# Presentation: 565980

## Are Real Options Real? 

**Are Real Options Real? **

**Steve Hoye  CFA, MBA**Senior Risk Consultant, Hyperion – Crystal Ball
- shoye@crystalball.com

- CBUC

**Notes:**
This Title Slide uses art targeted for the CFO.

## What We Will Discuss:

- What Is a Real Option?
- As Opposed to ‘Unreal’ Options?
- What Are the Issues with Real Options in Corporate Valuations and Strategy?
- A High-Level Approach to Real Options
- Keeping it Simple
- Examples of Real Options

- Copyright © 2007, Hyperion. All rights reserved.

**Notes:**
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## What Are Real Options? 

**What Are Real Options? **

- CBUC

**Notes:**
This Title Slide uses art targeted for the CFO.

## Slide 4

- Copyright © 2007, Hyperion. All rights reserved.

## This Project Should Return NPV of $91 M

**This Project Should Return NPV of $91 M**

- Copyright © 2007, Hyperion. All rights reserved.

## “We Could Sell the Land Under This Project for $75 M Anytime. . .”

**Chief Financial Officer**
**Your Company**

- Copyright © 2007, Hyperion. All rights reserved.

## What Are the Implications for the Cash Flows?

**What Are the Implications for the Cash Flows?**

- Copyright © 2007, Hyperion. All rights reserved.

## The Implications of Management’s Option to Change the Cash Flows Are:

- Management Acknowledges Uncertainty About the Fixed Free Cash Flow Forecast in the Future
- There is volatility In
- Markets
- Revenues
- Macroeconomic Conditions
- Growth
- Competition
- Our Discounted Cash Flow Model is Naïve
- It doesn’t account for tweaking that management can do as uncertainty about future conditions becomes resolved over time
- The $91 M NPV We Promised Assumes Do-Nothing Project Management
- The true project NPV could be larger!

- Copyright © 2007, Hyperion. All rights reserved.

**Notes:**
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## Real Options are the Application of Financial Option Valuation Techniques to Business Assets

- Management’s Flexibility to Sell the Assets from this Project at a Known Price Over a Given Period of Time
-                                   Is Very Similar To:
- A Financial ‘Put’ Option, Which Gives the Owner the Right to Sell a Security at a Known Price Over a Given Period of Time

- Copyright © 2007, Hyperion. All rights reserved.

**Notes:**
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## Real Options Can Add Value to Projects If:

- There is Volatility in the Future Value of an Asset
- Management Has the Opportunity to Change the Cash Flows of an Asset
- Strategic flexibility
- Management is Willing and Able to Exercise its Strategic Flexibility When Doing So Will Increase the Value of the Project
- Under These Circumstances, Real Options Will:
- At worst, not change the value of the project
- At best, significantly increase the value of the project

- Copyright © 2007, Hyperion. All rights reserved.

**Notes:**
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## What Are the Issues with Real Option Valuation? 

**What Are the Issues with Real Option Valuation? **

- CBUC

**Notes:**
This Title Slide uses art targeted for the CFO.

## “How Do We Value This Option?”

**Chief Executive Officer**
**Your Company**

- Copyright © 2007, Hyperion. All rights reserved.

## “Well, first we assume that the future volatility of this asset’s value can be described with this equation. . .”

**Financial Analyst**
**Your Company**

- Copyright © 2007, Hyperion. All rights reserved.

## “. . .its called Geometric Brownian Motion.”

**Financial Analyst**
**Your Company**

- Copyright © 2007, Hyperion. All rights reserved.

## . . .Given that assumption, we plug the correct numbers into this equation. . .”

**Financial Analyst**
**Your Company**

- Copyright © 2007, Hyperion. All rights reserved.

## “. . .which won several brilliant people the Nobel Prize. . .”

**Financial Analyst**
**Your Company**

- Copyright © 2007, Hyperion. All rights reserved.

## “. . .I could have these numbers crunched in time for your presentation to the Board of Directors on Friday. . .”

**Financial Analyst**
**Your Company**

- Copyright © 2007, Hyperion. All rights reserved.

## Somehow We Must Frame This Process in High Level Terms

- Transform the Valuation of Strategic Flexibility
- 			from a
- Theoretical, Technical Finance Exercise
- 			To a
- Practical, Understandable Process
- If We Don’t, the Cost is High:
- Undervalue assets
- Poor capital allocation
- Underperformance of capital project portfolios

- Copyright © 2007, Hyperion. All rights reserved.

**Notes:**
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## A High-Level Approach to Real Options3 Tenets 

**A High-Level Approach to ****Real Options****3 Tenets **

- CBUC

**Notes:**
This Title Slide uses art targeted for the CFO.

## Tenet 1: Knowing the Value of an Asset Today, Uncertainty in its Future Value Increases with Time

- The Current Value of the Asset Comes from DCF Analysis
- All systematic or trending variables are accounted for in NPV today
- Future uncertainty in the value of the asset is by definition random

- Time

- Today

- Asset Value

- 5 years later

- Copyright © 2007, Hyperion. All rights reserved.

**Notes:**
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## Tenet 2: We Can Simulate the Future Value of the Asset with a Tree that has Simple Up or Down branches

- The More Levels of Branches in the Tree, the More Precisely we Approximate Any Possible Future Change in the Value of our Asset

- Time

- Today

- Asset Value

- In 5 years

- Value Went Up

- Value Went Down

- Copyright © 2007, Hyperion. All rights reserved.

