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Options in Projects/Investments/Acquisitions

Options in Projects/Investments/Acquisitions. One limitation of traditional investment analysis (NPV) is that it is static and does not adequately capture the options embedded in investment Option to delay an investment, when a company has exclusive rights to it, until a later date

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Options in Projects/Investments/Acquisitions

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  1. Options in Projects/Investments/Acquisitions • One limitation of traditional investment analysis (NPV) is that it is static and does not adequately capture the options embedded in investment • Option to delay an investment, when a company has exclusive rights to it, until a later date • Taking one investment may allow taking advantage of other opportunities in the future • Option to abandon if the cash flows do not measure up • These options add value to projects and may make a “bad” investment into a good one.

  2. Option to Delay • When a company has exclusive rights to a project, product, technology for a specific period, it can delay taking this project or product until a later date • A traditional NPV analysis just answers the question of whether the project is a “good” one if taken today • Thus, the fact that a project has negative NPV today does not mean that the rights to this project are not valuable

  3. Valuing the Option to Delay a Project PV Cash Flows From Project Initial Investment in Project PV Expected Cash Flows - NPV range + NPV range

  4. Insights for Investment Analyses • Having the exclusive rights to a product, project, or technology is valuable, even if it is not viable today. • The value of these rights increases with the volatility of the underlying business • The cost of acquiring these rights (by buying them or spending money on development, or by acquisition) has to be weighted against these benefits

  5. Example 1: Valuing Product Patents as Options • A product patent provides the company with the right to develop the product and market it • It will do so only if the PV of the expected cash flows from the product sales > cost of development • If not, the company can shelve the patent and not incur any further costs • If I is the PV of the costs of developing the product, V is the PV of expected cash flows from development, the payoffs from owning a product patent are: Payoff = V - I if V > I = 0 if V < I

  6. Payoff on Product Option Net payoff to introducing product Cost of product introduction PV Expected Cash Flows On product

  7. 6 Levers of Financial Options Time to Expiry Uncertainty Stock Price Exercise Price Dividends Risk-Free

  8. 6 Levers of Real Options Period for which opportunity is valid Unpredictability of cash flows PV Cash Flows PV fixed costs Value lost over duration of option Risk-Free

  9. Inputs for Patent Valuation

  10. NPV Simulation

  11. Valuing a Product Patent: Avonex Biogen has a patent on Avonex, a drug to treat MS, for the next 17 years, that it plans to produce and sell by itself. Key input assumptions: PV Cash Flows from Introducing Drug Now = S = $3.422 billion PV Cost of Developing Drug for Commercial Use = K = $2.875 Patent life = t = 17 yrs Rf = 6.7% (17-year T-Bond) Variance of E(PV) = 0.224 (industry avg bio-tech firms) Expected Cost of Delay = y = 1/17 = 5.89% d1 = 1.1362 N(d1) = 0.8720 d2 = -0.8512 N(d2) = 0.2976 Call Value = 3.422e(-.0589)(17) (0.8720) – 2.875e(-0.067)(17) (0.2076) = $907

  12. When is Managerial Flexibility Valuable? The flexibility value comes from the ability to respond to information that may be received in the future. The greater the likelihood that this new future information will elicit a managerial response and alter the course of a project, the more value the option will have Likelihood of Receiving New Information Flexibility Value Greatest When: Low High • 1. High uncertainty about the future • Very likely to receive new information over time • 2. High room for managerial flexibility • Allows management to respond appropriately to this new information Uncertainty High Moderate Flexibility Value HighFlexibility Value Room forManagerial Flexibility Ability to respond Low Flexibility Value ModerateFlexibility Value + • 3. NPV without flexibility near zero • If a project is neither obviously good nor obviously bad, flexibility to change course is more likely to be used and therefore is more valuable Low In every scenario flexibility value is greatest when the project’s value without flexibility is close to break even Under these conditions, the difference between ROA and other decision tools is substantial

  13. Valuing a Company with Patents • Value = Value of Commercial Products (DCF) + Value of existing patents (OPM) + Value of New Patents obtained in the future – Cost of Obtaining Patents • The last term measures the efficiency of the company in converting R&D into commercial products. If we assume R = K from research, this term is 0. Note: do not double count and allow for a high growth rate in cash flows in the DCF valuation.

