0:00

Okay then, so far we've identified how traditional NPV analysis might

lead to incorrect investment decision when it fails to account for the impact of

flexibility on the wealth effects of a particular investment proposal.

We then spent some time defining and

describing three of the most common types of real options found in practice,

options to invest or defer, options to expand and options to abandon operations.

It seems reasonable now to start thinking about how we might actually attempt to

ascribe some value to having the right, but not the obligation, to proceed with

a particular course of action in response to changing economic circumstances.

So how might we value an option?

0:44

Well, when we're dealing with financial options, that is, options written on

financial assets such as shares, we have some fairly decent models in place.

Indeed, the Black-Scholes-Merton Option Pricing Model,

as detailed in these equations, yielded the Nobel Prize in economics to the two

surviving researchers, Robert Merton and Myron Scholes.

There are a number of challenges we face in trying to apply these financial option

pricing models to settings that involve standalone projects,

as is applied by the option to invest, to expand, or to abandon.

1:18

Firstly, the Black-Scholes-Merton Option Pricing Model is a model for

the valuation of a European-style option, that is,

an option that can only be exercised at expiry.

1:40

Well, that's fine.

As a discipline, we've developed a range of what we

refer to as numerical techniques, such as binomial lattices,

that can help us deal with things like the ability to exercise an option early.

2:08

So where does that leave us?

Well, the short story is that it would be really helpful to have an easier way to

try to come up with the value implied by a real option, even if the approach itself

provides only an approximation of the real option's value.

2:36

Let's demonstrate how decision trees work in practice.

We assume that you are trying to decide whether to

invest $200,000 up front in a new retail outlet with a life of five years.

There's a 50% chance that the outlet will experience high demand in the first year,

in which case it would remain high for the remaining four years.

Each year, it would generate $150,000 per annum.

If demand is low in the first year, then it will remain low for

the remaining four years, generating only $50,000 each year.

So where is the option?

Well, the firm has the ability,

at the end of the first year, to expand operations in response to high demand.

Doing so will cost the firm $50,000 up front but

will increase subsequent annual cash flows to $170,000 per annum.

Let's assume a discount rate of 10% per annum, and further assume, for

the sake of the example, that all cash flows occur at year end.

Let's have a look at that decision tree.

So here is the decision tree.

The key with decision tree analysis is that before we can assess

the decisions that we face soonest, we must first reconcile the decisions that we

would make in the future depending upon the circumstances we find ourselves in.

3:58

And then,

having made that decision, we can go on to assess whether we should invest at all.

So let's do that.

Would we spend the $50,000 at the end of the first year to generate

an additional $20,000 in net cash flows per annum for the remaining four years?

4:15

The NPV of expanding at the end of the first year, indicated by NPV subscript 1,

assuming that demand is high, is $488,877.

If we don't expand in the face of high demand at the end of the first year,

then we save ourself the $50,000 in expansionary cost.

But the flip side is that our revenue stream is $20,000 less for

each of the remaining four years.

Hence, we know that if demand is high in the first year,

then we will choose to expand operations.

4:56

Furthermore, we now know the present value of the expansionary arm

of the decision tree is $488,877, but

it's important to recognize that this is a valuation in one year's time.

Having resolved the most distant decision first,

we can now roll back through the decision tree, assessing the next most distant

decision, which in this case is the decision about whether we invest at all.

So here we are.

The wealth associated with investing in this retail outlet is

calculated as follows.

Firstly, we account for the initial investment of $200,000.

Next we consider the low-demand arm of the tree.

That's where there's a 50% chance of there being low demand in the first year,

in which case low demand will continue.

Across each of these five years,

we generate net cash flows of only $50,000 per year.

So this first expression gives us the present value of that cash flow stream.

5:52

Now switching our attention to the high demand state of the world, where we know

we will expand if demand is high enough in the first year, we account firstly for

the fact that there's a 50% chance of finding ourselves in that high demand

state, which, you will recall, generates $150,000 at the end of the first year,

followed, after we expand, by $170,000 in each of the remaining four years.

6:17

Fortunately, we've already calculated the present value of the remaining

four payments as $488,877.

So working our way through all this now, we end up with

an overall NPV of the project of $185,169.

Therefore, given the alternative decision,

which in this case would be to not invest at all, and therefore,

generate an NPV value of 0, our final decision is to invest in the project.

7:32

As you can see, the calculations will be relatively straightforward.

And here we go.

The net present value of the project without the option to

expand is equal to $179,079.

We now simply compare this number with the value of

the project with the embedded option.

And lo and behold, the approximation of the value today of the option to expand

operations in the case of high demand in the first year is equal to $6,090.

Now why do I keep using the term approximation here?

Well, unlike formal option pricing models, which provide very precise values for

option, although they're based on a set of sometimes very restrictive assumptions,

decision trees are a little bit more haphazard in that they only provide for

a set of discrete outcomes.

Compare the two figures at the bottom of this slide.

The left-hand side figure relates to the changing value of an option

as the present value of the cash flows from exercise of the option

increase continuously as we move from left to right of the figure.

8:42

If it was not optimal to invest, that is,

to exercise the option, in either of those states of the world,

the decision tree approach would suggest that the option has zero value.

Whereas we know that even where options are deep, deep out of the money,

provided there's some remaining term to expiry and

some volatility, the option will still have a value.

In summary, we've considered in this session together how to

use decision trees to evaluate projects that may involve

a sequence of decisions that are made over the life of the project.

And truth be told, that's one of the real advantages of decision tree analysis.

It gets management thinking strategically about

optimal decisions to be faced in the future.