( $ill !iscuss $hy many of the e'isting analysis techni%uesun!erestimate the value of a pro#ect an! ho$ real options can capture some of thebenefits that slip through the crac"s un!er e'isting analysis metho!s

Traditional Analysis Methods

The ma#ority of organizations use some sort of %uantitative analysis metho!s tocapture the estimate! costs an! benefits associate! $ith a propose! pro#ect The mostpopular metho!s inclu!e internal rate of return, net present value, an! paybac"

)o$ever, these metho!s have some associate! assumptions that can result in thevalue of an investment being un!erestimate! They assume management*s passivecommitment to a certain operating strategy +eg, to initiate the pro#ect imme!iately,an! operate it continuously at a set scale until the en! of its prespecifie! e'pecte!useful life- The metho!s also ignore the synergistic effects that an investment pro#ect

can create .ometimes the performance of one pro#ect $ill allo$ you to perform asecon! pro#ect that $oul! not have been possible $ithout the first +eg, manyresearch an! !evelopment pro#ects- Therefore, the analysis usually un!erestimatesinvestment opportunities because it ignores management*s fle'ibility to alter !ecisionsas ne$ information becomes available

One $ay to compare the results of a tra!itional analysis $ith an analysis that inclu!esmanagement*s fle'ibility is to loo" at !istributions of the potential outcomes (n theanalysis process, a number of the input variables can vary !epen!ing on !ifferentassumptions such as best case, $orst case, etc /ou can run the analysis a number oftimes varying the possible inputs /ou can then plot the results of the analysis The 'a'is is the range of possible outcomes, usually in !ollars The ya'is is the probabilityof any particular outcome

(f you perform this type of analysis using the tra!itional tools such as net presentvalue, you en! up $ith a figure similar to Figure 0 The most li"ely value $ill have thehighest probability an! the other outcomes $ill have lo$er probabilities associate! $iththem an! you en! up $ith a stan!ar! bell curve The most li"ely value is in thecenter, $orst case analyses are to the left of center, an! best cases are to the rightof center


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Fig. 1 Project value e!cluding the "le!i#ility value

(n reality, even though the analysis metho!s have the inherent assumptions ( !iscussabove, your actions are not limite! by these assumptions /ou have the fle'ibility toalter !ecisions as further information becomes available (f future con!itions arefavorable, you may e'pan! the pro#ect to ta"e a!vantage of these con!itions On the

other han!, if the future is unfavorable, you may curtail or even cancel the pro#ect asthe con!itions $arrant Another $ay to tal" about the fle'ibility is that it allo$s you toimprove a pro#ect*s upsi!e potential $hile limiting the impact of the pro#ect*s !o$nsi!elosses This results in a pro#ect $ith a higher e'pecte! value an! causes the!istribution to be s"e$e! to the right as sho$n in Figure 1

Fig. $ Project value including the value o" the "le!i#ility

The !ifference bet$een the e'pecte! value $ith an! $ithout fle'ibility is the value thatthe fle'ibility provi!es One $ay to loo" at the value of the fle'ibility is through the use

of real options

Fle!i#ility and Options

2hen $e loo" at the fle'ibility associate! $ith a pro#ect, there are a couple of typesThe first type is fle'ibility internal to the pro#ect itself This is the fle'ibility to mo!ifythe pro#ect as future con!itions change These changes can inclu!e e'pansion,alteration an! even aban!onment of the pro#ect For e'ample, assume you are loo"ing


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to buy a ne$ car The only real re%uirement of the vehicle is that it gets you to $or"an! bac" 2ith this is min!, you can buy any small t$o seat economy car to meet yournee!s )o$ever, being the for$ar! thin"er that you are, you !eci!e to buy a van $ithremovable seats No$, not only can you get to $or", you can perform tas"s notoriginally envisione!, li"e moving your motherinla$ to her ne$ apartment that ismuch farther a$ay from your house Thus your fle'ibility allo$e! you to use your

vehicle for other tas"s than originally consi!ere!

