Chapter

Brealey, Myers, and Allen

Principles of Corporate Finance

11th Edition

REAL OPTIONS

22

Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

22-2

22-1 VALUE OF FOLLOW-ON INVESTMENT OPPORTUNITIES

• Four Types of Real Opinions • Opportunity to expand, make follow-up investments

• Opportunity to wait, invest later

• Opportunity to shrink or abandon project

• Opportunity to vary firm’s output or production methods

• Value of real option = NPV with option

− NPV without option

22-3

TABLE 22.1 CASH FLOW AND FINANCIAL ANALYSIS OF MARK I MICROCOMPUTER

• Mark I Microcomputer in Millions

22-4

TABLE 22.2A MARK II MICROCOMPUTER

22-5

TABLE 22.2B MARK II MICROCOMPUTER

22-6

TABLE 22.3 CASH FLOW OF MARK II MICROCOMPUTER

• Forecasted from 1982 in millions

22-7

FIGURE 22.1 POSSIBLE PRESENT VALUES FOR MARK II IN 1985

• Distribution shows range of possible present values for Mark II project 1985

• Expected value roughly $800 million (less than required investment of $900 million)

• Option to invest pays off in shaded area above $900 million

22-8

FIGURE 22.1 POSSIBLE PRESENT VALUES FOR MARK II IN 1985

22-9

22-2 TIMING OPTIONO

ptio

n p

rice

Intrinsic value

Stock price

•Option to Wait

22-10

22-2 TIMING OPTION

• Intrinsic value plus time premium equals option value

• Time premium equals value of being able to wait

Opt

ion

pric

e

Stock price

22-11

22-2 TIMING OPTION

• Option to Wait• More time equals more value

Stock price

Opt

ion

pric

e

22-12

FIGURE 22.2 TIMING OPTION EXAMPLE

• Possible cash flow and end-of-period values for malted herring project shown in black

• Project costs $180 million

• Red figures in parentheses show payoffs from option to wait and invest later in project, now positive-NPV at year 1

• Waiting means loss of first year cash flow; figuring out current value of option is difficult

22-13

FIGURE 22.2 TIMING OPTION EXAMPLE

22-14

22-2 TIMING OPTION

• High demand generates $25 million, $250 million value at end of year

• Low demand generates $16 million with no value

High Demand Low Demand

375.

1200

)25025(return Total

12.

1200

)16016(return Total

Risk neutral return

22-15

22-2 TIMING OPTION

• Calculate probability of high demand for malted herring project

• Option value

343. demandhigh of Prob

05.return Expected

(-.12)demand)high of prob1(375.demand)high of prob(return Expected

22-16

FIGURE 22.3 DEVELOPMENT OPTION FOR VACANT LAND

22-17

22-3 ABANDONMENT OPTION

• Example • Mrs. Mulla gives nonretractable offer to buy company for $150 million at anytime within next year

• Given possible outcomes

• What is value of offer?

• What is most Mrs. Mulla could charge for that option?

• Use discount rate of 10%

22-18

22-3 ABANDONMENT OPTION

Year 0 Year 1 Year 2

120 (.6)

100 (.6)

90 (.4)

NPV = 145

70 (.6)

50 (.4)

40 (.4)

•Example

22-19

22-3 ABANDONMENT OPTION

Year 0 Year 1 Year 2

120 (.6)

100 (.6)

90 (.4)

NPV = 162

150 (.4)

Option value =

162 − 145 =

$17 Million

22-20

FIGURE 22.4 VALUE OF TANKER

22-21

FIGURE 22.5 PRICE OF ELECTRICITY IN U.K.

22-22

FIGURE 22.5 PRICE OF ELECTRICITY IN U.K.

22-23

FIGURE 22.6 AIRCRAFT PURCHASE OPTION

• If implemented at year 3, option guarantees fixed price and delivery at year 4

• Without option, plane can still be ordered at year 3 but with uncertain price and delivery

22-24

FIGURE 22.7 AIRCRAFT PURCHASE OPTION

22-25

FIGURE 22.8 DECISION TREE FOR FIGURE 22.6

22-26

22-6 CONCEPTUAL PROBLEM

• Real options are not always feasible to use• Options can be complex; it is sometimes impossible to arrive at “perfect” answer

• No clear structure to path and cash flows

• Competitors have real options, which alter option values by altering underlying assumptions and environment that serves as basis of valuation