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9

Introduction

The real options valuation is a dynamic approach to valuation in terms of flexibility and growth opportunities. The real options approach is an extension of financial options theory. Options are contingent decisions that provide an opportunity to make decisions after uncertainty become relevant. Uncertainty and the firm’s ability to respond in terms of flexibility are the sources of value of an option. The investment opportunities can be considered as corporate real options, which are integral for corporate resource allocation and planning. The opportunity to invest can be considered as a call option, which involve the right to acquire an asset for a specified price (investment outlay) in a future period. The underlying asset can be embedded corporate real options to expand production scale, delay the production, or abandon a project. The values derived from the options pricing help the management to set the course for future plans to capitalize on favorable investment opportunities by expansion. Similarly, if the situation is undesirable, the investment can be abandonment. The option to delay flexibility for a firm is an important criteria for the evaluation of many investment opportunities under uncertainty. The decision to delay an investment project would be based on the assumption that new information would affect the desirability of the investment and the value of the project increases if the option to delay is exercised. If the market conditions turn out to be unfavorable, then management has the option to discontinue the project. The option to delay a project is valuable when the project have a premium over the zero NPV value. The ability of the option-pricing theory to quantify flexibility in strategic investment projects is advocated by practitioners. A number of strategic decisions can be considered as real options. Investments in computer business, valuation of an aircraft purchase option, development of commercial real estate are all examples for real options before firms. Mining companies might acquire rights to an ore mine, which could be turned profitable if the price of products increases. The development of a worn-out farmland would become a strategic option for a real-estate developer to build a shopping mall if a new highway becomes feasible in the region (Brealey et al., 2008). The acquisition of patent to market a new drug is a viable strategic option for a pharmaceutical company. The value of flexibility of an investment project is basically a collection of real options, which can be valued with the techniques estimated for financial options. Strategic investment options by pioneering firms like development of technology provide such firms with cost or timing advantage, which could lead into value creation. Valuation of a gold mine concession license to develop a mine can be considered as considered as analogous to the valuation of a simple call option. The multistage R&D Investment can be considered as a compound option. Valuation. © 2016 Elsevier Inc. All rights reserved.

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Pioneering firms that make strategic investments on a large scale in a new geographic market have first mover advantage and competitors would have to overcome entry barriers to reach out to the market. In this context, the option before the competitor firms is to delay its entry into the market or stay out to avoid market share war. In this context, the strategic project can lead to higher term profits for the pioneer firm. In high-effort R&D projects, flexibility effect is a relevant factor in option valuation. The scenario in which management has to wait to invest in business under uncertain conditions results in flexibility effect. Flexibility is an integral component of value for many investment projects and option pricing framework is a useful tool for analyzing such flexibility.

9.2

Real options as strategic investments

Strategic investments facilitate firms to invest or divest in subsequent periods of time on the basis of new opportunities. Similar to financial options, these strategic investments provide the firms different options on the future market conditions. These strategic options which are based on value of real assets called strategic real options. Unlike financial options, real options require the purchase the sale or restructuring of the real or nonfinancial assets. These investment opportunities also involve investment in intangibles like Intellectual Property Rights and Patents. Amazon has the ability to adapt rapidly to the digital business environment. Amazon is more than an Internet book seller as it delivers a broad range of products to customers. Amazon provided a wide range of IT-based business initiatives in collaboration with other firms. Amazon developed the ability to acquire strategic digital options and nurture them by capitalizing on those likely to prove successful while exercising discipline to eliminate nonprofitable ones. Lotus’s development of notes illustrates the importance of organizational architecture as a strategic initiative to capture the value of options (Kulatilaka and Venkatraman, 2001). Future growth opportunities are considered analogous to ordinary call options on securities. Derivative options give the owner the right (no obligation) to buy a security at a fixed predetermined price (exercise price) on or before the fixed date (maturity date). By way of analogy, an opportunity to undertake capital investment in productive assets like plant, equipment, or brand names at some future point in time is termed as call option on real assets or growth option. The cost of investment is the option’s exercise price. Current investment may affect future opportunities by creating growth opportunities. The value of the option is the present value of the expected cash flows plus the value of new growth opportunities. The value of growth options can be estimated as the difference between the total market capitalization of a firm and its capitalized value of its earnings, which includes estimated earnings. Growth options are more valuable for small high-growth companies that market innovative products. At the time of its Initial Public Offering (IPO), Genentech had revenues of $9 million. The IPO was priced at $35

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per share. After listing, its market capitalization value was $262 million, which was basically attributed to the value of the growth option (Kester, 1984). Myers (1987) suggests strategic investment opportunities as growth options. Dixit and Pindyck (1994) provide various expositions to the real options approach to investment.

