CP

Valuing Real Options

How can we estimate the value of a real option? To begin answering this question,

consider a simple project consisting of a single risk-free cash flow due one year from

today. The pure DCF value of this project is found as follows:

The only required inputs are the cash flow, which is known, and the risk-free rate,

which can be estimated as the rate on a 52-week Treasury bill. Given these inputs, we

can calculate an accurate estimate of the project’s DCF value.

In contrast, valuing a real option requires a great deal of judgment, both to formu-

late the model and to estimate the inputs. This means the “answer” will not be nearly

as precise for a real option as for the simple one-period project described above. But

does this mean the answer won’t be useful? Definitely not. For example, the models

used by NASA only approximate the centers of gravity for the moon, the earth, and

other heavenly bodies, yet even with these “errors” in their models, NASA was able

to put a man on the moon. As one professor said, “All models are wrong, but some are

still quite useful.” This is especially true for real options. We might not be able to find

the exact value of a real option, but the value we find can be helpful in deciding whether

or not to accept the project. Equally as important, the process of looking for and

then valuing real options often identifies critical issues that might otherwise go unno-

ticed.

Five possible procedures can be used to deal with real options. Starting with the

simplest, these are as follows:

1. Use discounted cash flow (DCF) valuation and ignore any real options by assuming
   their values are zero.


2. Use DCF valuation and include a qualitative recognition of any real option’s value.


3. Use decision tree analysis.


4. Use a standard model for a financial option.


5. Develop a unique, project-specific model using financial engineering techniques.

The following sections illustrate these procedures.

List the five possible procedures for dealing with real options.

The Investment Timing Option: An Illustration

Murphy Systems is considering a project for a new type of hand-held device that pro-

vides wireless Internet connections. The cost of the project is $50 million, but the fu-

ture cash flows depend on the demand for wireless Internet connections, which is un-

certain. Murphy believes there is a 25 percent chance that demand for the new device

will be very high, in which case the project will generate cash flows of $33 million

each year for three years. There is a 50 percent chance of average demand, with cash

flows of $25 million per year, and a 25 percent chance that demand will be low and

annual cash flows will be only $5 million. A preliminary analysis indicates that

the project is somewhat riskier than average, so it has been assigned a cost of capital

Project DCF value

Cash flow

(1rRF)

.

The Investment Timing Option: An Illustration 637

All calculations for the

analysis of the investment

timing option are also

shown in Ch 17 Tool Kit.xls.

632 Option Pricing with Applications to Real Options