Identifying Real Options
Campbell R. Harvey,
Fuqua School of Business, Duke University, Durham, NC
National Bureau of Economic Research, Cambridge, MA
Latest Revision: December 30, 1999
Overview
The topic of real options applies the option valuation techniques to capital budgeting exercises in which a project is
coupled with a put or call option. For example, the firm may have the option
to abandon a project during its life. This amounts to a put option on the
remaining cash flows associated with the project. Ignoring the value of
these real options (as in standard discounted cash flow techniques) can
lead to incorrect investment evaluation decisions.
Objectives
After completing this module, you should be able to:
- Recognize real options in project evaluation exercises.
- Value project proposals with straightforward real option components.
- Construct NPV profiles for projects with real option components.
Introduction to Real Options
In many project evaluation settings, the firm has one or more options
to make strategic changes to the project during its life. For example,
a natural resource company may decide to suspend extraction of gold at
its mine if the price of gold falls below the extraction cost. Conversely,
a company with the right to mine in a particular area may decide to begin
operations if the price rises above the cost of extraction. This occurred
during the Gulf war when a number of oil fields in Texas and Southern California
(where the deposits are such that the cost of extraction is relatively
high) began operations when the price of oil rose.
These strategic options, which are known as real options, are typically
ignored in standard discounted cash flow (DCF) analysis where a single
expected present value is computed. These real options, however, can significantly
increase the value of a project by eliminating unfavorable outcomes. Consider
the following stylized example to illustrate the value of an option to
abandon a project during its life.
| Example: Abandonment Options
Suppose a clothing company is considering introducing a new line of
fashion. The project has a two year life. An initial investment of $50
(cash flows are in thousands) is required to fund a year-long development
phase. At the end of a year, a further $50 is required for production and
cash inflows from sales (net of selling expenses) will occur at the end
of the second year.
There is some uncertainty about the amount of the cash inflows since
it is unclear whether the market will embrace the new line. The firm currently
believes that there is a 70% chance that the new line will be a winner.
They also believe that the direction of fashions will become more apparent
over the next year. In particular, there is an 80% chance that the direction
over the next year will continue over the subsequent year.
This uncertainty, and the associated cash flows, are represented in
Figure 1. Suppose also that the required return on projects of this type
is 10%.
Standard capital budgeting techniques involve computing the expected
net present value (NPV) as:
in which case the project would be rejected.
Consider, however, the case where the firm has the option to abandon
the project after the first year. In this case, the second phase of the
project would only proceed if the market direction was favorable over the
first year. If the market direction was unfavorable, the firm would abandon
the project, since proceeding would cost a further $50 and the expected
present value (at time 1) of the cash inflows is
(0.2 (90)-0.8 (100)) / 1.1 = -$56.36.
Therefore, when the option is considered, the expected NPV is:
and the project should proceed.
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Whereas this example serves to establish that real options are important
in project evaluation, one important detail has been swept under the rug.
When the option is considered, the project becomes less risky because the
possibility of the large negative outcome is eliminated. Since the project
is less risky as a result of the option, a lower discount rate should be
used. This would make the project even more attractive than the above analysis
suggests. The issue of how to properly adjust the discount rate is dealt
with below after considering a range of common real options.
Figure 1: Example: Abandonment Option
Types of Real Options
Input Mix Options or Process Flexibility
The option to use different inputs to produce the same output is known
as an input mix option or process flexibility. These options are particularly
important in agricultural settings. For example, a beef producer will value
the option to switch between various feed sources, preferring to use the
cheapest acceptable alternative.
These options are also valuable in the utility industry. An electric
utility, for example, may have the option to switch between various fuel
sources to produce electricity. In particular, consider an electric utility
that has the choice of building a coal-fired plant or a plant that burns
either coal or gas.
Naive implementation of discounted cash flow analysis might suggest
that the coal-fired plant be constructed since it is considerably cheaper.
Whereas the dual plant costs more, it provides greater flexibility. Management
has the ability to select which fuel to use and can switch back and forth
depending on energy conditions and the relative prices of coal and gas.
The value of this operating option should be taken into account.
Output Mix Options or Product Flexibility
The option to produce different outputs from the same facility is known
as an output mix option or product flexibility. These options are particularly
valuable in industries where goods are typically bought in small batches
or where demand is volatile. For example, consider a toy manufacturer's
ability to cease producing a style of toy that has become unfashionable
and quickly begin producing a popular new style of toy.
