4.4 Empirical evidence and final points (Does anyone exercise their option to use real options?)

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En provenance du cours de The University of Melbourne

Alternative Approaches to Valuation and Investment

184 notes

The University of Melbourne

Alternative Approaches to Valuation and Investment

184 notes

Cours 4 sur 5 dans Specialization Essentials of Corporate Finance

In this course, participants will develop an understanding of the intuitive foundations of asset and investment valuation, and how alternative valuation techniques may be used in practice. This is part of a Specialization in corporate finance created in partnership between the University of Melbourne and Bank of New York Mellon (BNY Mellon). View the MOOC promotional video here: http://tinyurl.com/h75pzt6

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Addressing financial reality with real options analysis

This week we describe how standard NPV analysis might lead to incorrect decisions when we fail to account for the impact of (or upon) firm flexibility. We then describe the three most common types of real options that firms face in practice and then explain how decision trees might be used to arrive at an approximation of the value of the real option that is embedded within a project. We conclude by considering empirical evidence on the take-up of real options analysis and discuss the situations in which real options analysis might most be needed.

4.0 Introduction (One with all the options...)2:02

4.1 The Problem with NPV (It always works… except when it doesn’t…)6:37

4.2 Examples of Real Options in Practice (Is that an option in your project?)11:56

4.3 Approximation of Real Option Values Using Decision Trees (Options do grow on trees!)9:51

4.4 Empirical evidence and final points (Does anyone exercise their option to use real options?)8:57

Rencontrer les enseignants

Paul Kofman
Dean, Faculty of Business and Economics
Sidney Myer Chair of Commerce
Sean Pinder
Associate Professor
Faculty of Business and Economics

In this final session of the module, let's consider the evidence an exactly

how widespread the utilization of real options analysis is in practice.

So we turn first to anecdotal evidence of the decisions that companies have commonly

been observed making but are consistent with the real options type behavior.

So some examples of such behavior include the fact that companies don't

immediately abandon operations as soon as they turn negative MPV.

For example, exporters remain in markets

even when the domestic currency appreciates significantly.

Airlines maintain routes that have suddenly turned unprofitable.

The real options rationale for doing so is that they understand that a put option to

abandon operations is not merely exercised as soon as it is in the money

because to do so would give up the opportunity to benefit

from the project if conditions change back to something more favorable.

Similarly, companies looking to expand into new markets will often

investing small beat head operations that look to be negative NPV.

But if you think about it,

that can be readily explained by the valuable expansionary options that such

an initial footprint provides the firm with access too.

Well there's some anecdotal evidence.

What about something a little bit more firm?

Well you may recall from the previous module that there's some

fairly compelling evidence to suggest that firms use discount rates that are far

in excess of their weighted average cost of capital, their WACC.

One interpretation of this evidence is that managers are building in via a higher

discount rate, compensation for the flexibility that they're giving up

when they decide to exercise a real option to invest.

Now this is entirely consistent with real options analysis.

Sigh.

Wouldn't you think that if I were to survey managers and ask them,

how often do you use real options analysis when evaluating a new project,

that the number of affirmative responses would be very high.

Well, let's have a look.

As you can see here, the proportion of surveyed managers, both in Australia,

and the US.

Who always or almost always use real options analysis, it's only about 25%.

When asked in another survey, why don't you use real options analysis,

the key reasons were that there was a lack of top management support for

the technique and further the discounted cash flow techniques

were a proven method of project evaluation.

What this does is highlight perhaps a suspicion by senior management

that projects that don't stack up under standard MPV scrutiny

probably shouldn't be pushed through on the grounds of strategic reasons,

as might be suggested by some haphazard real options analysis.

Okay, so

we can see that it's not a technique that is used all the time by all companies.

Perhaps it might be useful to consider the particular circumstances

where real options analysis provides the most benefit to us.

In this figure, which we've see many times before, the distance between the curve to

green line and the straight red line reflects the additional value associated

with having the right but not the obligation to undertake an activity.

Such as expand operations.

Now what you can see from this diagram is that when the option is deep in the money,

that is where the project has a very high positive NPV.

