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Lecture 28

FINA 410 Lecture Notes - Lecture 28: Option Style, Profit Margin, Rainbow OptionPremium

12 pages53 viewsSummer 2017

Department
Finance
Course Code
FINA 410
Professor
Jean Mayer
Lecture
28

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CHAPTER 28 THE OPTION TO DELAY AND VALUATION IMPLICATIONS
In traditional investment analysis, the decision to accept a project only when return on
project > hurdle rate + NPV projets ased o CF’s ad disout rates
Limitation of this view is that it does not consider the options associated with many
investments.
One of the limitations of traditional investment analysis is that it is static and does not
do a good job of capturing the options embedded in an investment:
o the option to delay it
o The other opportunities in the future that may be available just because we took
the investment
o the option to abandon it, if the cash flows do not measure up.
These optios all add alue to projets ad a ake a ad iestet
(from traditional analysis) into a good one.
This chapter considers the option to wait and take the project in a later period
Why would a firm want to do this?
o If the PV of CF’s are olatile ad a hage oer tie, a projet that does ot
pass now (-NPV), may become valuable in the future
o Maybe the project has a +NPV, but the firm may gain from waiting because the
project has a higher value if taken at a later date
Most valuable when a company has exclusive right to invest in a project
and becomes less valuable as the barriers to entry decline.
Three cases where the option to delay can make a difference when valuing a firm:
o 1) undeveloped land in the hands of real estate investor or company
The choice of when to develop depends on owner, and will usually begin
to develop when real estate value increases enough to justify it
o 2) a firm that owns a patent
since patent represents a firm with exclusive right to produce a product
or service it should be valued as an option so we produce the
patented product?
o 3) a natural resource company that has undeveloped reserves that it can choose
to develop at a time of its choosingpresumably when the price of the resource
is high
THE OPTION TO DELAY A PROJECT
Usuall e look at CF’s ad disout rates ad opute the NPV to see if acceptable
Hoeer, CF’s ad rates hage oer tie changing NPV so a project that has
NPV today (rejected) may have a +NPV (accepted) in the future
o For regular firs, the fat that it a eoe positie i the future does’t
matter as they do not have a special advantage over their competitors (their
competitors will have a +NPV too)
In an environment where project can solely be taken by one firm, due to legal
restrictions or other barriers to entry the changes in the projects value over time are
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relevant and gives it the characteristics of a call option (right to buy) value = (V-X)
where X is initial upfront investment, and V is the PV of cash flows to the project
Payoff on the Option to Delay
NPVproject = V X
o X: initial up-front investment
o V= PV of expected cash inflows from investing in project
Now assuming the firm has exclusive rights if discount rate or cash flows changes
the PV of CF’s V) may change over time while the initial up-front investment (X) stays
the same
o So even if currently it has a NPV, it may still be a good project if the firm waits.
Decision rule:
o If V>X Invest in project as it has +NPV
o If V<X do not invest
if firm does not invest, it will still loose what it invested to get
exclusive rights to the project
Payoff diagram assuming firm has exclusive rights & firm holds out until end of period:
The profit diagram is that of a call:
o the underlying asset is the project
o the strike price of the option is the investment needed to take the project
We assume it to be constant
o the life of the option is the period for which the firm has rights to the project
o the value and variance of the underlying asset is represented by the PV of the
cash flows on this project and the expected variance in this PV
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Inputs for Valuing the Option to Delay
We need the same inputs as any option pricing model: value of underlying asset & the
variance in that value, time to expiration of the option, strike price, riskless rate, and the
equivalent of dividend yield.
Value of Underlying Asset:
o underlying asset is the project that firm has exclusive rights
o Value underlying asset = PVexpected CF’s not including intial investement
Solve PV with DCF using a risk adjusted discount rate
o May have a lot of error in CF estimates & PV especially for new business or if
it involves untested technology
This uncertainty is normal, and is what makes the option to delay
valuable
Variance in the Value of the Asset:
o The uertait o CF’s ad alue of the projet toda a oe fro either:
Potential market for product unknown
Technological shifts can change the cost structure and profitability of
product
o Value of option is largel deried fro ariae i CF’s higher variance =
higher value of the project delay option
So value of option to invest in a project in stable business < one in an
environment where technology, competition, and markets are changing
o Variance in PV can be estimated in one of three ways:
1. If we have invested in similar projects in the past, the variance in the
cash flows from those projects can be used as an estimate
Example. Gillet uses variance of introducing new blades
2. We can assign probabilities to various market scenarios, estimate cash
flows and a present value under each scenario, and then calculate the
variance across PVs
Could also use probabilities for each individual input, like market
share and profit margin, and use a simulation to solve variance in
the PV’s that eerge.
This approach tends to work best when there are only one or two
sources of significant uncertainty about future cash flows
3. We can use the variance in the value of firms involved in the same
business (as the project we are considering) as an estimate
Ex. Average variance of firms involved in software business can be
used as the variance in PV for software project.
Exercise Price on Option:
o Option to delay is exercised when firm owning rights decides to invest in it so
cost of making this investment is the exercise price
o Assumption: this cost remains constant (in PV $) and any uncertainty in this
iestet ith e refletig i PV of the CF’s o the produt
Expiration of Option & Riskless Rate:
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