[MUSIC] In this module, we'll discuss in detail one approach to valuation of real options, namely decision trees. Valuation of options on financial assets, is well developed and typically, one of two approaches is used. These two approaches are referred to as the binomial model and the Black-Scholes formula. The use of these two approaches for evaluation of real assets is somewhat complex and difficult to understand. Moreover, these two approaches require the estimation of the standard deviation sigma, of continuously compounded annualized return from the project. On the other hand, a decision tree approach to value real options is easy to understand, although this approach requires the estimation of several probabilities, as we will see next. Let's consider a simple example motivated by the case Cypress Telecommunications Authority that we talked about in the previous module. When an organization is considering upgrading its information system, the amount of investment required now has been estimated to be said 225 in thousands of the unit of currency. It's not clear how well this upgradation will be used. If the upgradation is a success, it's estimated that the incremental cash flow during the first year, attributable to this expansion of the information system, will be 80 in thousands. The probability of success estimated as 0.55. Note that although the incremental cash flows occur during the year, we assume, for simplicity, that all the cash flows occur at the end of year one. Alternatively, the amount 80 should be interpreted as the future that is at the end of year one. Value of incremented cash flows occurring during year one. Moreover, the upgradation is successful at the end of year one, or equivalently, the beginning of year two, some uncertainty in the subsequent incremental cash flows attributable to this upgradation is resolved, but not completely. In this case, it is estimated that the sum of the incremental cash flows from year two onwards till the life of the project, when the entire information system will be changed completely. Discounted to the end of year two is expected to be 300 with a probability 0.6 or 150 with probability 0.4. This uncertainty whether it will 300 or 150 is not resolved at the beginning of year two. On the other hand, if the upgradation of the information system is not a success, then incremental cash flows attributable to this upgradation during the first year will be only ten in thousands with probability 1- 0.55 = 0.45. In this situation, it is estimated that the sum of the incremental cash flows from year two onwards till the life of the project, discounted to the end of year two would be 200 with probability of 0.6 or 100 with probability 0.4. Again, this uncertainty whether it will be 200 or 100 is not resolved the beginning of year 2. The yearly discount rate for this project is assumed to be 10%. The first project is to upgrade the information system now. The data are represented in a diagram as shown. This diagram is an effort as to the tree. Using the data represented in the tree, the decision problem is whether to accept the project or not. A typical approach to solving this decision problem is to use the Net Present Value Rule, which states that, accept the project if NPV is greater than zero. Otherwise, reject the project. We'll illustrate the application of NPV for this problem. We'll start at the end node. In this example, we have two end nodes, namely denoted as 1a and 1b. We must consider each end node in turn, and work backwards still we reach the starting node denoted as b. The calculations are done as follows. At node 1a, the value of the expected incremental future cash flows of 300 and 150 are multiplied by the respective probabilities of 0.6 and 0.4, and added to arrive at the total. This total expected incremental cash flows is discounted to the end of the year one and added to the cash flows of the end of the year one, as shown in the next diagram. Similar calculations are done for node 1b in the same diagram. Thus, at node 1a and node 1b, we have the expected incremental cash flows as 298.18 and 155.45, respectively. Now, working backwards to node b, we first multiply the values 298.18 and 155.45 calculated for nodes 1a and 1b by the respective probabilities of 0.55 and 0.45 and add it to get the total. This total is discounted to get the present value that is at node B, and subtract the investment cost of 225 to get the NPV. This gives an NPV of -12.32, as shown in the diagram. So the project upgrade information system is not worth undertaking by itself. Now, as in the case of Cyprus Telecommunication Authority, suppose upgrading the information system is necessary for the organization to be able to expand its operations one year from now. So, we will next consider the project to upgrade the information system and expand operations. As shown in the diagram, if upgrading the information system is successful, the expected incremental cash flows of the end of the first year would be 80 as before. But with the expansion of operations, the sum of the incremental cash flows from year 2 onwards till the life of the project, discounted to the end of year 2 is expected to be 500 with probability of 0.6 or 250 with probability 0.4. As before, this uncertainty of whether it'll be 500 or 250 is not resolved at the beginning of year two. On the other hand, if the upgradation for the information system is not a success, the incremental cash flows attributable to its upgradation during the