Financial Options Pricing Model to Estimate the Value of the Investment Timing Option - Assignment Example

Corporate Finance Mini case Table of Content Corporate Finance Mini case Table of Content 2 What are some types of real options? 3 What are five possible procedures for analyzing a real option? 6 Investment made in present year 8 Investment made after a year 10 Financial option pricing model to estimate the value of the investment timing option 11 Growth option 11 Reference 13 What are some types of real options? Real option is the method of valuating financial option. In corporate financing, this technique is used as the combination of put option and call option. The real option is not an obligation but a right for under taking business decision. This decision making is related to the option of making some capital investing. Compared to the other technique of capital budgeting live Net Present Value (NPV), this technique is better in term of flexibility and thus the technique is readily applied in business strategy formulation for making major decisions. But one particular difficulty lies with the Real Option Analysis (ROA) that is when real asset investments are made, certain degree of uncertainty always remains attached with the multiple factors affecting the investment. Hence such type of option is often called the Rainbow Options. If any manager has to under take an investment plan, then Real Option Analysis technique helps the manager to drill down and decompose the investment option into the component of options and risks associated with it. This gives an opportunity to identify the sources of uncertainty and the way to dissolve them. Through this analysis the manager can implement a more flexibility. There are many types of Real Options, which are as follow- Waiting-to-invest option Time-to-built-option Abandonment option Shutdown option Growth option Flexibility option Waiting-to-invest option This option remains active until the investment is actually made and as soon the investment is made or committed the option actually gets killed. For this option the decision maker should initially have few mutually exclusive options for making the decision. For making the decision it is not sufficient that Net Present value (NPV) is positive. It is important that we select the NPV maximization alternative. Before applying the Waiting-to-invest option, the initial operations are thoroughly defined before the real investment is actually made. The switching cost and the profit flow is taken into account. But ones the project is initiated and the project starts, it is not possible to return back (Kulatilaka, Naline, no d.). Time-to-built-option Waiting-to-invest is a crude form of Time-to-built option. Instead of the lump-sum investment, the projects are actually spread over the time. It can be realized that it is not possible for any project to make the investment in one go, as the time passes, investments are to be made in different slot as per the requirement. For any major project some criteria’s are common which are- 1. Investment decision and the subsequent cash flow occur at different time slot. 2. There is a maximum rate at which construction and cash outlay can occur. 3. No cash returns are generated from a project until it is not completed (Kulatilaka, Naline, no d.). Abandonment option This option provides an opportunity to disinvest the project when the NPV is negative. For example as the technology gets outdated, the company can go for disinvestment before the end of economic life of the project. This option can be interesting even the NPV goes negative, as the company can downside its exposure to the project. The worst which any company can make is the salvage value of the project, but chances are always to make health outcomes (Kulatilaka, Naline, no d.). Shutdown option Instead of abandonment the project one can temporarily shut down the project during the lean phase. But before taking this decision one should keep in mind certain things which are 1. The price of the output product 2. The cost of production and operation of the project 3. The switching cost 4. The fixed cost associated with the project when it remains shutdown (Kulatilaka, Naline, no d.). Growth option This option gives an option to expand the project which is already ongoing but have a negative NPV. Such option is always being taken into consideration when the market condition is favorable; it means that the present investment will lead to future investment opportunity. The growth option can be viable at the design stage of any projects, otherwise expansion becomes too expensive in the later stage of the project (Kulatilaka, Naline, no d.). Flexibility option A firm has basically two types of flexibility options which are Input flexibility option and output flexibility option. The input flexibility option gives the firm an option to choose between the law-cost alternative. Example is the low cost input mix. The another form of option is Output Flexibility Option through which the company can choose those output product whose price are viable as per the market condition. Hence the company can shift their production mix in response to the market condition (Kulatilaka, Naline, no d.). What are five possible procedures for analyzing a real option? The five possible procedures/methods for analyzing a real option are: Black-Scholes model Lattice models Dynamic programming Monte Carlo Simulation Decision analysis Black-Scholes model This technique is used for the managerial decision making. Through this model the decision maker estimate the parameters from Black-Scholes model and the results derived are compared with NPV analysis. This method is employed for calculating future cash flow, interest which will incur over the time if the project gets delayed. These data are discounted and decision rule is implied (Cobb, B. R. & Charnes, J. M., 2007). Lattice models Trigeorgis (1993) used binomial lattice method to find out the certain combination of multiple options that affect the project. These factors include option which can be “in money: or “out of money” and the orders of exercise of option. Depending on these factors, interaction between options can be positive or negative. Further this method was used to analyze the value of downstream investment and volatility per