11: Risk and Capital Budgetingfell to dangerously low levels. Although there were drought conditions prior to those years, rainfall has
increased in seasons since 2012. This outcome seems to remove the need for the desalination plants; but
climate change forecasts indicate longer, drier periods for Australia in coming decades, so the desalination
plants should be used more frequently as long as they are maintained in working condition.
11- 3 c THE SURPRISING LINK BETWEEN RISK AND REAL OPTION
VALUES
Until now, the approach presented for every standard valuation problem covered in this text satisfies the
following statement: holding other factors constant, an increase in an asset’s risk decreases its price. If
two bonds offer the same coupon, but investors perceive one to be riskier than the other, then the safer
bond will sell at a higher price. If two investment projects have identical cash flows, but one is riskier,
then analysts will discount the cash flows of the riskier project at a higher rate, resulting in a lower NPV.
A surprising fact is that this relationship does not hold for options. We saw this in Chapter 8. For a
brief explanation, we go back to the oil extraction problem. The extant price of oil is $75 per barrel and
extraction costs are $79. The expected future price of oil is the same as the current price, so an NPV
calculation would say that this investment is worthless.
Consider two different scenarios regarding the future price of oil. In the low-risk scenario, the price of
oil in the future will be $79 or $71, with each price equally probable. This means that the expected price
of oil is still $75. However, both an NPV and an options analysis would conclude that bidding on the rights
to this site is not a good idea because the price of oil will never be above the $79 extraction cost.
Next, think about the high-risk scenario. The price of oil may be $90 or $60 with equal probability, so
again we have an expected price of $75. If the price turns out to be $60, extracting the oil clearly does not
make sense. But if the price turns out to be $90, extracting oil generates a profit of $11 per barrel ($90
sale price –$79 extraction cost). Therefore, a real options analysis would say that bidding for the right to
extract the oil is a sensible decision.
Why does more risk lead to higher option values? Observe that in these two scenarios, the payoff
from extracting oil equals zero whether the price of oil falls to $71 or all the way to $60. At either price,
an oil producer would simply decline to incur extraction costs; thus, a huge decrease in the price of oil is
no more costly than a small decrease. On the other hand, the payoffs on the upside increase as the price
of oil rises. This all means that options are characterised by asymmetric payoffs. When the price of oil is
extremely volatile, the potential benefits if prices rise are quite large. Yet if oil prices fall precipitously, then
there is no additional cost relative to a slight decline in prices, since in either case the payoff is zero. When
describing financial option pricing theory in Chapter 8, we showed that an increase in the volatility of the
underlying price on which the option is based increases the value of the option: more opportunities can
occur with higher volatility and, due to the asymmetric payoffs in options, this greater volatility adds to the
value of the option that the investor holds. This insight applies to both call and put options.
Andy Bryant, Executive
Vice President and Chief
Administrative Officer,
Intel Corp.
‘Option theory was
always used to show why
we should do something.
I never saw an analysis
that said why we should
not do something.’
See the entire interview on
the CourseMate website.COURSEMATE
SMART VIDEO8 Give a real-world example of an expansion option and an abandonment option.9 We know that riskier companies must pay higher interest rates when they borrow money. Explain
this using the language of real options.CONCEPT REVIEW QUESTIONS 11-3