first year will be only ten and thousands with probability 1- 0.55 equal to 0.45 as before. In this situation, it is estimated that the sum of the incremental cash flows from the year two onwards till the life of the project, discounted to the end of year two, would be 210 with probability 0.6 or 105 with probability 0.4. Again, this uncertainty of whether it will be 210 and 105 is not resolved at the beginning of year two. The investment calls for an expansion of operations at the end of year 1 is 75. The yearly discount rate for this combined project of upgradation followed by expansions of evaluations one year later is assumed to be 10% as before. This data as shown in the diagram below. Project 2 is the composite project, upgrade the information system now and expand operations one year from now. We again start at the end node. In this example also, we have two end nodes, namely nodes denoted as 1b and 1d. We must consider each end node in turn. Work backwards till we reach the starting node denoted as b. The calculations are done as follows. At node 1b, the value of the expected incremental future cash flows are 500 and 250, multiplied by the respective probabilities of 0.6 and 0.4, and added to get the total. This total is discounted to the end of year one, and the investment cost of expansion is deducted to obtain the net incremental cash flow attributable to expense and of operations. We then add the incremental cash flow of 80 during the first year to the value calculated for node 1b to get the value of 368.64 for node 1a. This calculation for node 1a shown in the next diagram. Similar calculations are done for 1b and node 1c in the next diagram. Thus, at node 1a and 1c we have the expected incremental cash flows as 368.14 and 87.73, respectively. Now working backwards to node b, we first multiply the values 368.84 and 87.73, calculated for nodes 1a and 1c by the respective probabilities of 0.5 and 0.45, and then add them to get the total. This total is discounted as the present value, that is to node b, and we subtract the investment cost of 225 to get the net present value of -4.79 as shown on the diagram. So the composite project of upgrade information system and expand operations is also not worth undertaking. A little reflection about the composite project will suggest that the follow-on project of expanding the operations need not necessarily be undertaken at the end of the first year. Although at current time, we may anticipate the upgradation of the information system would be a success. And the follow-on project expansion of operations would be undertaken at the end of the first year. There is no need to decide now, that is, at the current time, to undertake the follow-on project of expansion of operations at the end of the first year. It should be kept in mind that the organization has the option to expand operations at the end of the first year, but not the obligation to do so. The decision to expand operation or not may be made at the end of the first year, when uncertainty pertaining to the success of the project, upgrade the information system would be resolved. For the sake of completions, we look at the possibility of expansion or no expansion of operations at the end of the first year for both outcomes of the success our failure of the first project, which is upgrade the information system. The different possibilities are shown in the diagram below. Project 3, upgrade the information system now with an option to expand operations at the end of the first year. Now at nodes 1a and 1d, we must decide whether to expand operations or not. Let us first consider node 1a. If we decide to expand, the expected value of incremental cash flows, net of the investment cost of operation, as calculated before, is equal to 500 times 0.6 plus 250 times 0.4. That sum divided by 1.1, and to which we add -75 + 80 to get 368.64. On the other hand, if at node 1A, we decide not to expand operations, the expected value of incremental cash flows is 300 times 0.6 plus 150 times 0.4 then the sum divided by 1.1 plus 80 equals 298.18. So the decision at node 1a is to expand the operations, and we have the expected incremental cash flow as 368.64. Next we consider node 1b to decide whether we should expand operations or not at that node. If we decide to expand, the expected value of incremental cash flows, net of the investment cost of expansion, as calculated before is 210 into 0.6 plus 105 into 0.4, the sum divided by 1.1, And to which we add -75 + 10 = 87.73. On the other hand, if at node 1d we decide not to expand operations, the expected value of incremental cash flows is 200 times 0.6 + 100 times 0.4, the sum divided by 1.1 + 10 = 155.45. So the decision at 1d is not to expand operations. And we have the expected incremental cash flows as 155.45. It does have the following diagram. Finally, we backtrack to node b, with the values at nodes 1a and 1d as calculated above. Now the expected net incremental cash flow at node b is 368.64 multiplied by 0.55 plus 155.45 multiplied by 0.45. And the sum is divided by 1.1, and we subtract the investment cost of -225, and get a net present value of 22.91. So, we accept the project. Note that the NPV of project 3 equals NPV of project 1 plus value of the option to expand at the end of year 1. So the value for the option is NPV of project 3 minus NPV of project 1. Which is equal to 22.91 minus -12.32, which is equal to 35.23. This concludes the module on valuation of real options, decision trees. [MUSIC]