unit time directly from the cash flow using the rate of return (Cobb, B. R. & Charnes, J. M., 2007). Dynamic programming This method was used by Smith and McCardle (1998) for project valuation. It says that mean reversion highly decreases the value of waiting and this happens more when the lead time is high. As per this method, risk and value associated with the project are less for long term project. The method is also used to find out optimum timing for investment as per the thresh hold demand. This method says that if the uncertainty is high, like the case in duopoly market, investments are usually delayed to wait that some new up-dated technology comes into market. Such waiting makes the environment more competitive and help for further developments (Cobb, B. R. & Charnes, J. M., 2007). Monte Carlo Simulation Gamba (2002) worked further on least-squares regression simulation method developed by Longstaff-Schwartz which determines the optimal stopping time and the real options for the three combinations. The options for investment are to be examined, the compounded real options are to be valued and finally mutually exclusive options should be selected. The time for completion and the cash flows are to be taken into consideration along with the technical uncertainty (Cobb, B. R. & Charnes, J. M., 2007). Decision analysis The technique of Decision analysis is readily being used in the area of capital budgeting, in decision analysis tools and in ROV. This method allows finding out valuation of the project and optimal investment decision rule. Lander (1997) and Lander and Shenoy (1999) combined the influence diagrams, decision trees, and binomial lattice methods for valuing real options. As per the conditional probability distribution specification, a decision tree or a binomial model was developed. Using this technique, the expected value of perfect information can be maximized. The decision tree was considered more practical compared to the ROV as because it is more flexible (Cobb, B. R. & Charnes, J. M., 2007). Investment made in present year Tropical Sweets is considering a project that will cost $70 million and will generate expected cash flows of $30 million per year for 3 years. The cost of capital for this type of project is 10% and the risk-free rate is 6%. After discussions with the marketing department, they learn that there is a 30% chance of high demand, with future cash flows of $45 million per year, 40% chance of average demand, with cash flows of $30 million per year, 30% chance of low demand with cash flows only $15 million per year. Hence the expected NPV is a follow- Cash out flow- $70 million Cash inflow per year $30 million Thus the expected cash flow without taking the expected demand into consideration is Cost of investment $70 million Cost of capital 10% Risk free rate 6% Demand probability annual cash flow prob. x (CF) High 0.3 $45 $13.50 Average 0.4 $30 $12 Low 0.3 $15 $4.50 Expected Cash Flow $30 Thus the Net Present Value (NPV) is as follow: year Discounting factor Cash outflow Cash inflow Present value 10% $million $million $million 0 1 $70 ($70) 1 0.9091 $30 $27.27 2 0.8264 $30 $24.79 3 0.7513 $30 $22.54 NPV $4.60 On taking the expected demand into consideration the NPV will be cost Future Cash Flow discounted @ 10% year-0 Probability year-1 year-2 year-3 NPV Prob x NPV ($70) 0.3 $45 $45 $45 $41.90 $12.57 ($70) 0.4 $30 $30 $30 $4.61 $1.84 ($70) 0.3 $15 $15 $15 ($32.70) ($9.81) Expected NPV of Future Cash flow $4.61 Thus the expected NPV of the project, considering the expected demand (high, average and low) will be $4.61 million. Investment made after a year Now suppose this project has an investment timing option, since it can be delayed for a year. The cost will still be $70 million at the end of the year, and the cash flows for the scenarios will still last 3 years. However, Tropical Sweets will know the level of demand and will implement the project only if it adds value to the company. Thus the qualitative assessment of the investment timing option’s value will be as follow- cost Future Cash Flow discounted @ 10% year-0 Probability year-1 year-2 year-3 year-4 NPV Prob x NPV $0 0.3 ($70) $45 $45 $45.00 $35.70 $10.71 $0 0.4 ($70) $30 $30 $30.00 $1.79 $0.71 $0 0.3 $0 $0 $0 $0.00 $0.00 $0 Expected NPV of Future Cash flow $11.42 As the Tropical Sweets will know the level of demand, hence they will no investment when the demand is low. Hence if the investment is made after a year, the NPV will increase to $11.42. Financial option pricing model to estimate the value of the investment timing option For the investment timing option in the case of Tropical Sweets investment plan, the best suitable method will be a decision Tree model. Thus the decision tree will be as follow. Yes (.3) $13.5million No (.7) $31.5 Cash flow $45millio Yes (.4) $12million Investment Cash flow $30 million No (.6) $18million Cash flow $15 million Yes (.3) $4.5million No (.7) $10.5million Growth option Now suppose the cost of the project is $75 million and the project cannot be delayed. But if Tropical Sweets implements the project, then Tropical Sweets will have a growth option. It will have the opportunity to replicate the original project at the end of its life. The total expected NPV of the two projects if both are implemented is as follow. cost Future Cash Flow discounted @ 10% year-0 Probability year-1 year-2 year-3 NPV Prob *NPV ($75) 0.3 $45 $45 $45 $36.91 $11.07 ($75) 0.4 $30 $30 $30 $0.16 ($0.16) ($75) 0.3 $15 $15 $15 ($37.70) ($11.31) Expected NPV of Future Cash flow ($0.31) Hence from the above analysis it is evidence that the Net Present value of the project becomes negative, so it should not be adopted by Tropical Sweets. Reference Kulatilaka, Naline (no date), “The Value of flexibility: A General Model of real Option”, Real Options in Capital Investment, 99-104, retrieved June 19th 2009, from: http://books.google.co.in/books?id=b9kEagS1yMkC&pg=PA89&lpg=PA89&dq=Abandonment+or+Shutdown+Options&source=bl&ots=orHykSfDio&sig=4URjHG6Ar7FlEDpR5W_EmKsIN5g&hl=en&ei=Zl47StyfF5iI6wP2w92mDg&sa=X&oi=book_result&ct=result&resnum=1 Cobb, B. R. & Charnes, J. M. (2007), Real Options Valuation, Proceedings of the 2007 Winter Simulation Conference, 176-178, retrieved June 19th 2009, from: http://www.vmi.edu/WorkArea/downloadasset.aspx?id=24823 Read More