The other type of fle'ibility is e'ternal fle'ibility 3erforming this pro#ect $ill no$ allo$you to perform another pro#ect that may not have been possible originally Fore'ample, your long lost uncle leaves you enough money to buy a cabin near yourfavorite s"i area 2ithout this cabin, your $ere limite! in the times you go s"iing sinceit $as not possible to get reservations at the resort hotels on a short term notice3urchasing the cabin gives you the fle'ibility to go s"iing $henever you $ant /ou areno longer at the mercy of the hotels

As these t$o e'amples sho$, fle'ibility is a valuable commo!ity an! usually the morefle'ibility associate! $ith a pro#ect the better The concept of real options is ane'tension of the concept of fle'ibility 2hen people tal" about fle'ibility, they are

typically !escribing it in %ualitative an! sub#ective terms A van has more fle'ibility inallo$ing you to move items than a t$o seat compact car )aving to stay at a resorthotel is less fle'ible than having your o$n cabin

Thus one problem $hen trying to measure the value of the fle'ibility is the !ifficulty intrying to get t$o or more people to agree on the value of the fle'ibility Consi!er thatto a person $ho loves s"iing, the cabin provi!es great fle'ibility Another person,$hose i!ea of $inter sports is $al"ing from the heate! car to the shopping mall, mayconsi!er that the cabin provi!es minimal fle'ibility

Another problem associate! $ith valuing fle'ibility is trying to inclu!e the value $ithother costs an! benefits that are %uantifie! +ie, !ollars- .tu!ies of management

!ecision ma"ing has sho$n that management typically assigns greater $eight to%uantitative costs an! benefits than %ualitative benefits +eg, fle'ibility- Therefore,even though a pro#ect*s fle'ibility may provi!e great benefits, these benefits aretypically given less consi!eration $hen comparing a pro#ect*s tangible costs an!benefits

(t is for the reasons #ust !iscusse! that the concept of real options $as !evelope!2hat separates the concept of real options from the concept of fle'ibility is the metho!by $hich each are measure! Fle'ibility is typically measure! %ualitatively +eg, a vanis more fle'ible than a car- The goal of real options is to measure the fle'ibility%uantitatively an! generate a !ollar value for the fle'ibility A real options mo!el of the!ecision to purchase a van instea! of a t$o seat compact car might fin! the a!!e!fle'ibility is $orth 45666

%toc& Options

7efore ( get into a !iscussion of real options, ( $ant to tal" about financial +eg, stoc"-options The !evelopment of real options is base! upon option pricing theory an! stoc"options The ma#ority of you may have hear! of stoc" options $hile probably only afe$ have hear! of real options


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Those of you involve! in either corporate or personal investment may alrea!y befamiliar $ith stoc" options A call stoc" option allo$s you to purchase stoc" at anagree! upon price before or on a certain !ate For e'ample, you can have a call optionto purchase stoc" at 485 $hich is goo! for seven !ays The stoc" is presently at 495 (fthe price of the stoc" rises above 485 $ithin the ne't $ee", you can purchase thestoc" for 485, even though it may be $orth 4056 On the other han!, if the stoc"

never goes above 485, your stoc" option is $orthless an! you forfeit the cost you pai!for the option

:et me give another e'ample in case you are not familiar $ith stoc" options 2hen yougo to get a fi'e! rate mortgage, you are concerne! that the interest rate may rise!uring the time that the mortgage ta"es to be approve! ;any mortgage companiesallo$ you to loc" in the e'isting rate for a fee This loc" is goo! for an agree! upontime, such as 96 !ays (f the mortgage rate stays constant, then you are out the fee$ith no gain On the other han!, if rates !o rise, you are protecte! against having topay a higher interest rate


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mo!el of the !ecision you might fin! that the a!!e! fle'ibility of the $oo! an! coalstove is $orth 4185 .ince the a!!itional cost is less than that + ie, 4166-, buying the$oo! an! coal burning stove is $orth$hile


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not have to start over an! purchase a ne$ machine


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Ta#le 1( )o*parison o" varia#les on stoc& and real option

%toc& Option Real Option

Current value of stoc" Eross present value of e'pecte!cash flo$s

'ercise price (nvestment cost

Time to e'piration Time until opportunity !isappears.toc" value uncertainty 3ro#ect uncertaintyBis"less interest rate Bis"less interest rate

The cash flo$s are the amount of money that the pro#ect $ill bring in As the e'pecte!cash flo$s increase, the real option becomes more valuable if the other variables are"ept constant For e'ample, if the amount of gol! that can be e'tracte! from the minecan be !ouble!, then the gol! mine becomes more valuable

