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Chapter 10 Real Options and Cross-Border Investment

Chapter 10 Real Options and Cross-Border Investment. 10.1 The Theory and Practice of Investment 10.2 Market Entry and the Option to Invest 10.3 Uncertainty and the Value of the Option to Invest 10.4 Market Exit and the Abandonment Option 10.5 The Multinational’s Entry into New Markets

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Chapter 10 Real Options and Cross-Border Investment

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  1. Chapter 10Real Options and Cross-Border Investment 10.1 The Theory and Practice of Investment 10.2 Market Entry and the Option to Invest 10.3 Uncertainty and the Value of the Option to Invest 10.4 Market Exit and the Abandonment Option 10.5 The Multinational’s Entry into New Markets 10.6 Options within Options 10.7 Option Theory as a Complement to NPV 10.8 Summary

  2. The theory of investment The conventional theory: Discount expected future cash flows at an appropriate risk-adjusted discount rate. NPV = St[E[CFt] / (1+i)t] • include only incremental cash flows • include all opportunity costs

  3. Three investment puzzles Puzzle #1: MNC’s use of inflated hurdle rates Puzzle #2: MNC’s failure to abandon unprofitable investments Puzzle #3: MNC’s ‘negative-NPV’ investments into new and emerging markets

  4. Puzzle #1: MNC’s use of inflated hurdle rates Market entry and the option to invest • By exercising its option to invest, the firm is foregoing the opportunity to invest at some future date. • Consequently, a project must be compared not only against other projects today but also against similar versions of itself initiated at some future date. • Because of the value of waiting for additional information, firms often demand hurdle rates that exceed investors’ required returns on investments into uncertain environments.

  5. An example of the option to invest Initial investment I0 = $20,000,000 (For simplicity, the present value of this initial investment is assumed to be PV(I) = $20,000,000 regardless of when investment is made.) Price of Oil P0 = $20/bbl P1 = either $30 or $10 with equal probability Þ E[P] = $20 Variable production cost V = $8 per barrels E[production] = Q = 200,000 barrels per year Discount rate i = 10%

  6. The option to invest as a “now or never” decision NPV = [ (E[P]-V) (Q) / i ] - I0 NPV(invest today) = [($20 - $8) (200,000) / .1] - $20,000,000 = $4,000,000 > $0 Þ invest today (?)

  7. Wait one year before deciding to invest

  8. The investment timing option NPV(wait one year½P1=$30) = (($30 - $8)(200,000) /.1)/(1.1) - $20,000,000 = $20,000,000 > $0 Þinvest if P1=$30 NPV(wait one year½P1=$10) = (($10 - $8)(200,000) /.1)/(1.1) - $20,000,000 = -$16,363,636 < $0 Þdo not invest if P1=$10 NPV(wait one year) = (½)($0) + (½)($20,000,000) = $10,000,000 > $0 Þwait one year before deciding to invest

  9. The opportunity cost of investing today

  10. The opportunity cost of investing today Option Value = Intrinsic Value + Time Value NPV(wait one year) = NPV(invest today) + Opportunity cost of investing today $10,000,000 = $4,000,000 + $6,000,000 Þ wait one year before deciding to invest

  11. A resolution of Puzzle #1: Use of inflated hurdle rates Financial managers facing this type of uncertainty have four choices: • Ignore the timing option (?!) • Estimate the value of the timing option using option pricing methods • Adjust the cash flows with a decision tree that captures as many future states of the world as possible • Inflate the hurdle rate (apply a “fudge factor”) to compensate for high uncertainty

  12. The investment call option Option value = intrinsic value + time value • Intrinsic value = value if exercised immediately ($4 million in BP example) • Time value = additional value if left unexercised ($6 million in BP example)

  13. Call option value determinants Increasing this determinant changes call option value Option value determinant BP example in the indicated direction Price of the underlying asset Poil+ Exercise price of the option K $20 million - Riskfree rate of interest RF 10% + Time to expiration of the option T one year + Volatility of the underlying asset sPoil+ Option value = intrinsic value + time value Intrinsic value = Asset value - exercise price = (Poil - K) Time value = f(Poil, K, RF , T, sPoil)

  14. Exogeneous price uncertainty Price of Oil: P1 = $35 or $5 with equal probability Þ E[P1] = $20/bbl NPV(invest today) = (($20-$8)(200,000) /.1)/(1.1)-$20,000,000 = $20,000,000 > $0 Þinvest today (?)