  14. Value of Biogen’s Existing Products • Biogen had 2 commercial products that it had licensed to other pharmaceutical firms (Hepatitis B, Intron). • The license fees on the two products were expected to generate $50m in after-tax cash flows each year for 12 years. • PV of License Fees = $50 [1 – (1.067)-12]/0.067 = $403.6m Note: Risk-free rate = 6.7%

  15. Value of Biogen’sFuture R&D • Biogen continued to fund research into new products, spending $100m on R&D, expecting to grow 20% per year for 10 years, and 5% thereafter. • From past experience, every $ invested in R&D would create $1.25 in value in patents (valued using OPM described above) for 10 years, and breakeven after that • Cost of capital = 15%, given the risk

  16. Value of Future R&D

  17. Value of Biogen Value = Existing Products + Existing patents (Avonex option) + Value Future R&D = $403.6 + $907 + $318.3 = $1,628.9 M Biogen had 35.5m shares outstanding, no debt Value per share = $1,628.9/ 35.5 = $45.88 per share

  18. Example 2: Valuing Natural Resource Options • In a natural resource investment, the underlying asset is the resource and the value of the asset is based on 2 variables: quantity and price of the resource available • There is a cost associated with developing the resource, and the difference between the value of the asset extracted and the cost of the development is the profit to the owner of the resource • If X is the cost of development, V is the estimated value of the resource, the potential payoffs on an natural resource option can be written as: • Payoff on natural resource investment = V - X if V > X = 0 if V < X

  19. Payoff on Natural Resource Firms Net payoff On extraction Cost of developing reserve PV Expected Cash Flows from natural resource reserve

  20. Inputs for Natural Resource Options

  21. Valuing an Oil Reserve • Consider an offshore oil property with an estimated oil reserve of 50 million barrels of oil, where the PV of the development cost is $12/barrel and the development lag is 2 years • The firms has the rights to exploit this reserve for the next 20 years and the marginal value/barrel is $12 (price/barrel – marginal cost/barrel • Once developed, the net production revenue each year will be 5% of the value of the reserves • The risk-free rate is 8% and the variance in ln(oil prices) is 0.03

  22. Inputs to Option Pricing Model • Current value of the asset = S = Value of the developed reserve discounted back the length of the development lag at the dividend yield = $12 * 50/(1.05)2 = $544.22 • Note: If development is started today, the oil will not be available for sale until 2 years from now. The opportunity cost of this delay is the lost production revenue over the delay period, hence, the discounting of the reserve back at the dividend yield • Exercise Price = PV of development cost = $12 * 50 = $600 • Time to expiration the option = 20 years • Variance in the value of the underying asset = 0.03 • Risk-free rate = 8% • Dividend Yield = Net production revenue/Value of reserve = 5%

  23. Valuing the Option • Based on these inputs, the Black-Scholes model provides the following value for the call: • d1 = 1.0359 N(d1) = 0.8498 • d2 = 0.2613 N(d2) = 0.6030 • Call Value = 544.22e(-.05)(20) (0.8498) – 600e(-0.08)(20) (0.6030) = $97.08 • This oil reserve, although not viable at current prices, still is a valuable property because of its potential to create value if oil prices go up.

  24. Option to Expand/Follow-On Projects • Taking a project today may allow a company to consider and take other valuable projects in the future • Therefore, even though a project may have a negative NPV, it may be a project worth taking if the option it provides the company to take other projects in the future provides a compensatory value • These are the options that companies often call “strategic options” and use as a rationale for taking on “negative NPV” or even “negative return” projects

  25. Option to Expand PV of Cash Flows From Expansion Additional Investment to Expand PV Expected Cash Flows on Expansion Company will not expand in this section Expansion becomes attractive in this section

  26. Option to Expand: Example • AmBev is considering introducing a soft drink to the U.S. market. The drink will initially be introduced only in the metropolitan areas of the U.S. and the cost of this limited introduction is $500m • A financial analysis of the cash flows from this investment suggest that the PV of the cash flows from this investment to AmBev will be only $400m. Thus, by itself, the new investment has a negative NPV of $100m • If the initial introduction works well, AmBev could go ahead with a full-scale introduction to the entire market with an additional investment of $1b any time over the next 5 years. While the current expectation is that the cash flows from having this investment is only $750m, there is considerable uncertainty about both the potential for the drink, leading to significant variance in this estimate

  27. Valuing the Expansion Option • Value of Underlying Asset (S) = PV of Cash Flows from expansion to entire U.S. market, if done now = $750m • Exercise Price (K) = Cost of Expansion into entire U.S. market = $1,000m • σ of project value = annualized σ in value of publicly-traded companies in the beverage markets = 34.25% • Time to expiration = period for which expansion option applies = 5 years Call Value = $234 m

  28. Project with Expansion Option • NPV of limited introduction = $400 - $500 = -$100 m • Value of Option to Expand to full market = $234m • NPV of project with option to expand = - $100 + $234 = $134 • Invest in Project !