9.3

Limitations of discounted cash flow methods

The major drawback of discounted cash flow valuation is that discounted cash flow valuation assumes that the future firm decisions are fixed at the beginning and ignores the flexibility in decision making during the course of the investment project. Moreover when there are exit options in the investment project, the choice of an appropriate discount rate for NPV calculation is a challenging task. The risk neutral valuation or certainty equivalent approach can effectively capture the flexibility embedded in real options valuation. The NPV method have major shortcomings in analyzing projects when future decisions are contingent on intermediate developments in a uncertain environment. Option theory provides a better analytical tool to evaluate such projects.

9.4

Different types of real options

Real option analysis deals with investments in real tangible assets where the sponsors have multiple options to continue or abandon the project. Basically, there are three main types of options associated with investment projects. They are the option to postpone or delay, the option to expand, and the option to abandon. Another variation of abandonment option is to temporarily suspend an investment.

9.4.1 The option to delay The option to delay becomes valuable when an investment project that has a negative NPV presently will have a positive NPV in future as the riskiness of the project and cash flow may change due to new changes in the scenario. A project with exclusive rights that have negative NPV today might still be valuable on account of the option characteristics. The option to delay can be valued using the binomial option pricing model. Generally, the Black Scholes model is applied for valuation of options to delay. Examples include patents for pharmaceutical firms. A product patent provides a firm with exclusive right to develop and market a product and can be considered as a real option. The value of the firm can be estimated as the value of commercial products plus the value of existing patents plus the value of options to obtain new patents in future minus the cost of obtaining these patents. The strategic decision to develop the undeveloped reserves of the natural resource oil and mining companies can also be considered as options. In this case, the

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variables required for estimation of value of option include available reserves of the resource, estimated cost of developing the resource, time of expiration of option, variance in value of underlying asset, and the cost of delay. By using the Black Scholes model, the value of the option to delay can be estimated as a call option.

9.4.2 Option to expand Firms can exercise options to expand for further investments or enter into a new market. Entering a large market or acquisition of a proprietary technology can be viewed as an option to expand. Options to expand are valued as call option. Consider the case of a firm with two projects—one initial project and the other the final project. The initial project may result in negative NPV, but the second project may be conditional on the initial project as it is a project for expansion. In another case, if the initial investment becomes successful, the firm can exercise the option to expand its market by entering into a new geographic market. An initial investment could serve as a platform to extend a company’s scope into related market opportunities. For example, Amazon’s huge investment to develop its customer base, brand name, and information infrastructure for its core book business created a portfolio of real option for expansion into a variety of businesses (Rappaport and Michael, 2001).

9.4.3 Abandonment option The option to abandon a project is valuable in research and development as it provides the flexibility to abandon a project in the presence of negative results. An abandonment option can be applicable in the valuation of pharmaceutical firms on account of procedures used by pharmaceutical researchers and high costs involved in the development stages. In the context of dotcom bubble, many dotcom firms exercised abandoned options. In abandonment option, firms have to bail out and recover the value of the project’s plant, equipment, or other assets. The option to abandon is equivalent to a put option. The abandonment option is exercised when the value recovered from the disposal of project’s assets is greater than the present value of continuing the project. Abandonment options can be valued with binomial method.

9.5

Solution approach to option valuation

The three main solution methods for option valuation are the dynamic programming approach, partial differential equations, and the simulation approach. The dynamic programming techniques involve finding out possible future outcomes and the value of the optimal future strategy using the risk neutral distributions. The partial differential equations (PDE) is a flexible method in which the PDE has to be solved numerically. Simulation approach to option valuation is applicable for American option. The most important tool for valuing real options valuation problems is the

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simulation approach. Simulation approach can be easily applied to multifactor models and path-dependent problems. The real options approach are applicable to natural resource investments and pharmaceutical R&D investments. Option-pricing methods were first developed to value financial options. Then it was applied to value options on real assets. Schwartz (2013) proposed a model on the Black Scholes option pricing framework which was extended by Merton (1972) and Cox and Ross (1976) to value commodity-linked bonds.

