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Real Options in Corporate Finance Real Options in Corporate Finance Ellen Bjarnadóttir Thesis of 30 ECTS credits Master of Science in Financial Engineering June 2013 i Real Options in Corporate Finance (Notkun Raunvilnana við töku Fjárfestingaákvarðana) Ellen Bjarnadóttir Thesis of 30 ECTS credits submitted to the School of Science and Engineering at Reykjavík University in partial fulfillment of the requirements for the degree of Master of Science in Financial Engineering June 2013 Supervisor: Dr.Sverrir Ólafsson. Professor in Financial Mathematichs, Reykjavík University, Iceland Examiner: Dr. Rögnvaldur Sæmundsson Associate Professor, Reyjavík University, Iceland. ii Abstract The way companies value their investment opportunities has changed in recent years. With changing market conditions companies are constantly confronted with investment decisions that are increasingly uncertain. Known investment analysis such as net present value and decision tree analysis increasingly undervalue investment opportunities as they lack the flexibility and ability to modify projects when new information is available. A method based on financial option valuation has become the basis for a new technique to value high risk investment opportunities. It is based on valuation in the risk-neutral world and therefore eliminates investors’ attitude to risk. Real option analysis can capture the value of this increased flexibility, which previous methods have not been able to, such as the option to defer, abandon, expand or default a project. These options can be exercised when new information arrives and therefore provide an opportunity to put a floor on project loss. Use of binomial option pricing model gives managers a whole range of possibilities in analyzing the flexibility and to value the uncertainty in their investments. In this thesis the disadvantages of net present value and decision tree analysis to value investment opportunities will be demonstrated. Next the framework of real options is introduced theoretically and in terms of examples it is demonstrated how it can be implemented in the valuation of investment opportunities, especially those that bear high risk and uncertain future cash flow. Key words: Net present value, Financial options, Real option analysis, Uncertainty, Flexibility. iii Útdráttur Aðferð fyrirtækja að til að verðleggja tækifæri til fjárfestinga hefur breyst mikið á undanförnum árum. Með stöðugum breytingum á mörkuðum standa fyrirtæki oftar frammi fyrir áhættumiklum fjárfestingum með óútreiknanlegri útkomu. Þær aðferðir sem þekktastar eru í dag við verðlagningu fjárfestinga eru núvirðisaðferðin (e. Net present value) og bygging ákvörðunartrjáa (e. Decision tree analysis). Ókosturinn við núgildandi aðferðir er að þær eiga það til að vanmeta virði fjárfestinga þar sem þau taka ekki inn í myndina sveiganleikan sem getur falist í því að geta tekið fleiri ákvarðanir eftir að nánari upplýsingar líta dagsins ljós og þær breytingar sem geta orðið á fjárstreymi (e. Cash flow) út fjárfestingartímann. Aðferð sem byggir á verðleggingu valrétta (e. Options) á fjármálamörkuðum hefur verið þróuð til að takast á við galla fyrri aðferða. Hún felst í því að verðleggja fjárfestingar í heimi þar sem fjárfestar eru hlutlausir vegna þeirrar áhættu sem er á markaðnum. Raunvilnanir (e. Real options) geta með hjálp valrétta fangað virði þess að hafa þennan sveiganleika. Val um að fresta, hætta við eða jafnvel stækka við sig eru möguleikar sem raunvilnanir geta verðlagt fyrir fyrirtæki. Fjárfestirinn getur ákveðið síðar hvort hann vilji nýta sér þessar breytingar þegar meiri upplýsingar eru til taks um fjárfestinguna. Með því að nota valrétti til að verðleggja fjárfestingar geta fyrirtæki takmarkað það tap sem þau verða fyrir við að taka að sér áhættumikla fjárfestingu. Í þessari ritgerð er farið yfir þá galla sem núverandi aðferðir hafa við að verðleggja fjárfestingatækifæri. Raunvilnanir verða síðan kynntar sem annar og betri kostur til að verðleggja fjárfestinga, sérstaklega þeirra sem stjórnast af mikilli áhættu og óvissu fjárstreymi. Lykilorð: Núvirðisaðferð, Valréttir, Raunvilnanir, Óvissa, Sveigjanleiki. iv Real Options in Corporate Finance Ellen Bjarnadóttir 30 ECTS thesis submitted to the School of Science and Engineering at Reykjavík University in partial fulfillment of the requirements for the degree of Master of Science in Financial Engineering. June 2013 Student: ___________________________________________ Ellen Bjarnadóttir Supervisor: ___________________________________________ Dr. Sverrir Ólafsson Examiner: ___________________________________________ Dr. Rögnvaldur Sæmundsson v Table of Contents 1 Introduction ...................................................................................................................... 1 1.1 Background .................................................................................................................. 1 1.2 Objectives .................................................................................................................... 2 1.3 Structure of thesis ........................................................................................................ 2 2 Investment analysis .......................................................................................................... 4 2.1 Net Present Value (NPV) ............................................................................................ 4 2.1.1 Determining the cost of capital ............................................................................ 5 2.2 Decision trees analysis (DTA) ..................................................................................... 7 2.3 NPV and DTA disadvantages ...................................................................................... 9 3 Financial options ............................................................................................................ 11 3.1 Introduction ............................................................................................................... 11 3.2 Mathematical background ......................................................................................... 12 3.3 Binomial option pricing ............................................................................................. 15 3.3.1 Methodology ...................................................................................................... 15 4 Real options ..................................................................................................................... 20 4.1 Introduction ............................................................................................................... 20 4.2 Connection between real option and financial option ............................................... 20 4.3 Option Types ............................................................................................................. 21 4.4 Valuation ................................................................................................................... 23 4.4.1 Option to defer ................................................................................................... 26 4.4.2 Option to abandon for salvage value .................................................................. 27 4.4.3 Option to expand ................................................................................................ 29 4.4.4 Option to switch ................................................................................................. 31 4.5 Comparison of ROA and DTA .................................................................................. 33 4.6 Managing uncertainty ................................................................................................ 34 4.7 Manage and value flexibility ..................................................................................... 38 4.8 What features of ROA attractive to companies ......................................................... 39 4.9 Comments about real options .................................................................................... 39 5 Case studies ..................................................................................................................... 40 5.1 Pharmaceutical companies ........................................................................................ 40 5.1.1 Introduction ........................................................................................................ 41 vi 5.1.2 Assumptions ....................................................................................................... 41 5.1.3 Calculations ........................................................................................................ 42 5.2 Telecommunication Industry ..................................................................................... 47 5.2.1 Introduction ........................................................................................................ 47 5.2.2 Assumptions ....................................................................................................... 48 5.2.3 Calculations ........................................................................................................ 48 6 Discussion and Conclusion ............................................................................................ 51 7 References ....................................................................................................................... 53 8 Appendices .....................................................................................................................
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