Having flexibility in your choice to proceed or not doesn't add much value.

Because you know with near certainty that you're going to proceed with the project.

Similarly, when the option is deep out of the money,

that is whether project has a very high negative NPV,

having the flexibility to change your mind doesn't create much value.

As you know that in all likelihood, you want to proceed with the project.

It's the middle range where flexibility has its growth its value.

Intuitively that makes sense, right?

When I'm most unsure about whether to proceed or

not that's the circumstance where I most highly value flexibility.

And that's where the NPV is in the region from just below to just above zero.

We can also break this analysis down a little further

by considering the interaction between flexibility and uncertainty.

So what we have here is a two by two matrix.

As we move from left to right the likelihood of receiving new information

increases.

That is uncertainty increases as we move from left to right.

Further, as we move from the bottom to the top,

our ability to respond to information increases.

That is our flexibility increases.

Okay, let's start at the bottom left cell, labeled number three.

Here there's very low uncertainty and also a low flexibility.

So in this region, standard MPV analysis is going to be fine.

Real option analysis doesn't provide much benefit at all.

Moving up to the top number, the top left cell labeled number one.

We have now the ability to respond to new information but

there's a low level of likelihood that new information will arrive.

That is there's very low uncertainty.

Once again, real options analysis is not going to provide much insight

here as were I'm likely to change our course of action and

circumstances are unlikely to change in a low risk environment.

Shifting to the bottom, right cell now, cell four, we find that while we're in

a high risk environment with a high chance of receiving new information, we now lack

the flexibility in our operations to respond to that new information.

So, we're once again stuck with standard MPV analysis.

Where does real options analysis really matter?

You guessed it.

Way up on the right hand top cell.

Cell number two.

Here's where we are facing a high risk environment and

we have the flexibility to respond to changes in market conditions.

This is where you get the biggest bang for your buck with real options analysis.

So thinking about it, as a side, perhaps the 25 percent or so

of managers that use real options analysis according to the earlier survey,

maybe those managers are those are ones who find themselves in the top right cell

with the other managers spread out amongst the other three.

Who knows.

In summary, in this session we have considered a range of anecdotal and

empirical evidence on the usage of real options analysis in practice by financial

managers.

We've also considered the circumstances where real options analysis might provide

the most benefit over an above standard discount cash flow techniques.

Highlighting that this might be the case where projects attach and

go and it's where the MVB's close to zero.

And also cases where the risk of a project is high as is managers ability to

change the way that operation is conducted as that risk is resolved,

whether they have high flexibility.

So we began this module by surveying the initial problem that we face

when using standard NPV analysis to assist projects that provide managers,

the ability to respond to new information.

We then describe the characteristics of the three main types of real options,

options to invest, expansion re-options and abandonment options.

We discussed how decision trees might be used to arrive at a approximation of

the value of a real option.

And have concluded with the discussion of empirical evidence and

warnings about when real options analysis might be most important.

And that concludes the final module of the course alternative approaches to valuation

and investment.

A course where we began by defining measures of and

alternative attitudes towards risk.

We then shifted to linking compensatable risk with an expected return.

Using tools such as the capitalized pricing model.

This then lead to a discussion of how we might use a firm's own financial

information to arrive at an estimate of its cost of capital.

Specifically its weighted average cost of capital and

then finally we got right into real options analysis.

So what's next?

Well for those of you enrolled in the signature track of the four course

specialization, Essentials of Corporate Financial Analysis and Decision Making.

The final stage is the capstone project where, across four weeks,

you'll be challenged to apply the skills that you've learned across these four

courses to assess a specially selected large list of companies financial and

competitive position in the role of the financial analyst.

You'll also be required to critically assess key corporate finance

decisions made by the selected firm as well as review the firm's suitability for

inclusion as part of a broader investment portfolio.

This capstone project has been developed in partnership with our colleagues at

BNY Mellon, and we have no doubt that it will act to cement the lessons learned

over the last 16 weeks of instruction.

All the best from all of us here at the University of Melbourne.

Cheers.

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