The investment cost is the amount of money that nee!s to be committe! to provi!ethe organization $ith the real option eeping the other variables fi'e!, increasing thisamount $ill !ecrease the overall value of the real option For e'ample, if the cost to

e'tract the gol! !oubles, the value of the mine !ecreases

(ncreasing the time a pro#ect can be !eferre! increases the real option*s value As the!eferment time increases, the uncertainty associate! $ith future events !ecreasessince there is more time to gather information about future con!itions (f the future isunfavorable, the pro#ect is not pursue! (f the future is favorable, the original pro#ectcan be e'pan!e! to provi!e the ma'imum return A!!itionally, the longer you can!efer the pro#ect, the greater the li"elihoo! that a favorable outcome may happen Fore'ample, you can "eep the gol! mine for only one $ee" The price of gol! is unli"ely torise enough !uring the $ee" to $arrant the e'traction costs On the other han!, if youcan "eep the gol! mine for ten years, it is more li"ely that the price of gol! may go upenough in that time to ma"e mining the gol! $orth$hile

The uncertainty associate! $ith a pro#ect impacts the value of the real option (f t$opro#ects $ith i!entical values can be !eferre! the same amount of time, the ris"ier ofthe pro#ects $ill have a greater potential value A ris"y pro#ect usually provi!es theopportunity to generate high returns, but there is also a high probability of failureassociate! $ith the pro#ect .ince management has the fle'ibility to e'pan! the pro#ectif it succee!s or aban!on it if things !o not go $ell, the associate! ris"iness is re!uce!For e'ample, if the price of gol! remains relatively stable, the value of the gol! in themine stays stable (f gol! prices can fluctuate $il!ly, it is more li"ely that the price ofgol! may !rop !ramatically (n that case, you ta"e no action On the other han!, if youare luc"y, the price of gol! greatly increases an! you can e'tract the gol! an! ma"e aprofit

)igher interest rates increase the value of the real options associate! $ith a pro#ectNormally, higher interest rates convert into higher !iscount rates that !ecrease thevalue of a pro#ect )o$ever, higher !iscount rates also mean a !ecrease! present valueof the future capital nee!e! to e'ercise the real option This counterbalancing effecthelps to sustain the option*s value as interest rates rise This real option can givegro$th oriente! pro#ects an a!vantage in the capital bu!geting process For e'ample,since you have a ten year lease on your gol! mine, you can $ait a fe$ years beforeyou have to buy the nee!e! e%uipment to e'tract the gol! The present value of the


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e%uipment is cheaper since the greater e'pense of the e%uipment is further out in timean! thus less e'pensive in to!ay*s !ollars

+hat ,as -een one

Beal options are relatively ne$ an! there is not a large bo!y of "no$le!ge Thema#ority of $or" on real options has been !one in the aca!emic community The $or"

coul! be bro"en !o$n into three categories conceptual, simplifie! mo!els, an!in!ustry applications The first t$o categories encompass the vast ma#ority of theliterature $ritten on this topic

The conceptual articles provi!e the basis for real options .ome of the articlesformalize the theory un!erlying real options Other articles e'pan! upon the theoryan! give e'amples of ho$ the real options coul! be use! to increase the value ofpro#ects in a number of !ifferent in!ustries such as pharmaceuticals, natural resourcee'traction, consumer electronics, etc These articles !o not !evelop any %uantitativemo!els but rather !iscuss real options from a %ualitative perspective

The secon! category of literature is those articles that !evelop %uantitative mo!els that!emonstrate ho$ real options can impact a pro#ect*s overall value (n many of thearticles, the mo!els !evelope! are simple an! e'amine only a fe$ states of nature Formost, the numbers entere! into the mo!els are create! by the author+s- of the articleA fe$ of the articles use input !ata !ra$n from actual pro#ects The %uantitativemo!els !evelope! are not !etaile! enough for actual use by management

The thir! category of articles inclu!es those that !escribe mo!els sufficiently !etaile!to actually be use! by in!ustry to support !ecision ma"ing A revie$ of literature foun!only four articles that fell into this category The first t$o articles provi!e a comparisonbet$een the results of real options mo!els an! the results of tra!itional financialanalysis (n these t$o cases, the real option mo!els are not use! by management forany !ecision ma"ing purposes The thir! article !iscusses insights gaine! from the useof real options to assist in the !ecision ma"ing process at .hell The fourth article

!iscusses the use of real options at ;erc" 3harmaceutical Company ;erc" hasintegrate! the use of real options into their formal financial analysis process

