Presented at Agile carnival Chandigarh on 7th-8th May at ISB Mohali Campus

1. Real Options & Decision Making
Ramabhadran S. Thirumalai
Indian School of Business
Agile Carnival, Chandigarh
May 8, 2016

2. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Agenda
1 Introduction
Capital Budgeting
Option Types
2 Real Options
3 Option to Defer
4 Option to Abandon
5 A Four-Step Process
6 Wrap-Up
Ram Thirumalai Real Options
Agile Carnival 2 / 16

3. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
A capital budgeting example
• XYZ Pharma Ltd. is looking to make an additional R&D
investment of |10 billion for a cure to cancer.
• If the additional investment results in a breakthrough cure
(probability of 0.05), the future net inflows are worth |200
billion at the end of year 1.
• If the additional investment fails (probability of 0.95), the
future net inflows are worth zero at the end of year 1.
• The discount rate is 30%.
• Traditional capital budgeting would say:
NPV =
0.05 × 200 + 0
1.30
− 10 = −2 billion ⇒ Reject the
project.
Ram Thirumalai Real Options
Agile Carnival 3 / 16

4. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
A capital budgeting example . . . 2
• However, since this has significant implications for the health
of its citizens, the government agrees to pay the company |20
billion if the additional investment fails.
• Does this change the decision?
Ram Thirumalai Real Options
Agile Carnival 4 / 16

5. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
A capital budgeting example . . . 2
• However, since this has significant implications for the health
of its citizens, the government agrees to pay the company |20
billion if the additional investment fails.
• Does this change the decision?
• NPV =
0.05 × 200 + 0.95 × 20
1.30
− 10 = 12.31 billion ⇒
Accept the project.
Ram Thirumalai Real Options
Agile Carnival 4 / 16

6. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
A capital budgeting example . . . 2
• However, since this has significant implications for the health
of its citizens, the government agrees to pay the company |20
billion if the additional investment fails.
• Does this change the decision?
• NPV =
0.05 × 200 + 0.95 × 20
1.30
− 10 = 12.31 billion ⇒
Accept the project.
• Value of option = 12.31 − −2 = 14.31 billion.
Ram Thirumalai Real Options
Agile Carnival 4 / 16

7. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Options contract
• Option: It gives the holder the right to trade the underlying
asset at a stated price (called the exercise or strike price).
Right to buy: call.
Right to sell: put.
Ram Thirumalai Real Options
Agile Carnival 5 / 16

8. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Options contract
• Option: It gives the holder the right to trade the underlying
asset at a stated price (called the exercise or strike price).
Right to buy: call.
Right to sell: put.
• Option in the previous example: call or put?
Ram Thirumalai Real Options
Agile Carnival 5 / 16

9. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Options contract
• Option: It gives the holder the right to trade the underlying
asset at a stated price (called the exercise or strike price).
Right to buy: call.
Right to sell: put.
• Option in the previous example: call or put? It is a put as it
gives the company the right to “sell” the project to the
government and receive the guaranteed amount if the
additional investment is a failure.
Ram Thirumalai Real Options
Agile Carnival 5 / 16

10. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Options contract
• Option: It gives the holder the right to trade the underlying
asset at a stated price (called the exercise or strike price).
Right to buy: call.
Right to sell: put.
• Option in the previous example: call or put? It is a put as it
gives the company the right to “sell” the project to the
government and receive the guaranteed amount if the
additional investment is a failure.
• Can be viewed as insurance contracts.
Ram Thirumalai Real Options
Agile Carnival 5 / 16

11. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Why real options?
• Traditional valuation assumes that there is no uncertainty in cash
flows and projects are irreversible.
• Ignoring options will lead to incorrect valuation and hence wrong
decisions.
• The decision to invest is an option itself, which need not be
decided right away.
For example, project may be unattractive if price drops by 10% in a year’s
time but may be lucrative if price increases by 5% in a year’s time. So
wait for a year (to resolve uncertainty in price) before deciding to accept
or reject the project.
• Flexibility is valuable and cannot be ignored.
Ram Thirumalai Real Options
Agile Carnival 6 / 16

12. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Why real options?
• Traditional valuation assumes that there is no uncertainty in cash
flows and projects are irreversible.
• Ignoring options will lead to incorrect valuation and hence wrong
decisions.
• The decision to invest is an option itself, which need not be
decided right away.
For example, project may be unattractive if price drops by 10% in a year’s
time but may be lucrative if price increases by 5% in a year’s time. So
wait for a year (to resolve uncertainty in price) before deciding to accept
or reject the project.
• Flexibility is valuable and cannot be ignored.
• Definition: A real option is an alternative or choice that is
available or becomes available with a business investment
opportunity.
Ram Thirumalai Real Options
Agile Carnival 6 / 16

13. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Why real options? . . . 2
• Common examples of real options (from “Real Options” by Lenos
Trigeorgis):
Option to defer: company holds a lease on or an option to buy valuable
land. Typical in oil extraction, mining and real-estate industries.
Ram Thirumalai Real Options
Agile Carnival 7 / 16

14. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Why real options? . . . 2
• Common examples of real options (from “Real Options” by Lenos
Trigeorgis):
Option to defer: company holds a lease on or an option to buy valuable
land. Typical in oil extraction, mining and real-estate industries.
Staged investment: each stage may be viewed as an option on the
subsequent stages. Typical in start-up, R&D-intensive and
energy-generating industries.
Ram Thirumalai Real Options
Agile Carnival 7 / 16

15. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Why real options? . . . 2
• Common examples of real options (from “Real Options” by Lenos
Trigeorgis):
Option to defer: company holds a lease on or an option to buy valuable
land. Typical in oil extraction, mining and real-estate industries.
Staged investment: each stage may be viewed as an option on the
subsequent stages. Typical in start-up, R&D-intensive and
energy-generating industries.
Option to alter operating scale: expand, contract, shutdown and restart.
Typical in consumer goods, mining and fashion apparel industries.
Ram Thirumalai Real Options
Agile Carnival 7 / 16

16. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Why real options? . . . 2
• Common examples of real options (from “Real Options” by Lenos
Trigeorgis):
Option to defer: company holds a lease on or an option to buy valuable
land. Typical in oil extraction, mining and real-estate industries.
Staged investment: each stage may be viewed as an option on the
subsequent stages. Typical in start-up, R&D-intensive and
energy-generating industries.
Option to alter operating scale: expand, contract, shutdown and restart.
Typical in consumer goods, mining and fashion apparel industries.
Option to abandon: sell all capital assets. Typical in capital-intensive
industries.
Ram Thirumalai Real Options
Agile Carnival 7 / 16

17. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Why real options? . . . 2
• Common examples of real options (from “Real Options” by Lenos
Trigeorgis):
Option to defer: company holds a lease on or an option to buy valuable
land. Typical in oil extraction, mining and real-estate industries.
Staged investment: each stage may be viewed as an option on the
subsequent stages. Typical in start-up, R&D-intensive and
energy-generating industries.
Option to alter operating scale: expand, contract, shutdown and restart.
Typical in consumer goods, mining and fashion apparel industries.
Option to abandon: sell all capital assets. Typical in capital-intensive
industries.
Option to switch: change output mix or produce same output using
different inputs. Typical in toy industries, automobile.
Ram Thirumalai Real Options
Agile Carnival 7 / 16

18. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Why real options? . . . 2
• Common examples of real options (from “Real Options” by Lenos
Trigeorgis):
Option to defer: company holds a lease on or an option to buy valuable
land. Typical in oil extraction, mining and real-estate industries.
Staged investment: each stage may be viewed as an option on the
subsequent stages. Typical in start-up, R&D-intensive and
energy-generating industries.
Option to alter operating scale: expand, contract, shutdown and restart.
Typical in consumer goods, mining and fashion apparel industries.
Option to abandon: sell all capital assets. Typical in capital-intensive
industries.
Option to switch: change output mix or produce same output using
different inputs. Typical in toy industries, automobile.
Even football clubs have real options: whether to hire players from school,
when to fire them, when to promote them to second team and full team.
Ram Thirumalai Real Options
Agile Carnival 7 / 16

19. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Option to defer
• Decide right now whether to precommit to a project that will
cost $115 million next year.
• This produces cash flows of $170 million or $65 million, with a
probability of 0.50 each.
• The alternative is to wait until the end of the year to decide.
• Risk-free rate is 8% and the discount rate is 17.5% for the
project.
Ram Thirumalai Real Options
Agile Carnival 8 / 16

20. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Option to defer . . . 2
• NPV =
0.5 × 170 + 0.5 × 65
1 + 0.175
−
115
1.08
= −6.48 million.
• Reject the project.
Ram Thirumalai Real Options
Agile Carnival 9 / 16

21. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Option to defer . . . 2
• NPV =
0.5 × 170 + 0.5 × 65
1 + 0.175
−
115
1.08
= −6.48 million.
• Reject the project.
• Alternatively, if you wait a year, the uncertainty is resolved.
If “good” state occurs, payoff = max (170 − 115, 0) = 55.
If “bad” state occurs, payoff = max (65 − 115, 0) = 0.
You will invest only in the “good” state. This is a simple call option.
Ram Thirumalai Real Options
Agile Carnival 9 / 16

22. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Option to defer . . . 2
• NPV =
0.5 × 170 + 0.5 × 65
1 + 0.175
−
115
1.08
= −6.48 million.
• Reject the project.
• Alternatively, if you wait a year, the uncertainty is resolved.
If “good” state occurs, payoff = max (170 − 115, 0) = 55.
If “bad” state occurs, payoff = max (65 − 115, 0) = 0.
You will invest only in the “good” state. This is a simple call option.
NPV =
0.5 × 55 + 0.5 × 0
1 + 0.175
= 23.40.
Value of option to defer = 23.40 − −6.48 = 29.88 million.
Ram Thirumalai Real Options
Agile Carnival 9 / 16

23. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Option to abandon: An example
• A company is looking at a new project.
• The current investment for the project is |550 million.
• If the project succeeds, the project will generate |150 million in
annual cash flows in perpetuity.
• If the project fails, the project will generate |50 million in
annual cash flows in perpetuity.
• Success and failure are equally likely.
• The management has the option to terminate the project at
the end of the first year and sell all equipment and assets for
|400 million.
• What is the value of this option to the company?
• What type of an option is this: call or put?
• A discount rate of 20 percent is appropriate for all cash flows.
Ram Thirumalai Real Options
Agile Carnival 10 / 16

24. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Example . . . 2
• First step: what is the NPV without the option to abandon?
Ram Thirumalai Real Options
Agile Carnival 11 / 16

25. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Example . . . 2
• First step: what is the NPV without the option to abandon?
• If the project is a success,
NPV = −550 + 150/0.20 = 200 million
Ram Thirumalai Real Options
Agile Carnival 11 / 16

26. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Example . . . 2
• First step: what is the NPV without the option to abandon?
• If the project is a success,
NPV = −550 + 150/0.20 = 200 million
• If the project is a failure,
NPV = −550 + 50/0.20 = −300 million
Ram Thirumalai Real Options
Agile Carnival 11 / 16

27. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Example . . . 2
• First step: what is the NPV without the option to abandon?
• If the project is a success,
NPV = −550 + 150/0.20 = 200 million
• If the project is a failure,
NPV = −550 + 50/0.20 = −300 million
• Expected NPV = 0.5 × 200 + 0.5 × −300 = −50 million
Ram Thirumalai Real Options
Agile Carnival 11 / 16

28. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Example . . . 3
• Now assume that the abandonment option exists.
• Payoff at end of year 1 if project is a success =
max (400, 150/0.20) = 750 million
• NPV at time 0 if project is a success =
−550 + (750 + 150) / (1 + 0.20) = 200 million
Ram Thirumalai Real Options
Agile Carnival 12 / 16

29. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Example . . . 3
• Now assume that the abandonment option exists.
• Payoff at end of year 1 if project is a success =
max (400, 150/0.20) = 750 million
• NPV at time 0 if project is a success =
−550 + (750 + 150) / (1 + 0.20) = 200 million
• Payoff at end of year 1 if project is a failure =
max (400, 50/0.20) = 400 million
• NPV at time 0 if project is a failure =
−550 + (400 + 50) / (1 + 0.20) = −175 million
Ram Thirumalai Real Options
Agile Carnival 12 / 16

30. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Example . . . 3
• Now assume that the abandonment option exists.
• Payoff at end of year 1 if project is a success =
max (400, 150/0.20) = 750 million
• NPV at time 0 if project is a success =
−550 + (750 + 150) / (1 + 0.20) = 200 million
• Payoff at end of year 1 if project is a failure =
max (400, 50/0.20) = 400 million
• NPV at time 0 if project is a failure =
−550 + (400 + 50) / (1 + 0.20) = −175 million
• Expected NPV = 0.5 × 200 + 0.5 × −175 = 12.5 million
Ram Thirumalai Real Options
Agile Carnival 12 / 16

31. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Example . . . 3
• Now assume that the abandonment option exists.
• Payoff at end of year 1 if project is a success =
max (400, 150/0.20) = 750 million
• NPV at time 0 if project is a success =
−550 + (750 + 150) / (1 + 0.20) = 200 million
• Payoff at end of year 1 if project is a failure =
max (400, 50/0.20) = 400 million
• NPV at time 0 if project is a failure =
−550 + (400 + 50) / (1 + 0.20) = −175 million
• Expected NPV = 0.5 × 200 + 0.5 × −175 = 12.5 million
• Value of option = 12.5 − (−50) = 62.5 million
Ram Thirumalai Real Options
Agile Carnival 12 / 16

32. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Example . . . 4
• This is a put option because the company has the right to sell
its assets if the project is a failure.
Ram Thirumalai Real Options
Agile Carnival 13 / 16

33. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
A four-step process
• Compute base case NPV without flexibility using traditional
discounted cash flow methodology.
• Model the uncertainties using trees.
This is NOT a decision tree.
This step allows you to get a better understanding of the
uncertainties that drive the value of the project through time.
In other words, you build a tree that shows how the project value (of
base case) evolves over time.
Using a Monte Carlo simulation will help in building this tree.
Ram Thirumalai Real Options
Agile Carnival 14 / 16

34. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
A four-step process . . . 2
• Identify the managerial flexibilities and incorporate them in the
tree built in the previous step.
Now the tree is a decision tree.
• Value the real option.
Most difficult step!
Ram Thirumalai Real Options
Agile Carnival 15 / 16

35. Introduction Real Options Option to Defer Option to Abandon A Four-Step Process Wrap-Up
Wrap-up
• Real options are valuable and cannot be ignored.
• Factoring them could change the decision to accept/reject the
project.
• These options are valuable only if they help resolve uncertainty.
• These options have positive value i.e., including them in NPV
calculations will increase NPV.
Ram Thirumalai Real Options
Agile Carnival 16 / 16