  29. NPV’ = NPVpassive + Option Value

  30. Link to Strategy • In many investments, especially acquisitions, strategic options or considerations are used to take investments that otherwise do not meet financial standards • These strategic options or considerations are usually related to the expansion option described here. Key differences are: • Unlike “strategic options” which are usually qualitative and not valued, expansion options can be assigned a value and can be incorporated into the investment analysis • Not all “strategic considerations” have option value. For an expansion option to have value, the first investment (acquisition) must be necessary for the later expansion (investment). If not, there is no option value that can be added on to the first investment

  31. The Determinants of Real Option Value • Does taking the 1st investment/expenditure provide the firm with an exclusive advantage on taking on the 2nd investment? • If yes, the firm is entitled to consider 100% of the value of the real option • If no, the firm is entitled to only a portion of the value of the real option with the proportion determined by the degree of exclusivity provided by the 1st investment • Is there a possibility of earning significant and sustainable excess returns on the 2nd investment? • If yes, the real option will have significant value • If no, the real option has no value

  32. The Exclusivity Requirement in Option Value Is the 1st investment necessary for the 2nd investment? Not necessary Pre-Requisite Zero Competitive Advantage on 2nd Investment Exclusive Right to 2nd Investment No Option Value 100% of Option Value

  33. The Exclusivity Requirement in Option Value Zero Competitive Advantage on 2nd Investment Exclusive Right to 2nd Investment No Option Value 100% of Option Value Pharmaceutical Patents First-Mover Technology Edge Brand Name Increasing competitive advantage / Barriers to entry

  34. Internet Companies as Options • Some analysts have justified the valuation of Internet companies on the basis that you are buying the option to expand into a very large market. • Is there an option to expand embedded in these companies? • Is it a valuable option

  35. NPV’ = NPVpassive + Option Value

  36. Amazon.com: Building Value Through Options Success Success Success Failure Start Failure Failure Books Music Video

  37. Amazon.com: Building Value Through Options Option Value DCF Video Option Value DCF Music Market Capitalization DCF Music DCF books Option Value DCF books DCF books TIME

  38. Value of whole strategy Product call 1st expansion call (2nd expansion Introduction value option value option) PV + +

  39. Option to Abandon • A firm may sometimes have the option to abandon a project, if the cash flows do not meet expectations • If abandoning the project allows the firm to save itself from further losses, this option can make a project more valuable

  40. Payoff on Put Option Net payoff on put Exercise price Price of underlying asset If asset value > exercise price, you lose what you paid for put

  41. Option to Abandon PV Cash Flows from Project Cost of Abandonment PV Project Expected Cash Flows

  42. Valuing the Option to Abandon • Airbus is considering a joint venture with Lear Aircraft to produce a small commercial 40-50 passenger airplane on short haul flights • Airbus will have to invest $500m for a 50% share of the venture • Its share of the PV of Expected Cash Flows is $480m • Lear Aircraft offers to buy Airbus’ 50% share of the investment anytime over the next 5 years for $400m, if Airbus decides to get out of the venture • A simulation of the cash flows yields a variance of the PV of expected cash flow from the partnership of 0.16 • Project life is 30 years

  43. Valuing the Option to Abandon • Value of Underlying Asset (S) = PV of Cash Flows from project = $480m • Exercise Price (K) = Salvage Value from Abandonment = $400m • σ2 in Underlying Asset’s value = 0.16 • Time to expiration = Life of the Project= 5 yrs • Dividend Yield = 1/Life = 1/30 = 0.033 • (i.e. PV will drop by 1/30 each year) • Rf = 6% Put Value = $73 m

  44. Should Airbus Enter the Joint Venture? • Value of Put = Ke-rt[1 – N(d2)] – Se-yt[1 – N(d1)] = 400 e(-.06)(5)[1 - 0.7496] – 480e(-0.033)(5) [1 - 0.9105] = $73m • Value of abandonment option has to be added to the NPV of the project of -$20m, yielding a total NPV with the abandonment option of $53m

  45. Implications for Investment Analysis • Having an option to abandon a project can make otherwise unacceptable projects acceptable • Actions that increase the value of the abandonment option: • More cost flexibility, i.e., make more of the costs of the projects into variable vs fixed costs • Fewer long-term contracts/obligations with employees and customers because these add to the cost of abandoning a project • Find partners in the investment who are willing to acquire your share of the investment in the future • These actions will cost the firm some value, but this has to be weighted off against the increase in the value of the abandonment option

  46. Option Analysis at Merck • Project Gamma - new line of business that required the acquisition of appropriate technologies from a small biotech company called Gamma • Merck would make a $2 million payment to Gamma over a period of three years • Merck would pay royalties to Gamma should the product ever come to market • Merck had the option to terminate the agreement at any time if dissatisfied with the research

  47. Option Analysis at Merck • Merck’s finance group used the Black-Scholes option-pricing model • Exercise price = capital investment to be made 2 years hence • Stock price = present value of cash flows from the project • Time to expiration = varied over two, three and four years (with market entry unfeasible after four years) • Volatility = standard deviation of returns for typical biotech stocks • Risk-free interest rate = U.S. Treasury rate over the two to four year period

  48. Example: Business Plan: Option to Launch New Product

  49. Business Plan fixed cash flow optional cash flow If Launch, obtain value of established participant Raise $4M spend $0.5M/quarter on product development X Spend $12M on Market Launch Year 1 Year 2 Year 3

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