Real Options
1 Introduction
A real option relates to project appraisal. In previous questions we have assumed that the only choice available us is to accept or reject the project based on the expected cash flows.
However, as will be explained below, it may be possible to improve the potential return by having the right to change something about the project during its life. This would be a ‘real’ option. In the exam you are expected to be aware of the different types of ‘real’ options that might exist, and to be able to value them using the Black Scholes model.
2 Types of real options
In order to explain the different types of real options, we will list them in turn together with a brief illustration of the idea.
2.1 Option to delay
Suppose we are considering a project, but the returns are uncertain because of forecast general economic problems over the next few years.
The ability to delay starting the project could be attractive because if economic conditions turn out to be unfavourable we could cancel, whereas if they turn out to be favourable we could go ahead and maybe get even better returns.
The fact that we would be able to remove the ‘downside’ potential would mean that we had an option and this would be worth paying for.
It would effectively be a call option (the right to invest in the project at a future date) and we could use the formula to value it.
2.2 Option to expand
This would be similar to an option to delay in that we could invest a certain amount in the project now and decide later whether or not to invest more (when we find out how successful the project is).
Again, this right would be worth money to us and could be valued, as a call option.
2.3 Option to abandon
When appraising (for example) a 5 year project, we usually assume that the project lasts for the full 5 years. However, if the cash flows turned out to be lower than expected, we would clearly want to be able to consider stopping the project early.
Yet again, this right would effectively be an option – although this time a put option.
2.4 Option to redeploy
A firm may have decided to invest a considerable amount in equipment, staff, training etc. to commence teaching ACCA courses, on the basis that currently they appear to be the most profitable use of the resources. However, projections could turn out to be wrong and it could be beneficial to effectively stop the project earlier than planned and use the resources to teach some other qualification.
This ability would be a put option (and the option to abandon is a special case of this).
Warsaw plc is considering a new project which requires an outlay of $10 million and has an expected net present value of $2 million.
However, the economic climate over the next few years is thought to be very risky and the volatility attaching to the net present value of the project is 20%.
Warsaw is able to delay commencing the project for three years.
The risk free rate of interest is 6% p.a..
Estimate the value of the option to delay the start of the project for three years, using the Black Scholes option pricing model.