9.6

Real options in different industry sectors

Real options valuation in R&D Investment projects is mainly applicable in pharmaceutical industry. The new drug development in the pharma industry is characterized by a number of public policy issues like financing of research, cost of product development, prices charged for its products, and patent protection. There exist a trade-off between promoting innovative efforts and securing competitive market outcomes. Regulation also has important effects on the cost of innovation in the pharmaceutical industry. The average span of new drug development is between 10 and 12 years. In the United States, the average time from discovery to Food and Drug Administration approval is around 15 years. The odds of a compound making it through this process are around one in 10,000, while the cost of getting it through is around $200 million. The cost of research process is increasing significantly as many of the drugs are focusing on complex and difficult targets. There is also a high probability of failure for either technical or economic reasons. Approximately, 80% of projects that start clinical trials are later abandoned. The economic reasons comprise the high cost of production and inefficacy of the drugs. Even if the drug have been approved, there is uncertainty about the level and duration of future cash flows as the time to complete and length of the patent are also uncertain. Real options valuation is applicable in natural resources investment projects. The valuation of mining and other natural resources project have option characteristics as traditional valuation methods are difficult on account of uncertainty of output prices. The techniques of continuous-time arbitrage and stochastic control theory may be used to value natural resources investment projects and to determine optimal policies for development, management, and abandonment of such projects. In natural resources, industries price swings in the range of 2540% is commonly observed. In technological innovation-based firms, investors’ expectations are formed on the basis of timings and significance of future innovations. Firms in the technology market have the option to adopt the new innovation or wait to adopt new technologies that are evolved in the near future, which could be more valuable. Firms in the rapidly changing high-technology markets are faced with valuable innovations, which are undergoing volatile and unpredictable change. These types of changes are relevant in a number of sectors like computer and semiconductor industry.

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A firm have the option to choose a current version of innovation or wait to respond to future technological innovations. Bypassing a current innovation to wait for future innovation can result in the firm losing important learning that results from using the technological innovations (Grenadier and Weiss, 1995). Offshore oil and gas industry often faces decision problems with respect to timing option. Companies buy licenses from government to explore and develop oil fields. The exploration phase involves the estimation of the amount and quantity of oil and gas reserves within that sector. The license for exploration usually expires after a certain time. When the exploration time expires, the oil companies have three possible option strategies. The firm can abandon the project and return the field to the government. The next strategy of action could be to start and develop the reserve immediately. The third strategy would be to postpone development and thus extend the exploration phase. In order to extend the exploration phase, the company have to undertake further drilling at additional costs. The first two options can be analyzed on the basis of NPV analysis as it does not contain any real option. The third alternative provides an option to the management to postpone the investment and wait for the oil prices to increase. The deferment of investment could lead to higher NPV in the future due to increase in oil prices. If the NPV is negative initially, the firm could exercise the option to wait, which finally may result in positive NPV. Discounted cash flow analysis assumes that project starts immediately without considering future NPV. The risk of an option changes over time with changing prices. Decision tree analysis (DTA) can be used as a basic framework to determine the value of options embedded in the investment project (Kemna, 1993). When the oil company decides to postpone the investment, it is exercising the option to delay by incurring the costs of extra drilling. The oil firm buys the right to start development at the expiration date of the extended license. The benefit of exercising the option at the expiration date is the market value of the developed project. The cost is equal to the investment outlay. The option to wait is similar to a European call option on an installed project with maturity date. Consider a case in which the management have decided to abandon crude distiller in a refinery as the supply of distillates from crude oil has exceeded the demand. This case can be considered as an option to abandon and valued as a put option.

9.7

Factors affecting the value of real growth options

The NPV of an investment opportunity is estimated as the present value of the project’s cash inflow minus the present value of its outflow. The major factors that affect the value of the growth option are the length of time the project could be deferred; project risk, level of interest rates, and the exclusivity of owner’s rights to exercise the option. The option to delay a project gives the decision maker the flexibility to examine the course of future events and avoid errors if unfavorable scenarios occur. During the deferred time interval, positive turn of events can make

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the investment project more profitable. In this context it can be argued that the longer a project can be deferred, the more valuable the growth option will be. Thus the firm’s investment opportunity with negative NPV currently (out of money growth option) can delay the investment (option to delay) so that in future it becomes in the money growth option. Project risk is an important determinant of the value of a firm’s growth option. Higher the risk or variance of a growth option, higher would be the value of the option. Higher interest lowers the value of an option. Exclusivity of owner’s right to exercise the option is also an important determinant of value of a growth option. In this context, two types of growth options can be highlighted—the proprietary and the shared options. Proprietary options results from patents possessed by the firm or a firm’s unique knowledge of a market or a superior technology difficult to be imitated by competitors. Shared growth options represent collective opportunities of industry sectors, which could generate cash flow opportunities. Proprietary growth options are more valuable than shared growth options since counter investments in shared options by different firms can reduce or preempt profits. Compound growth options might become more valuable than simple growth options. A simple growth option requires the evaluation of only one cash flow from one investment opportunity while compound growth option involves estimation and valuation of cash flows from different investment opportunities like R&D investments, expansion into existing and new markets. Strategic investments, which could lead to future comparative advantage, may be investments in research to develop new technology, advertisement investments that increases brand awareness and recognition, organizational and logistic planning, which would result in lower cost in building production capacity.