  15. Exogeneous price uncertainty NPV(wait one year½P1=$35) = (($35-$8)(200,000) /.1)/(1.1)-$20,000,000 = $29,090,909 > $0 Þinvest if P1=$35 NPV(wait one year½P1=$5) = (($5-$8)(200,000) /.1)/(1.1)-$20,000,000 = -$25,454,545 < $0 Þdo not invest if P1=$5 (Þ NPV=0) NPV(wait one year) = (½)($0)+(½)($29,090,909) = $14,545,455 > $0 Þwait one year before deciding to invest

  16. Exogeneous price uncertainty The effect of uncertainty over the future price of oil P1 = $30 or $10 Option value = Intrinsic value + Time value $10,000,000 = $4,000,000 + $6,000,000 P1 = $35 or $5 Option value = Intrinsic value + Time value $14,545,455 = $4,000,000 + $10,545,455 The time value of the investment option increases with exogeneous price uncertainty.

  17. A resolution of Puzzle #2:Failure to abandon unprofitable investments Why do firms remain in unprofitable markets even though they are losing money? Market exit - the option to disinvest • By abandoning a losing venture today, the firm is foregoing the opportunity to abandon at a future date. • A part of the exercise price of the abandonment option is the opportunity cost of exiting today rather than at a future date. • Firms retain losing ventures because of the option value of waiting for additional information.

  18. The abandonment option Cost of disinvestment PV(I) = $2,000,000 Assume the present value of abandoning the oil well is $2 million regardless of when the well is abandoned Price of Oil P0 = $10/bbl; P1 = either $15 or $5 with equal probability Variable production cost V = $12 per barrels Expected production Q = 200,000 barrels per year Discount rate i = 10%

  19. The abandonment option NPV(now or never) = -(($10-$12) (200,000)/.1)-$2,000,000 = $2,000,000 > $0 Þabandon today (?)

  20. The abandonment option NPV(abandon in one year½P1=$15) = -(($15-$12) (200,000)/.1)/(1.10)-$2,000,000 = -$7,454,545 < $0 (Þ NPV=0) Þdo not abandon given P1=$15 NPV(abandon in one year½P1=$5) = -(($5-$12) (200,000)/.1)/(1.10)-$2,000,000 = +$10,727,273 > $0 Þabandon in one year given P1=$5 NPV(wait one year) = (½) ($0) + (½) ($10,727,273) = $5,363,636 > $0 Þwait one year before deciding

  21. The abandonment option

  22. The opportunity cost of abandoning today Option Value = Intrinsic Value + Time Value NPV(wait one year) = NPV(exit today) + Opportunity cost of exiting today $5,363,636 = $2,000,000 + $3,363,636 Þ wait one year before deciding to abandon

  23. Hysteresis: Entry-exit decisions in combination Cross-border investments often have different thresholds for investment and disinvestment. • Cross-border investments are often not undertaken until the expected return is well above the required return. • Once invested, cross-border investments are frequently left in place well after they have turned unprofitable. This is called “hysteresis” - the failure of a phenomenon to reverse itself as its underlying cause is reversed.

  24. A resolution of Puzzle #3: Entry into emerging markets Firms often make investments into emerging markets even though further investment does not seem warranted according to the “accept all positive-NPV projects” rule. The value of growth options • Negative-NPV investments into emerging markets are often out-of-the-money call options entitling the MNC to make further investments should conditions improve. • If conditions worsen, the MNC can avoid making a large sunk investment. • If conditions improve, the MNC can choose to expand its investment. Vfirm = Vassets-in-place + Vgrowth options

  25. Why DCF fails • Option volatility - Options are inherently riskier than the underlying asset on which they are based. • Changing option volatility - Option volatility changes with changes in the value of the underlying asset. • Returns on options are not normally distributed.

  26. The option pricing alternative • Option pricing methods circumvent problems with the opportunity cost of capital by constructing a replicating portfolio that mimics the payoffs on the option. • Costless arbitrage then ensures that the value of the option equals the value of the replicating portfolio.

  27. The option pricing alternative • Option pricing works well for financial options • low transactions costs facilitate arbitrage • observable prices • Option pricing is more difficult for real options • higher transactions costs impede arbitrage • the price of the underlying asset (such as a factory or product line) is usually unobservable

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