EM11 - Real options and project evaluation. (Part 1)

This clip is part of Professor Campbell Harvey's advanced MBA elective on Large Scale Project Evaluation in Emerging Markets

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Closed Caption:

one of the most significant mistakes
that is making capital budgeting project
evaluation
is ignoring the value of certain real
options
indeed I think they're too
significant mistakes that are made we've
talked about one mistake already and
that's the mistake of signing and
discount rate to a project that doesn't
reflect the risk of that project but
reflects the risk of the corporation as
a whole
and that's really a mistake in terms of
choosing a discount rate what I'm
talking about is a mistake in terms of
choosing or estimating cash flows what I
like to do and certainly the the text
material of this lecture is extensive
what I'd like to do is just to give a
bit of an introduction to some of the
real options that exist and how to deal
with it
let me start with an example it's a very
simple example
we're looking at building up power
generation plant and their two competing
possibilities to competing technologies
one of the plants is simply an oil fire
plant the second plant is oil fire but
it's got to keep ability of switching
the coal
the plant has got this capability of
switching the coal is more expensive to
construct we do our standard project
evaluation type of analysis we got
expected while prices we figure out our
expected cash flows and it looks like
the hundred-percent oil fire plant has a
larger net present value and we can only
choose one
so that's the plant we choose the
problem with this sort of analysis that
uses the expected cash flows is that it
ignores the possibility that there is a
value to the ability to switch from oil
to call there are scenarios where oil
becomes very expensive and that this
plant is not profitable given certain
controls on energy prices and it would
be profitable if we could switch to Cole
this is an example of classic example of
an input mix option and that option is
valuable
now you might think
how to evaluate how do I put that in the
cash flows and their two approaches
one approach would be actually try to
model and value that option in some sort
of binomial or black-scholes like
framework and then we can simply add
value to the auction at the value of the
option to the bottom line in terms of
net present value actually what I tend
to prefer is what we do our project
evaluation not to simply use like one
line for expected cash flows but to do
some money Carlo analysis is crystal
ball or something like that and look
explicitly at different possible paths
for oil prices and when we actually look
at those paths it's clear that if the
price goes up certain amount that we
trigger to switch to Cole
and the cash flows reflect that switch
so the monte carlo type of analysis we
construct such that the input mix is
actually is actually operational
and then our cash flows properly reflect
the value of this auction so indeed what
you could do is to kind of like back out
the value of the option by looking at
the project without any switching just
keep it a hundred percent oil look at
all the Monte Carlo has oil price and
then you can look at it with the
possibility of switching and take the
difference in value and that's going to
be the value of the option so input mix
flexibility is important real option is
maybe the most intuitive there's also
the possibility of an output exception
so it might be the case that you can
change the mix of your product output
and that's valuable because you would
want to allocate or wait more the
product and Scott higher price depending
on market conditions
so put mix options are important
there's various options that are very
intuitive that are often ignored such as
the the auction to stop production if
you
market conditions are not that favorable
a temporary stop and then a restart of
course are costs associated with
stopping but at some point the product
the price goes solo that it makes sense
to actually stop and then when it
sufficiently recovers and you can
restart
there is something related to this
called an intensity option so that we
can turn up the the amount of output
being produced or turn down the amount
about being produced depending upon
market conditions that is a valuable
option
they're related to this is the option to
expand so if the price goes sufficiently
high there might be an option built into
the original project to expand capacity
that needs to be technically
consideration
there's the option to contract which is
analogous that if the product price does
not perform on kind of a positive for
the upper part of the decision tree then
you can actually contract
I guess the final one here that's a
that's quite important is the option to
abandon that is a valuable option if
you've got the option to abandon it
needs to be taken into account in the
decision tree type of analysis the
probabilities uncertain no just
suggested
that is an important real option that
needs to be taken into account
as many other types of real options out
there and I could talk for a very long
time on these types of options
some of them are extremely subtle for
example shadow cost options in example i
like to give here is corporation a
pursues a project was called a project B
and Part the cost of project B is that
it will take some of the time of the
management of a two-run project being
well if things don't go well for project
be in some of those monte carlo pads or
nodes on the decision tree it might be
dad extra time of management of a needs
to be devoted to be and if the
management of a is devoting its time to
be it's not devoting its time to the
affairs of a and their other projects
that's a real channel cost something
that needs to be figured into
valuation you might say all lot of these
three options just seem seem like things
that we kind of forgot to include in our
net present value analysis and I think
that's exactly the way to look at this
so don't let somebody tell you well net
present value is wrong because it
doesn't include some of these options
the net present value is correct
the fundamental basis of net present
value is exactly what we want to do but
when you actually implement you that
present value it might be that you've
forgotten or ignored certain factors
that are important and I think it's
useful to think about the real option
paradigm because people help us identify
some of these things that have been
forgotten