The last article $as particularly interesting ;erc" 3harmaceutical Company actuallyuses real options to evaluate pro#ects an! assist management in evaluating potentialpro#ects The article !escribes ho$ real options are use! to value research investments$hich typically are not amenable to tra!itional financial analysis techni%ues ;erc"!etermines the values of the real options inherent in a pro#ect 7ecause of the natureof the pharmaceutical in!ustry, !evelopment of ne$ !rugs ta"es a number of yearsbefore a return can be seen on the investment (n a!!ition, !evelopment is a veryris"y business $ith many of the !rugs never being mar"ete! ;ar"et con!itions an!cash flo$s so far in the future are !ifficult to pre!ict These factors ten! to causetra!itional financial analysis techni%ues to un!erestimate the value of a pro#ect

Beal options allo$ the potential profit from ne$ !rugs to be better incorporate! in thefinancial mo!el 7ecause of the nature of the in!ustry, large pharmaceutical companiestypically farm out initial research an! !evelopment to either small companies oruniversities The large company fun!s the research as a series of payments +ie,stage! investment- These payments give the company the right, but not there%uirement, to ma"e further investments base! upon the results of the research (ftra!itional financial analysis techni%ues $ere use!, many of the pro#ects that yiel! apositive net $orth un!er options analysis $oul! not be pursue! since the tra!itional


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net $orth $oul! be negative The article in!icates that real options analysis is currentlyuse! only for research an! !evelopment pro#ects, ho$ever, ;erc" $oul! li"e to e'ten!this type of analysis to tra!itional pro#ects such as buil!ing ne$ facilities orpurchasing ne$ companies

(n a!!ition to the articles ( #ust mentione!, ( recently complete! some research

e'amining ho$ real options might assist the insurance in!ustry in evaluatinginformation technology pro#ects ( chose to loo" at information technology since it is ata !isa!vantage $hen comparing costs an! benefits ;any of the benefits provi!e! byinformation technology are particularly !ifficult to measure Among the benefits that aninformation system can provi!e inclu!e@ more information, faster information, moreaccurate information, increase! customer satisfaction, etc

As part of my research, ( sent out a %uestionnaire to the chief information officers at:O;A member companies in the Unite! .tates an! Cana!a The %uestionnaire as"e!about their e'isting an! potential use of real options :imite! space allo$s me tosummarize only a fe$ of the ma#or fin!ings@

Gery fe$ of the respon!ents ha! ever hear! of the term real option After e'plaining$hat the term meant, the ma#ority of respon!ents in!icate! that they !o inclu!e atleast some of the fle'ibility aspects of a pro#ect in their cost benefit analysis(n appro'imately 96H of the cases, the value of the real options inherent in a pro#ectma!e a !ifference bet$een approval an! !isapproval(t appears that no companies are using formal mo!els !esigne! to value the realoptions (n the ma#ority of cases, the value of the real options is being incorporate!%ualitativelyA ma#ority of the companies +85H- accept pro#ects even $hen the %uantitativeanalysis !oes not support this action

+hat )an /ou o(n this article ( have e'plaine! the concept of real options an! ho$ they can be use! tosupplement your e'isting analysis process Unfortunately, the level of %uantitativeanalysis for real options is no$here as a!vance! as the %uantitative mo!els forfinancial +ie, stoc"- options Therefore, ( !on*t e'pect any of you to be able to startgenerating !ollar estimates for the values of the real options inherent in your pro#ects

Bather $hat ( hope happens is that you ta"e another loo" at the pro#ects you nee! toevaluate :oo" at the pro#ects for the options they provi!e 2hen possible, use theframe$or" ( !escribe! before to e'amine a pro#ect to see if it alrea!y containsfle'ibility embo!ie! in the si' types of real options Alternately, see if the pro#ect!esign can be mo!ifie! to inclu!e the !ifferent types of real options thus provi!ing you$ith a!!itional fle'ibility Bemember, a!!itional fle'ibility is a benefit ven though youcan*t %uantitatively !etermine the value of the real options, you can %ualitativelyinclu!e the value of all the real options in the cost benefit analysis process

( $ant to leave you $ith a comment by .teven Boss, .terling 3rofessor of conomicsan! Finance at /ale .chool of ;anagement .teven Boss $as one of the in!ivi!ualsheavily involve! in the !evelopment of option pricing theory an! financial options The%uotes are from his "eynote a!!ress at the 0II Financial ;anagement AssociationAnnual ;eeting )e states@ ( have become convince! that it is time to revisit theusefulness of N3G


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to place in it )e further goes on to say@ For most investments, the usefulness of theN3G rule is severely limite! K (f mo!ern finance is to have a practical an! salutaryimpact on investment!ecision ma"ing, it is no$ obligate! to treat all ma#or investment!ecisions as option pricing problems

Using Real Options in Project Evaluation.doc

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