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.
