BPHD 8650 Real Options Lecture 1: A New View of Investment

1. BPHD 8650Real OptionsLecture 1:A New View of Investment

2. Overview • Based solely on Chapter 1 of Dixit and Pindyck • Designed to lay out the general issues in investment. • Primary issue is to point out that “classical” investment theory, i.e. Net Present Value, does not fully value investments because it cannot value “real” options that the investor may hold. • Mostly intuitive in nature. Math really begins with Chapter 3 – please read ahead and get “ahead of the curve” on that.

3. Overview • Investment Defined: • “the act of incurring an immediate cost in the expectation of future rewards.” • Three major characteristics shared by most investments: • Irreversible – cannot recover everything if you change your mind. • Uncertainty – all you know is the probability of various future rewards, not which one you will get. • Timing – typically you have some discretion as to when you take various actions in the investment.

4. Overview • Our focus will be on the optimal behavior of investors, and on valuing investments given that behavior. • Note that optimal means optimal conditional upon the three factors previously listed – it does not mean that investors are prescient or that they make “perfect” decisions. • The interaction of irreversibility, uncertainty, and timing make this an interesting problem.

5. Orthodox Theory • You are probably quite familiar with this from BPHD 8210, but as a brief refresher: • Net Present Value rule: • Calculate the present value of the expected benefits of investment (PVbenefits). • Calculate the present value of the expected costs of investment (PVcosts). • Difference in the two is Net Present Value: NPV = PVbenefits-PVcosts. • Invest if NPV>0. • Difficulties lie in determining expected cash flows and selecting the appropriate discount rate.

6. Orthodox Theory • If you pick up an economics text you will see this outlined in the “theory of the firm” portion of the text. The rule is stated as: • “invest until the value of an incremental unit of capital is just equal to its cost.” • i.e. invest until marginal benefit equals marginal cost. • Two approaches: • Jorgenson (1963) – compare per-period value of an incremental unit of capital vs an “equivalent per-period rental cost” or user cost.

7. Orthodox Theory • Two approaches (cont.) • Tobin’s Q – compares the capitalized value of marginal investment to purchase cost. • Value is directly observe if ownership is traded in a secondary market (assumes liquidity – huge assumption.) • Otherwise imputed value computed as the expected PV of the future cash flows from project. • q = Value/Cost • q>1, invest. • q<1, divest.

8. Option Approach • Static NPV rules only work if investment is reversible or that it is a “now or never: proposition. • Key point is that NPV rule does work at “event horizon” of investment. • Option to delay is frequently overlooked, but very important. • Beginning investment is tantamount to exercising financial option. • At a minimum must re-state the rule to be: “Invest when expected PV of benefits exceeds PV of cost plus the cost of the option you are terminating. • Probably explains why empirical studies show that firms require much higher rates of return than WACC before accepting investments; also why they wait longer to shut down projects than you would otherwise expect.

9. Irreversibility • Why do we think of investment expenditures as irrecoverable? Can’t you sell to recover your expenditure? • Within an industry: If we assume competitive markets, then in all likelihood your competitors cannot make more with your asset than you can. If you invested X and you now realize its worth Y (where X>Y), then you have lost (X-Y), and in all likelihood the market will value it at about Y. • Outside of an industry: You could sell certain assets (say a copier) to those outside your industry, but you have the classic “Lemon’s Problem. (Akerlof 1970.) You will almost always get far less than what you paid for the asset. • Think of the problem of used cars and how Carmax and CPO programs solve it.

10. Delayed Investment • A theme which will be repeated throughout the course is the idea that the option to delay investment can be very valuable. • Basic idea is, as already mentioned, that the option to invest is analogous to a financial call on a stock. • We know that in general you do not want to exercise call options early, because they are worth more “alive” than “dead.” • Similarly, when you invest you “kill” the option to invest in the future – you also kill the option to not invest in the future. This is costly and you only want to do it when the benefits outweigh the costs.

11. General Comment • One of the main focuses that we will have is on the building of models within each section. • Be prepared to do homework that involves building models in the appropriate computing language.

12. Extensions and Applications • Interest Rates and Investments • Don’t seem to respond to rates as much as we might expect. • Suspension and Abandoment • Investing also brings the option to abandon. • Hugely important in housing markets. • Employment • Why pay more for temporary employees than permanent would cost?

13. Extensions and Applications • Hyesteresis • Path Dependency is a frequent component of real options. • Consider value of a mortgage pool depending upon prepayments. • Consider a plant that can be suspended and restarted. • A return to original economic conditions may not restore the original condition of the firm. • May chose to stay invested because the cost of mothballing might be high. • Trade theory • Foreign firms may chose to operate at a loss just to maintain the option to operate, not because they are “dumping” or engaging in predatory pricing.

14. Fun Applications • Marriage and Divorce • Suicide • Starting a football team • Staying in a Presidential race