Real Option— the Evolution of an Idea

3989 P-01 10/2/02 12:55 PM Page 1 CHAPTER 1 Real Option— The Evolution of an Idea REAL OPTIONS—WHAT ARE THEY AND WHAT ARE THEY USED FOR? An option represents freedom of choice, after the revelation of information. An option is the act of choosing, the power of choice, or the freedom of alternatives. The word comes from the medieval French and is derived from the Latin optio, optare, meaning to choose, to wish, to desire. An option is a right, but not an obligation, for example, to follow through on a business decision. In the financial markets, it is the freedom of choice after revelation of additional information that increases or decreases the value of the asset on which the option owner holds the option. A financial call option gives the owner the right, but not the obligation, to purchase the underlying stock in the future for a price fixed today. A put option gives the owner the right, but not the obligation, to sell the stock in the future for a price fixed today. A “real” option is an option “relating to things,” from the Late Latin word realis. Real refers to fixed, permanent, or immovable things, as op- posed to illusory things. Strategic investment and budget decisions within any given firm are decisions to acquire, exercise, abandon or let expire real options. Managerial decisions create call and put options on real assets that give management the right, but not the obligation, to utilize those assets to achieve strategic goals and ultimately maximize the value of the firm. As this book will show in practice, real options analysis is as much about valuation as it is about thorough strategic analysis. It is about defining the financial boundaries for a decision, but also about discovering new real options when laying out the option framework. The key advantage and value of real option analysis is to integrate managerial flexibility into the valuation process and thereby assist in making the best decisions. Such a 1 3989 P-01 10/2/02 12:55 PM Page 2 2 REAL OPTIONS IN PRACTICE concept is immediately attractive on an intuitive level to most managers. However, ambiguity and uncertainty settle in when it comes to using the concept in practice. Key questions center on defining the right input para- meters and using the right methodology to value and price the option. Also, given the efforts, time, and resources likely required for making decisions based on real option analysis, the question arises whether such a level of additional sophistication will actually pay off and help make better investment decisions. Hopefully, by the end of this book, some of the ambiguity and uncertainty will be resolved and some avenues to making better investment decisions without investing heavily in the analytical side will become apparent. Typically, within any given firm, there are multiple short- and long-term goals along the path of value maximization and, typically, managers can en- vision more than one way of achieving those goals. In many ways, Paul Klee’s 1929 painting Highways and Byways is one of the most dazzling rep- resentations of just this concept (See cover). If the goal is to reach the blue horizon at the top, then there are multiple paths to get there. These paths come in different colors and shapes. Some fork and twist, and the path to the top is rockier and perhaps a more diffi- cult climb. Others are straighter, but still point to the same direction. More importantly, it seems the decision maker can switch between paths, much in the same way a rock climber may take many different paths to reach the summit, depending on weather conditions and his or her own physical sta- mina to cope with the inherent risks of each path. One could start out in the lower left and end up in the upper right, but still reach the blue horizon. Fur- thermore, all paths come in incremental steps. These have different appear- ances and may bear different degrees of difficulty and risk, but they all are clearly defined and separated from each other and are contained within certain boundaries. Investment decisions are the firm’s walk or climb to the blue horizon. They lead to strategic and financial goals, and they can follow different paths. They usually come in incremental steps. Some paths display fewer but bigger increments to navigate; others have more but smaller steps. The real option at each step in the decision-making process is the freedom of choice to embark on the next step in the climb, or to choose against doing so based on the examination of additional information. Most managers will agree that this freedom of choice characterizes most if not all investment decisions, though admittedly within constraints. An investment decision is rarely a now-or-never decision and rarely a decision that cannot be abandoned or changed during the course of a project. In most in- stances, the decision can be delayed or accelerated, and often it comes in se- quential steps with various decision points, including “go” and “no-go” 3989 P-01 10/2/02 12:55 PM Page 3 Real Option—The Evolution of an Idea 3 alternatives. All of these choices are real managerial options and impact on the value of the investment opportunity. Further, managers are very conscious of preserving a certain freedom of choice to respond to future uncertainties. Uncertainties derive from internal and external sources; they fall into several categories that include market dynamics, regulatory or political uncertainty, organizational capabilities, knowledge, and the evolution of the competitive environment. Each category is comprised of several subcate- gories, and those come in different flavors and have different importance for different organizations in different industries. The ability of each organization to overcome and manage internal or private uncertainties and cope with the external uncertainties is valued in the real option analysis, as it is valued in the financial market. Uncertainty, or risk, is the possibility of suf- fering harm or loss, according to Webster’s dictionary. Corporations that are perceived as good risk managers tend to be favored by analysts and in- vestors. Supposedly, companies that manage risk well will also succeed in making money. Banks that were caught up in the Enron crisis—and appar- ently had failed to manage that risk well—had to watch their stocks “go south.” Bristol-Myers Squibb failed to manage the risk associated with tech- nical uncertainty related to the lead drug of its partner company Imclone in the contractual details of the deal made between the two. The pharmaceuti- cal giant lost 4.5% in market value within a few days after its smaller partner announced that the FDA had rejected its application for approval of the new drug, for which Bristol Myers had acquired the marketing rights. Risk management from a corporate strategy perspective entails enterprise- wide risk management, and includes business risks such as an economic downturn, competitive entry, or an overturn of key technology. This ability drives the future asset value, a function of market penetration, market share, and cost-structure; the likelihood of getting the product to market and ob- taining the market payoff; the time-frame; and the managerial ability to ex- ecute. The combination of assets and options in place and exercisable options in the pipeline drives the value of the organization. There are in essence three tools available to management to evaluate corporate risk and uncertainty, as shown in Figure 1.1. The capital budgeting method, which looks at projects in isolation, de- termines the future cash flows the project may generate, and discounts those to today’s value at a project-specific discount rate that reflects the perceived risk of the cash flows. Risk is measured indirectly; in fact, the discount rate represents the opportunity cost of capital, which is the rate of returns an in- vestor expects from traded securities that carry the same risk as the project being valued.1 Portfolio analysis looks at the investment project in relation 3989 P-01 10/2/02 12:55 PM Page 4 4 REAL OPTIONS IN PRACTICE Method Approach to Risk Instrument Capital Budgeting Indirect Discount Rate Portfolio Analysis Relative Benchmark Option Pricing Direct Probability FIGURE 1.1 Three approaches to risk to the assets and options already in place; risk is evaluated in the context of the existing assets and projects. Specifically, the portfolio manager is inter- ested in identifying the relative risk contribution of the project to the over- all risk profile of the portfolio, and how the new portfolio, enriched by the new project, will compare in its risk/return profile to established bench- marks. Portfolio analysis diversifies risk; it permits only those projects to be added to the existing asset portfolio that reduce risk exposure while preserving or enhancing returns. Among the three methods, only option pricing is concerned with a direct analysis of project-specific risks. Risk is quantified via probability assignment. The expected future payoff of the investment option reflects assumptions and insights on the probability of market dynamics, global economics, the competitive environment and competitive strength of the product or service to be developed, as well as the probability distrib- ution of costs associated with the project. The risk-neutral expected payoff, discounted back to today’s value at the risk-free rate, gives today’s value of the investment option. Traditional project appraisal within the context of capital budgeting as- sumes that the firm will embark on a rigid and inflexible path forward, ig- noring and failing to respond and adjust to any changes in the market place.

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