9.8

Real options in mergers and acquisitions

The operating synergies acquiring from a merger can be valued as a real option (Kinnunen). The target firm’s value is equal to the value of existing assets plus the value of the future growth opportunities. The value of these synergistic future growth opportunities can be valued as real options (Collan and Kinnunen). The major sources of value for the target firm are the cash flows from economic capital, strategic capital consisting of intangibles, and human capital. The strategic capital can be valued as real options (Luehrman, 1998). The synergies are dependent on management decisions on the redeployments and additional investments. Real options in mergers and acquisitions can be valued using DTA and Black Scholes model (Kulatillaka and Perotti, 1998). The options to expand, delay, and abandon exist for an acquirer firm. An acquirer can use the option to delay to purchase additional stakes in the target firm. If the bidding for a target firm turns competitive due to simultaneous bidding by number of acquirers, acquirers have the option to abandon the bid if the proposal is not attractive. Examples of option to delay or abandon include scenarios like an acquiring firm choosing to delay a merger due to outstanding litigation or delay in regulatory approval. General Electric Honeywell deal was

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opposed by the European Union regulatory commission. When GE found the deal unattractive, it abandoned the option to acquire Honeywell UK. The due diligence of the potential target enables acquirer firms to take optimal decision regarding the option to acquire or postpone the acquisition. The time the options are available may be limited by the existence of competing bidders.

9.9

Empirical studies on real options

Black and Scholes (1973) introduced the option pricing formulae for European financial options. Myers (1977) suggests that growth opportunities can be viewed as real options whose value depends on future investment by firms. The general theory of real options have been discussed by studies of McDonald and Siegel (1986), Majd and Pindyck (1987), and Dixit (1989). Real option valuation of interrelated projects are found in studies by Trigeorgis (1993). The study by Ekern (1985) and Paddock et al. (1988) apply real-option analysis to petroleum sector. Brennan et al. (1985) discusses real option in natural resources. Benaroch and Kauffman (1999) examines real option application in information technology. Kester (1984) suggests that the difference between the total value of a firm’s equity and the capitalized value of its current earnings stream estimates the value of its growth options. McDonald et al. (1986) suggest that the option to delay investments is significant in corporate acquisition based on a rule for timing of acquisition investment with the practical intention to minimize the lost NPV of suboptimal investment financing. Smith and Triantis (1995) suggest that the success of an acquisition program is determined by the options acquired, created, or developed and the actions taken for the optimal exercise of these options. The study suggest three classes of real options important in acquisitions: growth options, flexibility options, and divestiture options. Dapena and Fidalgo (2003) analyzes embedded options in tender offers and acquisitions. The study calculates the value of control premium and presents a model for optimal acquisition timing. Smit et al. (2005) research the distribution of value gains in acquisitions with a real options game model that examines the bidding process, the likelihood of a bidding contest (war), and the expected value distribution for the acquirer. Alvarez and Stenbacka (2006) focus on the option to divest parts of the acquired company. The study suggest divestment option as an embedded sequential option.

9.10

Real option valuation using decision tree approach

The discrete-time approach to real option valuation has typically been implemented in the finance literature using a binomial lattice framework (Branda˜o et al., 2005). Real option valuation problems can be solved by using binomial decision tree to determine the cash flows and probabilities that give the correct project values when discounted to each period and to each uncertain state. Project flexibilities, or real

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options, can then be modeled easily as decisions that affect these cash flows. In the decision tree approach, binomial lattice is augmented with decision nodes to represent investment alternatives. A binomial lattice can be viewed as a probability tree with binary chance branches, with the feature that the outcome resulting from moving up u and then down d in value is the same as the outcome from moving down and then up. Thus, this probability tree is recombining, since there are numerous paths to the same outcomes, which significantly reduces the number of nodes in the lattice. The backward induction is used to determine optimal exercise strategy and associated option value. The binomial lattice model can be used to accurately approximate solutions from the BlackScholes Merton continuous-time valuation model for financial options, with the added advantage of allowing a solution for the value of early-exercise American options, whereas the BlackScholesMerton model can value only European options. DTA can be used to model managerial flexibility in discrete time by constructing a tree with decision nodes that represent decisions the manager can make to maximize the value of the project as uncertainties are resolved over the project’s life.

