Valuing Real Options

In this chapter, we have presented several examples of important real options. In each case, we used the option-pricing methods developed in Chapter 21, as if the real options were traded calls or puts. Was it right to value the real options as if they were traded? Also we said next to nothing about taxes. Shouldn’t the risk-free rate be after-tax? What about the practical problems that managers face when they try to value real options in real life? We now address these questions.

1. A Conceptual Problem?

When we introduced option pricing models in Chapter 21, we showed that the trick is to con­struct a package of the underlying asset and a loan that would give exactly the same payoffs as the option. If the two investments do not sell for the same price, then there are arbitrage pos­sibilities. But most real assets are not freely traded. This means that we can no longer rely on arbitrage arguments to justify the use of Black-Scholes or binomial option valuation methods.

The risk-neutral method still makes practical sense for real options, however. It’s really just an application of the certainty-equivalent method introduced in Chapter 9. The key assumption—implicit until now—is that the company’s shareholders have access to assets with the same risk characteristics (e.g., the same beta) as the capital investments being evalu­ated by the firm.

Think of each real investment opportunity as having a “double,” a security or portfolio with identical risk. Then the expected rate of return offered by the double is also the cost of capital for the real investment and the discount rate for a DCF valuation of the investment project. Now what would investors pay for a real option based on the project? The same as for an identical traded option written on the double. This traded option does not have to exist; it is enough to know how it would be valued by investors, who could employ either the arbitrage or the risk-neutral method. The two methods give the same answer, of course.

When we value a real option by the risk-neutral method, we are calculating the option’s value if it could be traded. This exactly parallels standard capital budgeting. Shareholders would vote unanimously to accept any capital investment whose market value if traded exceeds its cost, as long as they can buy traded securities with the same risk characteristics as the project. This key assumption supports the use of both DCF and real-option valua­tion methods.

2. What about Taxes?

So far, this chapter has mostly ignored taxes, but just for simplicity. Taxes have to be accounted for when valuing real options. Take the Mark II microcomputer in Table 22.2 as an example. The Mark II’s forecasted PV of $807 million should be calculated from after-tax cash flows generated by the product. The required investment of $900 million should likewise be calcu­lated after-tax.

What about the risk-free discount rate used in the risk-neutral method? It should also be after-tax. Look back to the Chapter 19 Appendix, which demonstrates that the proper discount rate for safe cash flows is the after-tax interest rate. The same logic applies here because pro­jected cash flows in the risk-neutral method are valued as if they were safe.

Recall that the value of a real call option can be expressed as a position in the underlying asset minus a loan. Thus, the call behaves like a claim on the underlying asset partly financed with borrowed money. The borrowing does not show up on the corporation’s balance sheet, but it is nevertheless really there. The implicit borrowing is a debt-equivalent obligation that must be valued using an after-tax interest rate.

The implicit borrowing creates off-balance-sheet financial leverage. The resulting finan­cial risk is the reason why the real call option’s value is more volatile than the value of the underlying asset. (The real option would have a higher beta than the underlying asset if both were traded in financial markets.)

In Chapter 18, we pointed out that highly profitable growth companies like Alphabet and Amazon use mostly equity finance. These companies’ real growth options are one expla­nation. The options contain implicit debt. If the CFOs of these growth firms recognize the implicit debt, or at least the extra financial risk attached to the options, they should reduce ordinary borrowing to compensate. Option leverage therefore displaces ordinary financial leverage. The displacement means that if you forget to count both the debt that is on and off the balance sheet, a growth firm will appear to be less leveraged than it actually is.

3. Practical Challenges

The challenges in applying real-options analysis are not conceptual but practical. It isn’t always easy. We can tick off some of the reasons why.

First, real options can be complex, and valuing them can absorb a lot of analytical and computational horsepower. Whether you want to invest in that horsepower is a matter for busi­ness judgment. Sometimes an approximate answer now is more useful than a “perfect” answer later, particularly if the perfect answer comes from a complicated model that other managers will regard as a black box. One advantage of real-options analysis, if you keep it simple, is that it’s relatively easy to explain. Complex decision trees can often be described as the pay­offs to one or two simple call or put options.

The second problem is lack of structure. To quantify the value of a real option, you have to specify its possible payoffs, which depend on the range of possible values of the underlying asset, exercise prices, timing of exercise, etc. In this chapter, we have taken well-structured examples where it is easy to see the road map of possible outcomes. For example, investments in pharmaceutical R&D are well-structured because all new drugs have to go through the same series of clinical trials to get approved by the U.S. Food and Drug Administration. Out­comes are uncertain, but the road map is clear. In other cases, you may not have a road map. For example, reading this book can enhance your personal call option to work in financial management, yet we suspect that you would find it hard to write down how that option would change the binomial tree of your entire future career.

A third problem can arise when your competitors have real options. This is not a problem in industries where products are standardized and no single competitor can shift demand and prices. But when you face just a few key competitors, all with real options, then the options can interact. If so, you can’t value your options without thinking of your competitors’ moves. Your competitors will be thinking in the same fashion.

An analysis of competitive interactions would take us into other branches of economics, including game theory. But you can see the danger of assuming passive competitors. Think of the timing option. A simple real-options analysis will often tell you to wait and learn before invest­ing in a new market. Be careful that you don’t wait and learn that a competitor has moved first.[4]

Given these hurdles, you can understand why systematic, quantitative valuation of real options is restricted mostly to well-structured problems like the examples in this chapter. The qualitative implications of real options are widely appreciated, however. Real options give the financial manager a conceptual framework for strategic planning and thinking about capital investments. If you can identify and understand real options, you will be a more sophisticated consumer of DCF analysis and better equipped to invest your company’s money wisely.

Understanding real options also pays off when you can create real options, adding value by adding flexibility to the company’s investments and operations. For example, it may be better to design and build a series of modular production plants, each with capacity of 50,000 tons per year of magnoosium alloy, than to commit to one large plant with capacity of 150,000 tons per year. The larger plant will probably be more efficient because of economies of scale. But with the smaller plants, you retain the flexibility to expand in step with demand and to defer investment when demand growth is disappointing.

Sometimes valuable options can be created simply by “overbuilding” in the initial round of investment. For example, oil-production platforms are typically built with vacant deck space to reduce the cost of adding equipment later. Undersea oil pipelines from the platforms to shore are often built with larger diameters and capacity than production from the platform will require. The additional capacity is then available at low cost if additional oil is found nearby. The extra cost of a larger-diameter pipeline is much less than the cost of building a second pipeline later.

Source:  Brealey Richard A., Myers Stewart C., Allen Franklin (2020), Principles of Corporate Finance, McGraw-Hill Education; 13th edition.

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