Abandonment or Termination Options
Whereas traditional capital budgeting analysis assumes that a project
will operate in each year of its lifetime, the firm may have the option
to cease a project during its life. This option is known as an abandonment
or termination option. Abandonment options, which are the right to sell
the cash flows over the remainder of the project's life for some salvage
value, are like American put options. When the present value of the remaining
cash flows falls below the liquidation value, the asset may be sold. Abandonment
is effectively the exercising of a put option. These options are particularly
important for large capital intensive projects such as nuclear plants,
airlines, and railroads. They are also important for projects involving
new products where their acceptance in the market is uncertain.
Figure 2
Temporary-Stop or Shutdown Options
For projects with production facilities, it may not be optimal to operate
a plant for a given period if revenues will not cover variable costs. If
the price of oil falls below the cost of extraction, for example, it may
be optimal to temporarily shut down the oil well until the oil price recovers.
This type of option is known as a temporary-stop or shutdown options. Shutdown
options are also valuable in farming (where they may be exercised if the
cost of fertilizing, watering and harvesting exceeds the sale price of
the product) and real-estate development (where they may be exercised if
the cost of construction exceeds rent revenues). Explicit recognition of
this type of flexibility is critical when choosing among alternative production
technologies with different ratios of variable-to-fixed costs.
Intensity or Operating Scale Options
Intensity or operating scale options involve the flexibility to expand
or contract the scale of the project. For example, management may have
the option to change the output rate per unit of time or to change the
total length of production run time.
In order to obtain the option to expand production if demand increases
suddenly, a firm may build production capacity in excess of the expected
level of output. In this case, management has the right, but not the obligation
to expand, and will exercise the option only if project conditions turn
out to be favorable. Whereas the excess capacity will have an initial cost,
the project with the option to expand is worth more than the project without
the possibility of expansion, in which case the extra cost may be justified.
Also, a firm may build a plant whose physical life exceeds the expected
duration of use, thereby providing the firm with the option of producing
more by extending the life of the project.
Conversely, many projects can be engineered in such a way that output
can be contracted in future. For example, many projects can be modularized.
Forgoing future expenditures by contracting a project is equivalent to
exercising a put option. Since this put option has value, a project with
an option to contract is worth more than a project without the possibility
of contraction. Also, a firm may choose to construct a plant with high
maintenance costs relative to construction costs. Management thereby gains
the flexibility to reduce the life of the plant and contract the scale
of project by reducing expenditures on maintenance in the future.
Option to Expand
Build production capacity in excess of expected level of output (so
it can produce at higher rate if needed). Management has the right (not
the obligation to expand). If project conditions turn out to be favorable,
management will exercise this option.
Figure 3
A project with option to expand is worth more than project without possibility
of expansion
Option to Contract
This is the equivalent to a put option. Many projects can be engineered
in such a way that output can be contracted in future. Example--modularization
of project. Forgoing future expenditures is equivalent to exercising the
put option.
Figure 4 Option to Contract
A project with an option to contract is worth more than project without
possibility of contraction.
Option to Expand or Contract (Switching Option).
This is the most general situation. It is equivalent to the firm having
a portfolio of call and put options. Restarting operations when project
currently shut down is a call option. Shutting down is a put option.
Figure 5
A project whose operation can be dynamically turned on and off (or switched
to two distinct locations) is worth more than the same project without
the flexibility to switch.
A flexible manufacturing system (FMS) is a good example of this type
of option.
Other examples include the following:
Choose a plant with high maintenance costs relative to construction
costs. Management gains the flexibility to reduce the life of the plant
and contract the scale of project by reducing expenditures on maintenance.
Build plant whose physical life exceeds the expected duration of use
(thereby providing the firm with the option of producing more by extending
the life of project).
Initiation or Deferment Options
The option to choose when to start a project is an initiation or deferment
option. For example, the purchaser of an off-shore lease can choose when,
if at all, to develop property. Initiation options are particularly valuable
in natural resource exploration where a firm can delay mining a deposit
until market conditions are favorable. If natural resource companies were
committed to producing all resources discovered, they would never explore
in areas where the estimated extraction cost exceeded the expected future
price at which the resource could be sold.
For example, a purchaser of an off-shore lease can choose when, if at
all, to develop property. This option has significant value.
If the U.S. government required immediate development of leases:
- Prices paid for leases would decline
- Some leases would not be purchased at all.
This is also true for exploration in general. If natural resource companies
were committed to produce all resources discovered, then they would never
explore in areas where the estimated extraction cost exceeded the expected
future price at which the resource could be sold.
Figure 6
Sequencing Options
The sequencing of projects is an important issue in corporate strategy.
For example, successful marketing of consumer products often requires brand
name recognition or brand equity. Suppose a firm is evaluating
projects to produce a number of consumer products. It may be advantageous
to implement the projects sequentially rather than in parallel. Pursuing
the development of a single product, the firm can resolve some of the uncertainty
surrounding its ability to establish brand equity. Once resolved, management
has the option to proceed or not with the development of the other projects.
