Real Options

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Real Options. Richard de Neufville Professor of Engineering Systems and of Civil and Environmental Engineering MIT. Outline. Motivational Example: Garage Case General Perspective. Garage Case Topics. Value at Risk Analyzing flexibility using spreadsheet Parking garage case.

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Presentation Transcript
Real Options

Richard de Neufville

Professor of Engineering Systems and of

Civil and Environmental Engineering

MIT

Outline
• Motivational Example: Garage Case
• General Perspective
Garage Case Topics
• Value at Risk
• Parking garage case
Value at Risk Concept
• Value at Risk (VAR) recognizes fundamental reality: actual value of any design can only be known probabilistically
• Because of inevitable uncertainty in
• Future demands on system
• Future performance of technology
• Many other market, political factors
Value at Risk Definition
• Value at Risk (VAR) definition:
• A loss that will not be exceeded at some specified confidence level
• “We are p percent certain that we will not lose more than V dollars for this project.”
• VAR easy to see on cumulative probability distribution (see next figure)
Look at distribution of NPV of designs A, B:
• 90% VAR for NPVA is -\$91
• 90% VAR for NPVB is \$102
VAR and Flexibility
• VAR is a common financial concept
• It stresses downside losses, risks
• However, designers also need to look at upside potential: “Value of Gain”
• Flexible design provides value by both:
• Decreasing downside risk
• Increasing upside potential
• See next figure
Sources of value for flexibility

Cut downside ; Expand Upside

Excel Analysis Sequence toillustrate value of flexibility

1: Examine situation without flexibility

• This is Base case design

2: Introduce variability (simulation)

• a different design (in general)

3: Introduce flexibility

=> a even different and better design

Parking Garage Case
• Garage in area where population expands
• Actual demand is necessarily uncertain
• Design Opportunity: Strengthened structure
• enables future addition of floor(s) (flexibility)
• costs more (flexibility costs)
• Design issue: is extra cost worthwhile?
Parking Garage Case details
• Demand
• At start is for 750 spaces
• Over next 10 years is expected to rise exponentially by another 750 spaces
• After year 10 may be 250 more spaces
• could be 50% off the projections, either way;
• Annual volatility for growth is 10%
• Average annual revenue/space used = \$10,000
• The discount rate is taken to be 12%
Step 1: Set up base case

Demand growth as predicted, no variability

Lower demand => Loss

Higher demand => Gain limited by garage size

Step 2: Simulate uncertainty
NPV Cumulative Distributions

Compare Actual (5 Fl) with unrealistic fixed 6 Fl design

Including Flexibility => Another, better design:

4 Floors with strengthened structure enabling expansion

Summary of design results from different perspectives

Why is the optimal design much better when we design with flexibility?

Sources of value for flexibility:

1) Minimize exposure to downside risk

Sources of value for flexibility:

2) Maximize potential for upside gain

Comparison of designswith and without flexibility
• Wow! Everything is better! How did it happen?
• Root cause: change the framing of the problem
• recognize uncertainty ; add in flexibility thinking
Summary from Garage Case
• Sources of value for flexibility
• Cut downside risk
• Expand upside potential
• VAR chart is a neat way to represent the sources of value for flexibility
• Spreadsheet with simulation is a powerful tool for estimating value of flexibility
“Options” Embody Idea of Flexibility
• An “Option” provides a formal way of defining flexibility
• An “Option” has a specific technical definition
• Semantic Caution:
• The technical meaning of an “option” is… much more specific and limited than … ordinary meaning of “option” in conversation... where “option” = “alternative”
• Pay careful attention to definition that follows!
Technical definition of an Option

An Option is...

• A right, but not an obligation…
• “Exercise”, that is “use” only if advantageous
• Asymmetric returns -- “all gain, no pain”
• Usually acquired at some cost or effort
• to take some action…
• to grow or change system, buy or sell something, etc, etc,
• now, or in the future...
• May be indefinite
• But can be for a limited time after which option expires
• for a pre-determined price (the “strike” price).
• Cost of action separate from cost of option
Financial Options
• Focus first on financial options because
• Consequences easiest to present
• This is where options and valuation developed
• Financial Options
• Are tradable assets (see quotes finance.yahoo.com)
• Sold through exchanges similar to stock markets
• Are on all kinds of goods (known as “underlying assets”)
• Stocks, that is, shares in companies
• Commodities (oil, meat, cotton, electricity...)
• Foreign exchange, etc., etc.
Real Options
• “Real” because they refer to project and systems
• Contrast with financial options that are contracts
• Real Options are focus of interest for Design
• They provide flexibility for evolution of system
• Projects often contain option-like flexibilities
• Rights, not obligations (example: to expand garage)
• These flexibilities are “real” options
• Let’s develop idea by looking at possibilities…
Real Options are Everywhere
• Examples:
• Lease equipment with option to buy at end of lease
• Action is to buy at end of lease (or to walk away)
• Lease period defined up-front (typically 2-3 years)
• Purchase price defined in lease contract
• Flexible manufacturing processes
• Ability to select mode of operation (e.g. thermal power by burning either gas or oil)
• Switching between modes is action
• Continuous opportunity (can switch at any time)
• Switching often entails some cost (e.g.: set-up time)

These need

knowledge

of system

Options ON

projects

Financial

options

Options IN

projects

Real Options

Real Options “IN” and “ON” projects
• Those “real” because, in contrast to financial options, they concern projects, they are “ON” projects
• E.g.: the option to open a mine
• These do not concern themselves with system design
• Most common in literature
• Those “real” because they concern the design elements of system, they are “IN” projects
• EX: options for staging of system of communication satellites
• These require detailed understanding of system
• Most interesting to system designers
Real Options “ON” projects
• These are financial options, but on technical things
• They treat technology as a “black box”
• Example: Antamina Copper
• option to open the mine after a two-year exploration period
• Uncertainty concerns: amount of ore and future price =>uncertainty in revenue and thus in value of mine
• Option is a Financial Call Option (on Mine as asset)
• Differs from normal Financial Option because
• Much longer period -- financial option usually < 2 years
• Special effort needed to model future value of asset, it can’t be projected simply from past data (as otherwise typical)
Real Options “IN” projects
• These create options by design of technical system
• They require understanding of technology
• Example: Communications Satellites
• Designers can create options for expansion of capacity by way they configure original satellites
• Technical skill needed to create and exercise option
• Differ from other “real” Options because
• Special effort needed to model feasible flexibility within system itself (e.g.: modeling of ‘trade space” for design of communication satellites)
Summary
• Options embody formal concept of flexibility
• Options are not “alternatives”
• 4 step Mantra “right, but not obligation, to act…”
• “Calls” for opportunities, “puts” for downside risks
• OPTIONS MAY HAVE GREAT VALUE
• Options are Financial and “Real”
• Many “real” options available to system designers
• “Real” Options “ON ” and “IN” systems