The Reality of Real Options

   When any company has to make an investment, they evaluate a number of available projectseither in domestic or foreign markets. There are various techniques to to value a project but the most widely used method is Net Present Value (NPV) method. The NPV method enables thecompany to find the present value of the future outflows and inflows of cash by discounting the cash flows at the desired rate of return.

 

But NPV method also has certain drawbacks such as itdoes not quantify the qualitative aspects of a project. This could be an option to delay or defer theproject or switch from one project to another project or exit the project during the project. Also sometimes it might happen that there is a project for a period of 10 years and it looks very attractive in the initial phase but going further there is a requirement of cash outflow say at theend of year 3. This would reduce the overall NPV of the project. Where as if the NPV is calculatedfor first 3 years as phase 1 and the rest as phase 2, the NPV for phase 1 would be significantly higher than the overall NPV of the Project. Now, what if the company has an option to invest in the project today but make payment in year 3 at it’s own discretion.

 

Alternatively, there could be a project for 2 years but the company has an option to expand for another 6 years, if after 2 years it thinks it to be aviable project. These kind of options can betermed as real options in an Investment appraisal. Obviously, these options will increase theactual value of the project. And even a not so attractive looking project could yield more returns ifany of such option is attached to the project. Thus, there could be number of real options available. Mainly they are classified in these 3 categories : (i) When decision does not need to be made on now or never basis (delay the project), (ii) When decision can be change once made(switching or abandoning) and (iii) When there are opportunities to exploit in the future contingenton an initial project earlier undertaken (expanding).

 

The next step is the understand that how these options are valued. We can use the Black Scholesoption pricing method to determine the value of real options. This technique uses 5 inputs namely,spot rate (present value of future cash flows in case of real options), Exercise price (investmentvalue to exercise the option), Risk free rate of return (generally rate on govt. bonds), time (time period of the option validity) and standard deviation (the volatility of the option).Let us take a live example, say if an oil company wants to explore by erecting a rig in the northeastern part of India. Their business is exploring oil and selling it to major refineries in India suchas RIL in Jamnagar. The Oil company is aware that the crude oil prices per barrel are very low andthey might not be able to cover the cost of investment of erecting the rig and exploring by sellingthe crude oil. But the crude oil prices are going to rise after two years as there is a government restriction coming for oil imports. The NPV of the project calculated today would be lower, could be negative as well but if there is an option of delaying the investment by two years the NPV ofthe project would be higher. This will enable the oil company to make higher returns.

 

Let's look at a numeric example now for the expansion of a project.A company is considering a project with a small positive NPV of $4m but there is a possibility of expansion of the project. The further project can be undertaken in 2 years time with an initial investment of $100m and yields present value of cash flows as $150m with a standard deviationof 40%. The risk free rate is 5%.

Here the inputs for the BSOP model would be:

Pe = $100m

Pa= $150m

r= 0.05

Sd = 0.40

Time = 2years

D1 = 1.09

D2 = 0.52

N(d1) = 0.8621

N(d2) = 0.6985

 

When this is calculated the value of the call option turns out to be $66.11 m

Thus the value of the overall project along with the embedded option will become = 4m +66.11 m

= $70.11 m

This is much higher than the original project value without considering the option.

Therefore, the right value of the project would be the value of the project + value of the any option attached to the project.There are certain limitations of the BSOP model used to value options. One of the major drawbacks is that it considers only European option I.e. the option can be exercised only after acertain period of time. Like in the above example it was 2 years. But in real life there are various options available that can be exercised at any point in time, like what we call the American options.

Also there could be other limitations such as uncertain volatility, behavioural anomalies or considering a perfect and efficient market etc which might not be the case in real life. Hence the BSOP model provides and estimated value of the options in real life.

The end conclusion is that any company while appraising an investment opportunity should consider the value of any option attached to such project to find the true value of the project. Aviable decision can then be made to accept or reject the project.