If taken in parallel, management would have already spent the resources
and the value of the option not to spend them is lost.
Intraproject vs. Interproject Options
Interproject options arise when the development of one project creates
options that attach to other projects. Sequencing options, for example,
are interproject options because the sequencing of projects creates options
subsequent projects as the direct result of undertaking the initial project.
Traditional capital budgeting analysis will miss this option because projects
evaluated on stand-alone basis. Ignoring interproject options can lead
to significant undervaluation of projects. The obvious example is research
and development expenditure. The real value in R&D is in the options
that are created to undertake other projects. Interproject options are
created whenever management makes an investment that places the firm in
a position to use new technology to enter a different industry.
Growth Options
The value of the firm can exceed the market value of the projects currently
in place because the firm may have the opportunity to undertake positive
NPV projects in the future. Standard capital budgeting techniques involve
establishing the present value of these projects based on anticipated implementation
dates. However, this implicitly assumes that the firm is committed to go
ahead with the projects. Since management need not make such a commitment,
they retain the option to exercise only those projects that appear to be
profitable at the time of initiation. The value of these options should
be considered in valuing the firm. Growth options are particularly valuable
in infrastructure-based or strategic industries. For example, in the high-tech
and software industries (where there are significant first-mover advantages)
valuable growth options can be obtained through R&D expenditure and
by creating strategic links with other industry players -- even though
these activities may appear to be negative NPV investments when viewed
in isolation.
Shadow Costs
Standard valuation techniques may overvalue some projects by failing
to recognize the losses in flexibility to the firm that result from implementation.
The acceptance of one project may eliminate options that attach to other
projects. These shadow costs should be considered in project evaluation.
For example, building a plant in a particular city eliminates the options
to expand the capacity of plants in nearby cities.
Financial Flexibility:
Choice of capital structure can affect value of project. Like operating
flexibility, financial flexibility can be measured by the value of the
financial options made available to the firm by its choice of capital structure.
Interaction between financial and operating options can be strong -- especially
for long-term investment projects with a lot of uncertainty. The option
valuation framework is particularly useful to the corporate strategist
because it provides an integrative analysis of both operating and financial
options associated with the combined investment and financing decisions.
| Example: Oil Extraction
Valuation of heavy oil asset.
Deferral options are critical. In addition, production could be phased
in over time. Conventional NPV will significantly undervalue these assets.
Two operating options are important: The option to defer and the option
of deferring expansion program.
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| Example: Precious Metal Mining
Four silver production sites, each with different layout and extraction
technologies.
The price of silver has been very volatile. To value firm based upon
forecasts of silver prices (traditional NPV approach) could grossly underestimate
the value.
Value is enhanced by:
(i) Operational flexibilities and
(ii) Switching options (shut down, reopening, abandonment).
Insight can be gained into the opening-up and shutting-down decision.
If the mine is already open, it might be optimal to keep it open even
when the marginal revenue from a ton of output falls below the marginal
cost of extraction. Intuitively, the fixed cost of closing an operation
might be needlessly incurred if the price rose in the future.
The logic is just the opposite for the closing-down decision. Due to
the cost of reopening the mine, the optimal decision might be to keep it
closed until the commodity price rises substantially above the marginal
cost of production.
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| Example: Pharmaceutical R&D
A drug company needed to value a new drug research and development project.
There were four development phases:
- Initial R&D with 20% chance of success
- Preclinical testing, with 50% chance of success
- Testing I, with 40% chance of success
- Testing II, with a 90% chance of success.
Figure 7
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Abandonment Options in Natural Resource Investments
Suppose your resource management company has a two-year lease over a
small copper deposit and is deciding whether or not to mine the deposit.
At the end of the lease, all rights to the property revert to the government.
It is known that the deposit contains eight million pounds of copper. Mining
would involve a one-year development phase that would cost $1.25 million
immediately. The company would then pay all extraction costs to a subcontractor,
in advance, at a rate of 85 cents per pound. This amounts to a cash payment
of $6.8 million one year from now. Your company would then sell the rights
to the copper recovered (8 million pounds) to a third party at the spot
price of copper one year from now. Copper prices follow a process such
that percentage price changes are normally distributed with mean 7% and
standard deviation 20%, and the current price is 95 cents per pound.
What is the expected NPV of mining if the required return for copper
mining projects is 10% and the riskless rate of interest is 5%?
Standard Expected NPV Analysis
Standard capital budgeting techniques would involve computing the present
value of the expected payoffs from the mine over its life. This can be
written (all figures in millions) as
where E[S1] represents today's expectation of the
spot price of copper one year from now.
