Real ptions and Cross Border Investment.ppt

chapter18realoptionsandcross borderinvestment 18 1typesofoptions18 2thetheoryandpracticeofinvestment18 3puzzle 1 marketentryandtheoptiontoinvest18 4uncertaintyandthevalueoftheoptiontoinvest18 5puzzle 2 marketexitandtheabandonmentoption18 6puzzle 3 themultinational sentryintonewmarkets18 7realoptionsasacomplementtonpv18 8summary optionsonrealassets arealoptionisanoptiononarealassetrealoptionsderivetheirvaluefrommanagerialflexibilityoptiontoinvestorabandonoptiontoexpandorcontractoptiontospeedupordefer optionsonrealassets simpleoptionseuropean exercisableatmaturityamerican exercisablepriortomaturitycompoundoptionanoptiononanoptionswitchingoption analternatingsequenceofcallsandputsrainbowoptionmultiplesourcesofuncertainty twotypesofoptions calloptionanoptiontobuyanassetatapre determinedamountcalledtheexercisepriceputoptionanoptiontosellanasset theconventionaltheoryofinvestment discountexpectedfuturecashflowsatanappropriaterisk adjusteddiscountratenpv st e cft 1 i t includeonlyincrementalcashflowsincludeallopportunitycosts threeinvestmentpuzzles mnc suseofinflatedhurdleratesinuncertaininvestmentenvironmentsmnc sfailuretoabandonunprofitableinvestmentsmnc snegative npvinvestmentsinneworemergingmarkets puzzle 1firms useofinflatedhurdlerates marketentryandtheoptiontoinvestinvestingtodaymeansforegoingtheopportunitytoinvestatsomefuturedate sothatprojectsmustbecomparedagainstsimilarfutureprojectsbecauseofthevalueofwaitingformoreinformation corporatehurdleratesoninvestmentsinuncertainenvironmentsareoftensetaboveinvestors requiredreturn anexampleoftheoptiontoinvest investmenti0 pv i1 20millionthepresentvalueofinvestmentisassumedtobe 20millionregardlessofwheninvestmentismade priceofoilp 10or 30withequalprobability e p 20variableproductioncostv 8perbarrele production q 200 000barrels yeardiscountratei 10 valuinginvestmenttodayasanow or neveralternative theoptiontoinvestasanow or neverdecision npv investtoday 20 8 200 000 1 20million 4million 0 investtoday investtodayorwaitformoreinformation theoptiontowaitoneyearbeforedecidingtoinvest npv e p v q i 1 i i0inthisexample waitingoneyearrevealsthefuturepriceofoil theinvestmenttimingoption npv wait1year p 30 30 8 200 000 1 1 1 20 000 000 20 000 000 0 investifp 30npv wait1year p 10 10 8 200 000 1 1 1 20 000 000 16 363 636 0 donotinvestifp 10 npv wait1year p 10 0 theinvestmenttimingoption npv wait1year probability p 10 npv 10 probability p 30 npv 30 0 20 000 000 10 000 000 0 waitoneyearbeforedecidingtoinvest optionvalue intrinsic timevalues intrinsicvalue valueifexercisedimmediatelytimevalue additionalvalueifleftunexercised theopportunitycostofinvestingtoday optionvalue intrinsicvalue timevaluenpv wait1year valueifexercised additionalvalueimmediatelyfromwaiting 10 000 000 4 000 000 6 000 000 aresolutionofpuzzle 1useofinflatedhurdlerates managersfacingthistypeofuncertaintyhavefourchoicesignorethetimingoption estimatethevalueofthetimingoptionusingoptionpricingmethodsadjustthecashflowswithadecisiontreethatcapturesasmanyfuturestatesoftheworldaspossibleinflatethehurdlerate applya fudgefactor tocompensateforhighuncertainty optionvalue intrinsic timevalues intrinsicvalue optionvalue calloptionvaluedeterminants relationtocalloptionbpoptionvaluedeterminantvalueexamplevalueoftheunderlyingassetp 24millionexercisepriceoftheoptionk 20millionvolatilityoftheunderlyingassetsp 3 6mor 40m timetoexpirationoftheoptiont 1yearriskfreerateofinterestrf 10 timevalue f p k t sp rf volatilityandoptionvalue optionvalue valueoftheunderlyingasset exerciseprice exogenouspriceuncertainty exogenousuncertaintyisoutsidetheinfluenceorcontrolofthefirmoilpriceexamplep1 35or 5withequalprobability e p1 20 bblnpv investtoday 20 8 200 000 1 20million 4 000 000 0 investtoday exogenouspriceuncertainty npv wait1year p1 35 35 8 200 000 1 1 1 20million 29 090 909 0 investifp1 35npv wait1year p1 5 5 8 200 000 1 1 1 20million 25 454 545 0 donotinvestifp1 5 exogenouspriceuncertainty npv waitoneyear 0 29 090 909 14 545 455 0 waitoneyearbeforedecidingtoinvest timevalue exogenousuncertainty optionvalue intrinsicvalue timevalue 10 10 000 000 4 000 000 6 000 000 15 14 545 455 4 000 000 10 545 455thetimevalueofaninvestmentoptionincreaseswithexogenouspriceuncertainty puzzle 