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MBA201a: Real Options

MBA201a: Real Options. The value of information and real options. We’ve seen that acquiring information early can be valuable. Said another way: It can be valuable to delay decisions until you have more information.  REAL OPTIONS . Real options – an example.

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MBA201a: Real Options

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  1. MBA201a: Real Options

  2. The value of information and real options • We’ve seen that acquiring information early can be valuable. Said another way: • It can be valuable to delay decisions until you have more information.  REAL OPTIONS. MBA201a - Fall 2009

  3. Real options – an example • Consider the following situation: • September 2009: Anadarko is given the opportunity to buy mineral rights for a tract in the Gulf of Mexico. They believe that there’s a: • 10% chance that it will yield 25 million barrels of oil (great site), • 50% chance that it will yield 15mm barrels (OK site), and • 40% chance that it will yield 10mm barrels (mediocre site). • October 2009: If they win the site, Anadarko’s geologists can assess the site and determine whether it’s a great, OK or mediocre site. • Spring 2010: The company can start developing the site for drilling. If it chooses a cheap extraction technology, it will spend $100mm but it will only get 1/5th of the oil. Extracting all the oil costs $1,000mm. The company can sell the oil for $70/bbl. MBA201a - Fall 2009

  4. NPV analysis • Assuming the numbers are already discounted, the NPV of investing in the expensive extraction technology at this site is (in millions): $70  (.4  10 + .5  15 + .1  25) - $1000 = -$20 • Similarly, the NPV of investing in the cheap technology at this site is (in millions): $70  (.4  2 + .5  3 + .1  5) - $100 = $96 • This is a naïve NPV calculation, however. price med site OK site great site extraction profits per barrel probability x yield (in millions) cost MBA201a - Fall 2009

  5. Other real option examples • Companies are choosing to reverse choice and chance nodes: • Hewlett Packard’s printer production decision. • Old power plants with high running costs are kept around in case prices spike. MBA201a - Fall 2009

  6. Winglets • Besides the price of oil, and the resulting price of jet fuel, what other factors would go into Southwest’s decision analysis for installing winglets on a particular plane? • As the price of oil has climbed, what do you think has happened to the price an airline pays for installing winglets? • Compare what the article implies about Southwest’s and Alaska’s analyses about whether or not to install winglets on their planes. MBA201a - Fall 2009

  7. Real options • “Real” and “financial” options are the same animal. • A financial put option on the S&P500 gives you (for some cost) the right to sell the S&P500 at some strike price X at some point in the future after you’ve acquired information about where the stock market is going. • The value of an option depends on: • the likelihood you will exercise it, and • the expected profit when you do exercise it. • The higher the variance in possible returns, the higher the value of the option. MBA201a - Fall 2009

  8. Ask yourself: • Do I need to commit to a decision now, or would waiting provide me with more information? • What would this new information be worth? Would it be worth more than the cost, if any, of waiting? • If I commit to a decision now, to what extent can I back out of it? MBA201a - Fall 2009

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