From the statistics, we know that if percentage price changes are distributed
normally (with mean mu and standard deviation sigma) then
Now, the expected NPV of the project is
and the project has a negative expected NPV and would therefore this
analysis says it should be rejected.
Option Analysis
Now note that your company has the option to abandon the project after
the development phase. In this case, the mining phase will only proceed
if S1 > 0.85. This is a simple call option on copper
with strike price 85 cents and one year to maturity, and can be valued
using Black-Scholes:
where
Hence, the value of this call option is
Since the company has 8 million of these options (one for each pound
of copper) and the development phase costs $1.25 million, the value of
the project, incorporating the option to abandon is
and the project should proceed. Analyzing the problem in an option valuation
framework also enables a number of important statistics to be computed.
Some examples are reviewed below.
The Probability that Extraction will Proceed
Why is the lease more valuable when the abandonment option is considered?
The reason is that there is some chance that the second (extraction) phase
of the project could be unprofitable. This will occur if S1
< 0.85 which is equivalent to ln(S1) < ln(0.85)
= -0.1625. That is, the probability that extraction will proceed is
1 - pr[ln[S1] < -0.1625]
From the statistics, we know that if percentage price changes are distributed
normally (with mean mu and standard deviation sigma) then
In this case,
in which case
Since we know that ln(S1) ~ is N(0.00129,0.04), we
want to know the probability of getting a draw of less than -0.1625 from
a N(0.00129,0.04) distribution. Using the normdist function in Excel
yields a value of 0.33. That is, there is a 33% chance that the second
(extraction) phase of the project will be unprofitable. When the abandonment
option is included in the analysis, however, there is a 0% chance that
the second phase will be unprofitable.
If copper prices fall enough so that the extraction would be unprofitable,
the company chooses to let the call option lapse, and there are no cash
flows beyond the initial $1.25 million development cost.
Shutdown and Restart Options in Natural Resource Investments
Finally, we consider how real options to shutdown and restart a mine
can affect its value. Consider a gold mine that generates ongoing expenses
while operating (e.g., labor and fuel costs) and a stream of profits that
are linked to the (variable) spot price of gold. Also suppose that the
firm can shut the mine down (if the price of gold falls sufficiently) and
restart the mine (if the price of gold recovers sufficiently). There are,
however, costs associated with shutdown (severance pay for workers, security
costs for machinery) and restart (hiring new workers, refurbishing equipment).
These costs play the role of the exercise prices of the respective options.
Figure 8 illustrates how these options affect the value of the mine.
Suppose the mine is currently open (so the steeper curve is relevant)
and the spot price of gold is somewhere between P1 and
P2. As the gold price falls, the value of the mine falls.
In fact, as the gold price approaches P1 the mine is
worth more closed (the flatter curve) than open because the revenues from
the sale of gold are outweighed by the costs of operating the mine. However,
it is still optimal to continue operating the mine because the savings
from shutting down do not exceed the shutdown cost C. That is, we
have an option to pay C to save a loss that has a present value
that is less than C. Clearly, we would choose to let that option
lapse. When the gold price falls below P1 , the present
value of these savings exceeds C and the option should be exercised
and mine shut down.
Now suppose the mine is shut. As the gold price rises, approaching P2, the mine
is worth more open than closed because the revenues from the sale of gold
are outweigh the costs of operating the mine. However, it is still optimal
to keep the mine shut because the present value of the net operating revenues
do not exceed the opening cost O. That is, we have an option to
pay O to receive a net revenue stream that has a present value that
is less than O. Clearly, we would choose to let that option lapse.
When the gold price rises above P2, the present value
of these net revenues exceeds O and the option should be exercised
and mine restarted.
NPV Probability Distribution
A particularly useful diagnostic tool is the probability distribution
of the NPV of the project, sometimes called an NPV Profile Plot. For this
project, the NPV will be the present value of the cash inflow at the end
of one year less the $1.25 million cost of the development phase. The first
question is what discount rate should be used? Since this project is a
copper mining project coupled with an option to abandon, the regular discount
rate of 10% is inappropriate. This is because the project coupled with
the option is less risky than a standard copper mining project.
As discussed in the options lecture, the option valuation framework
is designed to avoid this issue. Instead of allowing the price of copper
to increase at 7% and then discounting the resulting cash flows at an appropriate
discount rate, the expected increase in the price of copper is adjusted
so that the resulting cash flows can be discounted at the riskless rate
of interest. This procedure is known as risk neutral valuation.
Acknowledgments
Some of the material for this lecture is drawn from Tom Copeland, Tim Koller and Jack Murrin,
Valuation: Measuring and Managing the Value of Companies