**Notes:**
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## Tenet 2: We Can Simulate the Future Value of the Asset with a Tree with Simple Up or Down branches

- The More Levels of Branches in the Tree, the More Precisely we Approximate Any Possible Future Change in the Value of our Asset

- Time

- Today

- Asset Value

- In 5 years

- A Possible Path for Future Value of Asset Over Time

- Copyright © 2007, Hyperion. All rights reserved.

**Notes:**
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## Tenet 2: We Can Simulate the Future Value of the Asset with a Tree with Simple Up or Down branches

- The More Levels of Branches in the Tree, the More Precisely we Approximate Any Possible Future Change in the Value of our Asset

- Time

- Today

- Asset Value

- In 5 years

- Another Possible Path for Future Value of Asset Over Time

- Copyright © 2007, Hyperion. All rights reserved.

**Notes:**
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## Tenet 3: Use the Tree as a Decision Tree, Assuming Management Maximizes Value of Project at Every Node 

- The Value of the Decision Tree Today is the Expected NPV of Many Future Possible Changes of the Asset Value Over Time

- Time

- Today

- Asset Value

- In 5 years

-  Probability Value Went Up

- Probability Value Went Down

-  Value if Down

- Value if Up

- Value Now

- Copyright © 2007, Hyperion. All rights reserved.

**Notes:**
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## That’s It!   We Simulate Future Uncertainty of the Asset’s Future Value with Up and Down Steps, Then Evaluate the Resulting Up/Down Step Decision Tree for the Expected Value of Asset At Every Point in Time for Every Future Possible Change in Value

- Copyright © 2007, Hyperion. All rights reserved.

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## Some Examples of Real Options

- Abandonment Option
- Expansion Option
- Contraction Option
- Combination Options

- Copyright © 2007, Hyperion. All rights reserved.

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## Let’s Use a Toolkit with our 3 Tenets to Value our Abandonment Option:

- 5 Year Project
- NPV from Discounted Cash Flow Analysis of $91 M
- At Any Time, Management Can Halt The Project and Sell Off Its Assets for $75 M
- How Does This Flexibility Change the $91 M NPV?

- Copyright © 2007, Hyperion. All rights reserved.

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## This $91 M Project is worth $97 M with Abandonment Option

**This $91 M Project is worth $97 M with Abandonment Option**

- Copyright © 2007, Hyperion. All rights reserved.

## What If Management Had Excess Capacity to Produce?

- 5 Year Project
- NPV from Discounted Cash Flow Analysis of $91 M
- At Any Time, Management Can Increase Production by 50%, by Spending $50 M
- How Does This Flexibility Change the $91 M NPV?

- Copyright © 2007, Hyperion. All rights reserved.

**Notes:**
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## This $91 M Project is worth $102 M with Expansion Option

**This $91 M Project is worth $102 M with Expansion Option**

- Copyright © 2007, Hyperion. All rights reserved.

## What If Management Had Both Options?

- 5 Year Project
- NPV from Discounted Cash Flow Analysis of $91 M
- At Any Time, Management Can Increase Production by 50%, by Spending $50 M
- At Any Time, Management Can Sell-Off the Project for $74 M
- How Does This Flexibility Change the $91 M NPV?

- Copyright © 2007, Hyperion. All rights reserved.

**Notes:**
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## Both Options Increase Project NPV by $14 M

**Both Options Increase Project NPV by $14 M**

- Copyright © 2007, Hyperion. All rights reserved.

## Option to Wait:

- 5 Year Project
- Initial Investments of $25 M Produces Cash Flows with PV of $30 M
- NPV of $30-$25 = $5 M

- Copyright © 2007, Hyperion. All rights reserved.

**Notes:**
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## What If Management Could Phase The $25 M Capital Costs?

- 5 Year Project
- $5 M Up Front Investment (Phase I)
- Remaining $20 M to Proceed to Phase II after 3 Years

- 3 Yrs

- 10=30-20

- Copyright © 2007, Hyperion. All rights reserved.

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## Value of Phase II Project Before $20 M Investment

**Value of Phase II Project Before $20 M Investment**

- Copyright © 2007, Hyperion. All rights reserved.

## Phase I Valuation is Nothing More Than Purchasing an Option to Proceed to Phase II for $20 M! 

**Phase I Valuation is Nothing More Than Purchasing an Option to Proceed to Phase II for $20 M! **

- Copyright © 2007, Hyperion. All rights reserved.

## This Option to Wait Increases the Value of this $5 M Project by 60% !  

**This Option to Wait Increases the Value of this $5 M Project by 60% !  **

- Copyright © 2007, Hyperion. All rights reserved.

## Conclusions

- DCF Analysis Often Doesn’t Account for Management’s Options to Change Cash Flows Based On Conditions At the Time
- Real Options Analysis is Often Presented with Unnecessary Complexity
- An Impediment to Adoption
- Keep It Simple
- 3 Tenets

- Copyright © 2007, Hyperion. All rights reserved.

**Notes:**
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## Are Real Options Real? 

**Are Real Options Real? **

**Q & A**

- CBUC

**Notes:**
This Title Slide uses art targeted for the CFO.

## Slide 40

- Copyright © 2007, Hyperion. All rights reserved.

**Notes:**
Slide 14:  Closing Hyperion Logo Slide
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