2failuretoabandonlosingventures marketexit theoptiontoabandonabandoningtodaymeansforegoingtheopportunitytoabandonatsomefuturedate sothatabandonmenttodaymustbecomparedtofutureabandonmentbecauseofthevalueofwaitingforadditionalinformation corporatehurdleratesonabandonmentdecisionsareoftensetaboveinvestors requiredreturn anexampleoftheoptiontoabandon costofdisinvestmenti0 pv i1 2millionpriceofoilp 5or 15withequalprobability e p 10variableproductioncostv 12perbarrele production q 200 000barrels yeardiscountratei 10 abandontodayorwaitformoreinformation theoptiontoabandonasanow or neverdecision npv abandontoday 10 12 200 000 1 2million 2million 0 abandontoday theabandonmenttimingoption npv wait1year p 5 5 12 200 000 1 1 1 2million 10 727 273 0 abandonifp 5npv wait1year p 15 15 12 200 000 1 1 1 2million 7 454 545 0 donotabandonifp 15 theabandonmenttimingoption npv wait1year probability p 5 npv 5 probability p 15 npv 15 10 727 273 0 5 363 636 0 waitoneyearbeforedecidingtoabandon opportunitycostofabandoningtoday optionvalue intrinsicvalue timevaluenpv wait1year npv abandontoday additionalvaluefromwaiting1year 5 363 636 2 000 000 3 363 636 hysteresis cross borderinvestmentsoftenhavedifferententryandexitthresholdscross borderinvestmentsmaynotbeundertakenuntiltheexpectedreturniswellabovetherequiredreturnonceinvested cross borderinvestmentsmaybeleftinplacewellaftertheyhaveturnedunprofitable puzzle 3negative npventryintoemergingmarkets firmsoftenmakeinvestmentsintoemergingmarketseventhoughinvestmentdoesnotseemwarrantedaccordingtothenpvdecisionruleanexploratory perhapsnegative npv investmentcanrevealinformationaboutthevalueofsubsequentinvestments growthoptionsandprojectvalue vasset vasset in place vgrowthoptions consideranegative npvinvestment initialinvestmenti0 pv i1 20millionpriceofoilp 10or 30withequalprobability e p 20variableproductioncostv 12perbarrele production q 200 000barrels yeardiscountratei 10 theoptiontoinvestasanow or neverdecision npv investtoday 20 12 200 000 1 20 000 000 4million 0 donotinvesttoday endogenouspriceuncertainty uncertaintyisendogenouswhentheactofinvestingrevealsinformationaboutthevalueofaninvestmentsupposethisoilwellisthefirstoftenidenticalwellsthatbpmightdrillandthatthequalityandhencepriceofoilfromthesewellscannotberevealedwithoutdrillingawell investtodayinordertorevealinformationaboutfutureinvestments investingtoday revealsinformation e p 20 bbl p 30 bbl p 10 bbl theinvestmenttimingoption npv wait1year p 30 30 12 200 000 1 1 1 20 000 000 12 727 273 0 investifp 30npv wait1year p 10 10 12 200 000 1 1 1 20 000 000 53 272 727 0 donotinvestifp 10 acompoundoptioninthepresenceofendogenousuncertainty npv investinanexploratorywell npv onenow or neverwelltoday prob 30 npvof9morewells 30 4 000 000 9 12 727 273 53 272 727 0 investinanexploratoryoilwellandreconsiderfurtherinvestmentinoneyear aresolutionofpuzzle 3entryintoemergingmarkets thevalueofgrowthoptionsnegative npvinvestmentsintoemergingmarketsareoftenout of the moneycalloptionsentitlingthefirmtomakefurtherinvestmentsshouldconditionsimproveifconditionsworsen thefirmcanavoidmakingalargesunkinvestmentifconditionsimprove thefirmcanchoosetoexpanditsinvestment whydcffails 3s 2s 1s 0 1s 2s 3s optionvalue valueoftheunderlyingasset exerciseprice whydcffails nonnormalityreturnsonoptionsarenotnormallydistributedevenifreturnstotheunderlyingassetarenormaloptionvolatilityoptionsareinherentlyriskierthantheunderlyingassetchangingoptionvolatilityoptionvolatilitychangeswithchangesinthevalueoftheunderlyingasset theoptionpricingalternative optionpricingmethodsconstructareplicatingportfoliothatmimicsthepayoffsontheoptioncostlessarbitragethenensuresthatthevalueoftheoptionequalsthevalueofthereplicatingportfolio underlyingassetvaluesareobservableforexample thepriceofashareofstocklowtransactionscostsallowarbitragemostfinancialassetsareliquidasinglesourceofuncertaintycontractualexerciseprices expirationdatesresultinasinglesourceofuncertaintyexogenousuncertainmostfinancialoptionsaresidebetsthatdon tdirectlyinvolvethefirm souncertaintyisexogenous pricingfinancialoptions pricingrealoptions underlyingassetvaluesareunobservablewhatisthevalueamanufacturingplant hightransactionscostsimpedearbitragerealassetsareilliquidmultiplesourcesofuncertaintye g exercisepri