The Real Options Approach
to Strategic Capital Budgeting
and Company Valuation
Wouter D E MAESENEIRE
Erasmus University Rotterdam
Table of Contents
Introduction 1 Chapter 1 Traditional Valuation Methodologies versus Real
Options Thinking 5
1.1. Valuing a Goldmine 6 1.2. The Opportunity to defer Investment 8 1.3- Opening up a new Restaurant: small or large? 13 1.4. Where does (naive) DCFgo wrong? The 3D Puzzles Example 19 1.5. Why does DCF fail? 22 1.6. When to use Real Options? 25
Chapter 2 A Printer on Option Terminology and Option
Valuation 27
2.1. Option Definition and Parameters 27 2.2. Valuation of financial Options 30 2.2.1. The Black and Scholes Model 30 2.2.2. The binomial Model and the basic Valuation Idea: Option
Replication and Risk Neutrality 33 2.2.2.1. The replicating Portfolio Approach 34 2.2.2.2. The binomial Model: risk-neutral Probabilities and
risk-neutral Valuation 36 2.2.2.3. The general multiplicative binomial Approach 39 2.2.3. Other Option Valuation Methods 43 Chapter 3 An Introduction to Real Options Analysis 51
31. Real Option Analysis: Definition 51 3-2. Where do the Real Options of the Firm come from? 53 3-3- An Overview of the various Types of Real Options 53
3.3.1. Time to build/deferral Option 53 3-32. Option to alter operating Scale 53 3.3.3. Option to abandon 54 3.3.4. Shutdown Option 54 3.3.5. Input Flexibility 55
II THE REAL OPTIONS APPROACH TO STRATEGIC CAPITAL BUDGETING AND COMPANY VALUATION
3.3.6. Output Flexibility 55 3.3.7. Growth Options 55 34. Some Examples of Projects that involve Real Options 58
3.4.1. Saab's Expansion Option: the turbo-charged Engine for the 900 Model 59 3-4.2. Car manufacturing Plants (Output Flexibility) 59 3.4.3. Power Plants (Input Flexibility) 60 34.4. Plant Construction in different Phases 62 3-4.5. Modular Plants and Facilities 62 3-4.6. Pilot or testing Projects/Test Marketing 63 3-4.7. Options in the Movie Business 63 3-4.8. R&D: the Case of new Drug Development 66 3.4.9- Valuing a Mine 69 3.4.10. Valuing an undeveloped Oil Reserve 71 34.11. US Software Company: starts selling one of its Products in
France via Sales Office and Internet Site ." 74 34.12. Amazon.com as a Portfolio of Options 74 3-4.13- The Valuation of Tiscali at IPO 75 3-4.14. Investments in Eastern Europe, China, India 76 3.4.15. Microsoft, Intel, Cisco: Participations 77 3-4.16. Staged Financing in Venture Capital Investments 77 34.17. Option to abandon 77 3.4.18. Valuing a Start-up Company 78 3.5- How to value Real Options? 78
Chapter 4 Valuing Real Options 83
4.1. A general Framework for valuing Real Options 83 4.2. Identifying the Real Option Parameters 88 4.2.1. Underlying Value 88 4.2.2. Variance 88 4.2.3. Exercise Price 93 4.2.4. Riskless Interest Rate 93 4.2.5. Maturity of the Option 94 4.2.6. Dividend-like Effects 94 4.3. Methodologies for Real Options Valuation 94 4.4. Some additional Remarks on Real Option Valuation 101 4.4.1. Valuing a Project with multiple Options 101 4.4.2. Difference between Real Options and Decision Trees 102
TABLE OF CONTENTS III
4.4.3. Real Options Thinking eliminates the Bias against Long Term Projects 102 Chapter 5 Real Option Applications and Cases 105
5.1. Valuing a Product Patent 105 5-2. Valuing an Expansion Option 106 5.3- Valuing a Start-up Restaurant 107 5-4. TheM-commerceProject. 114 5.5- A Real Options View on buy-and-build Strategies 123 5-6. Equity as a Call Option on the Firm's Value: the Eurotunnel
Example 127
Chapter 6 Advanced Real Option Applications 131
6.1. Valuing Innovation and Patents 131 6.2. UMTS Licenses 135 6.3. Liberalized Electricity Markets T 139
6.3.1. Structure of Investments in Power Plants 142 6.32. Real Options in Investments in Power Plants 145 6.4. Real Options in strategic Acquisitions 149 6.5- Real Options and Game Theory 152 6.6. Various Applications 158 6.6.1. Energy Plants and Pollution Allowances 158 6.6.2. Optimal Land Development 159 6.6.3- Temporary versus permanent Employment 159 6.6.4. Real Options and Risk Management 160 6.6.5. A Real Options Perspective on Supply Chain Management . . 160 6.7. An Overview of the Real Options Literature 161 6.7.1. Early Critics on the traditional Valuation Paradigm 161 6.7.2. A new Direction: conceptual Real Option Approaches 162 6.7.3. Foundations of Option Pricing 162 6.7.4. Risk-neutral Valuation 162 6.7.5. Valuing each Real Option separately 163 6.7.6. Multiple Options and Interdependencies 163 6.7.7. Numerical Techniques 164 6.7.8. The general Environment: Competition and strategic Real
Options 164 6.7.9- A Variety of Applications 165 6.7.10. Even more Applications 166
IV THE REAL OPTIONS APPROACH TO STRATEGIC CAPITAL BUDGETING AND COMPANY VALUATION
Chapter 7 Discussion and Conclusion 167
7.1. Criticism on the Real Options Approach 167 7.1.1. Real Options are hard to identify and to compute, and remain
a Black Box 167 7.1.2. Real Options are a new Economy Tool and have caused the
Internet Bubble 168 7.1.3. Real Options: old Wine in new Bottles? 168 7.1.4. Real Options only work for tradable Assets 170 7.1.5. Real Options are only valuable with good Management
around 170 7.2. Challenges that Real Options Analysis needs to address 171 7.2.1. Refine Option Valuation Models 171 7.2.2. Split the Value of Options 172 7.2.3- Model actual managerial Behaviour 172 7.2.4. Develop heuristics and user-friendly Software 173 7.2.5. Value the whole Firm T 173 7.3- Summary and Conclusion 174