9.11

Real option valuation using Black Scholes model

The basic formula for valuing a call option is given by the formula: CðS; tÞ d1

d2

5 Nðd1 ÞS 2 Nðd2 ÞKe2rðT2tÞ 2 0 1 0 1 3 2 1 S σ 5 pﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃ 4in @ A 1 @r 1 AðT 2 tÞ5 K 2 σ T2t 2 0 1 0 1 3 2 1 S σ 5 pﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃ 4in @ A 1 @r 2 AðT 2 tÞ5 K 2 σ T2t pﬃﬃﬃﬃﬃﬃﬃﬃﬃﬃ 5 d1 2 σ T 2 t

N(.) is the cumulative distribution function of the standard normal distribution. T 2 t is the time to maturity. S is the spot price of the underlying asset. K is the strike price. r is the risk free rate and σ is the volatility of returns of the underlying asset.

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Black, F., Scholes, M., 1973. The pricing of options and corporate liabilities. J. Polit. Econ. 81, 637659. Branda˜o, L.E., Dyer, J.S., Hahn, W.J., 2005. Using binomial decision trees to solve real-option valuation problems. Decis. Anal. 2 (2), 6988. Brealey, R.A., Myers, S.C., Allen, F., 2008. Brealey, myers, and allen on real options. J. Appl. Corp. Finance. 20, 5871. Brennan, M., Rennan, M., Schwartz, E., 1985. Evaluating natural resource investments. J. Bus. 58 (2), 135157. Collan M., Kinnunen J. Acquisition Strategy and Real Options, ,http://www.realoptions.org/ papers2009/34.pdf. Cox, J.C., Ross, S.A., 1976. The valuation of options for alternative stochastic processes. J. Financ. Econ. 3, 145166. Dapena, J., Fidalgo, S., 2003. A Real Options Approach to Tender Offers and Acquisitions Processes, CEMA Working Papers. Universidad del CEMA, Argentina. Dixit, A., 1989. Entry and exit decisions under uncertainty. J. Polit. Econ. 97 (3), 620638. Dixit, A., Pindyck, R.S., 1994. Investment Under Uncertainty. Princeton University Press, Princeton, NJ. Ekern, S., 1985. An option pricing approach to evaluating petroleum projects. Energy Econ. 10, 9199. Grenadier, S.R., Weiss, A.M., 1995. Investment in technological innovations: an options pricing approach. J. Financ. Econ. 44, 397416. Kemna, A., 1993. Case studies on real options. Financ. Manage. 22 (3), 259270. Kester, W.C., 1984. Today’s options for tomorrow’s growth. Harv. Bus. Rev. 62 (2), 153160. Kinnunen J. Valuing M&A Synergies as (Fuzzy) Real Options, ,http://www.realoptions.org/ papers2010/238.pdf.. Kulatillaka, N., Perotti, E., 1998. Strategic growth options. Manag. Sci. 44 (8), 10211031. Kulatilaka, N., Venkatraman, N., 2001. Strategic options in the digital era. Bus. Strategy Rev. 12 (4), 715. Luehrman, T., 1998. Strategy as a portfolio of real options. Harv. Bus. Rev.8999. Majd, S., Pindyck, R., 1987. Time to build, option value, and investment decisions. J. Financ. Econ. 18 (1), 727. McDonald, R., Siegel, D., 1986. The value of waiting to invest. Q. J. Econ. 101 (4), 707727. Merton, R., 1972. An analytic derivation of the efficient portfolio frontier. J. Financ. Quant. Anal. 7 (4), 18511872. Myers, S., 1977. Determinants of corporate borrowing. J. Financ. Econ. 5, 146175. Myers, S.C., 1987. Finance theory and financial strategy. Midland Corporate Financ. J. 5, 613. Paddock, J., Siegel, D., Smith, J., 1988. Option valuation of claims on real assets: the case of offshore petroleum leases. Q. J. Econ. 103 (3), 479508. Rappaport, A., Michael, M., 2001. Expectations Investing: Reading Stock Prices for Better Returns. HBS Press, pp. 118134 (Chapter 8). Schwartz, E., 2013. The real options approach to valuation: challenges and opportunities. Lat. Am. J. Econ. 50 (2), 163177. Smit, H., van den Berg, W., de Maeseneire, W., 2005. Acquisitions as a real options bidding game. FMA Annual Meeting. Chicago, IL. Smith, K.W., Triantis, A., 1995. The value of options in strategic acquisitions. In: Trigeorgis, L. (Ed.), Real Options Capital Investment: Models, Strategies and Applications. Praeger Publishers, Westport, CT. Trigeorgis, L., 1993. The nature of option interactions and the valuation of investments with multiple real options. J. Financ. Quant. Anal. 28 (1), 120.