3/27/2003

Chapter 17. Tool Kit for Financial Options and Real Options

Note: This sheet contains the tool kit for Financial Options. The tool kit for Real Options is in the sheet
with the TAB labeled "Real Options."

FINANCIAL OPTIONS
An option is a contract which gives its holder the right to buy (or sell) an asset at a predetermined price within
a specified period of time. Option contracts, though often quoted in terms of single shares, usually are
contracts for a 100 shares. A call option describes a situation in which one investor may sell to someone the
right to buy his/her shares of a stock over some interval of time. In this scenario, the writer of the call option
(the party that surrenders the right to exercise) is said to hold a short position on the option. Meanwhile, the
party that has purchased this right to buy is said to hold a long position on the option. The predetermined
price that the stock may be purchased for is called the strike, or exercise, price. When an investor "writes"
call options against stock held in his/her portfolio, this is called a "covered call". When the call options are
written without the stock to back them up, they are they are called "naked calls". When the exercise price is
below the current market price, the call option is said to be "in-the-money". Likewise, when the exercise
price exceeds the current market price, the call option is said to be "out-of-the-money". For instance, if you
believed that the price of stock was primed to rise, a call option would allow you to capture a profit off of the
rise in price.

A put option allows you to buy the right to sell a stock at a specified price within some future period. If you
happened to believe that the price of a stock was ready to fall, a put option would allow you the opportunity to
turn a profit out of that decline. In the cases of both call and put options, the profit or loss made on an
options transaction is determined by the value of the underlying asset, the strike price of the option, and the
price of the option.

FOR A CALL, AT EXPIRATION

If the value of the underlying asset exceeds that of the strike price, the profit/loss from the call
transaction would be equal to the difference between the value of the asset and the strike price less
the price of the call. In this case there could be either a profit or loss depending upon the spread at
exercise and the price of the call.

If the value of the underlying asset equals that of the strike price, the profit/loss from the call
transaction would be equal to the price of the call, because whether exercised or unexercised the
call value would be zero. In this case there is a loss equal to the price of the call.

If the value of the underlying asset is less than that of the strike price, the profit/loss from the call
transaction would be equal to the price of the call, because the option would not be exercised if the
strike price was greater than the market price. In this case there is a loss equal to the price of the
call.

FOR A PUT, AT EXPIRATION

If the value of the underlying asset is less than that of the strike price, the profit/loss from the put
transaction would be equal to the difference between the strike price and value of the asset less the
price of the put. In this case there could be either a profit or loss depending upon the spread at
exercise and the price of the put.

If the value of the underlying asset equals that of the strike price, the profit/loss from the put
transaction would be equal to the price of the call, because whether exercised or unexercised the
put value would be zero. In this case there is a loss equal to the price of the put.

If the value of the underlying asset exceeds that of the strike price, the profit/loss from the put
transaction would be equal to the price of the put, because the option would not be exercised if the
market price was greater than the strike price. In this case there is a loss equal to the price of the
put.

PROBLEM
Suppose you decided to begin investing in options. You chose to purchase a call option on ABC, Inc. with a
strike of 80 for $8.90. You buy a put option on DEF Industries with a strike of $40 for $4.65. Lastly, you
buy a call on GHI Technologies with a strike of 65 for $1.20. At expiration, ABC, DEF, and GHI have stock
prices of $95.50, $36.25, and $63.75, respectively. These options were purchased on the same day and
expired on the same day. What is the profit/loss for each options position? What is the profit/loss of the
investment portfolio.
Call Put Call
ABC DEF GHI
Price of the option $8.90 $4.65 $1.20
Value of stock (P or S) $95.50 $36.25 $63.75
Strike price (X) $80.00 $40.00 $65.00

Gain on the option $15.50 $3.75 $0.00

Price of the option $8.90 $4.65 $1.20
Profit/loss $6.60 ($0.90) ($1.20)
To find the gain on the options, we use the "max" function. The max function in Excel returns the largest
value within a specified range. We will evaluate the "max" between the stock price minus the strike price
and zero, for the call option(s). Likewise, we solve the max between the strike price minus the stock price
and zero for the put option(s). The rationale is that if the difference between the stock price and the strike
price for the given scenario is positive, that gain is captured. Whereas, if it is negative, the option would
not be exercised and there would be no gain on the option. By subtracting the price of the option from the
gain on the option, we find the net profit or loss from the investment.

LOOKING AT EXERCISE AND MARKET VALUE OF AN OPTION

We have established that at expiration a call option's value is simply the current price of the stock minus
the strike price. However, at any point prior to maturity, it is quite difficult to determine the value of an
option. Now, we must account for factors such as time to maturity and volatility. In other words, there is
a time value factor that simple subtraction can not account for.

Consider the case of Space Technology, Inc. (STI) whose common stock is currently trading at $21. We
will look at an option on STI's stock (with strike of 20), and look at the options value in different states of
the world. We calculate the exercise value of the option by simply subtracting the stock price from the
strike price, if exercised, or zero, if the option is not exercised. Once again, we use the MAX function.
The market values for the option we will treat as given information (it could be looked up in the newspaper).
The last column represents the difference between the market value and the exercise value of this option
in these different states of the world. We have graphed this relationship below.

Option Value
Price of Strike Exercise Market
the stock Price Value Value Premium
(1) (2) (3) (4) (5)
$0 $20.00 $0.00 $0.00 $0.00
$10 $20.00 $0.00 $2.00 $2.00
$20.00 $20.00 $0.00 $8.00 $8.00
$21.00 $20.00 $1.00 $8.75 $7.75
$22.00 $20.00 $2.00 $9.50 $7.50
$30.00 $20.00 $10.00 $16.00 $6.00
$40.00 $20.00 $20.00 $24.50 $4.50
$50.00 $20.00 $30.00 $33.50 $3.50
$73.00 $20.00 $53.00 $54.50 $1.50
$98.00 $20.00 $78.00 $79.00 $1.00

Exercise Value vs. Market Value of Options

$80.00
$70.00
$60.00
$50.00 Exercise Value
$40.00 Market Value
$30.00
$20.00
$10.00
$0.00
($10.00)$0 $20 $40 $60 $80 $100 $120

We can call this difference between the market and exercise values the time value of the option. There are
three factors that drive this premium. They are: (1) the option's term to maturity, (2) the variability of the
stock price, and (3) the risk-free rate. What we find is that there is a negative relationship between stock
price and the risk-free rate, but positive relationships with the time to maturity and the volatility of the
stock. However, trying to determine the nature and magnitudes of these relationships, prior to 1973, was
very difficult. In 1973, the Black-Scholes Option Pricing Model was developed. Using continuous time
mathematics and making several assumption, the Black-Scholes Option Pricing Model was born.
BLACK-SCHOLES OPTION PRICING MODEL

In deriving this option pricing model, Black and Scholes made the following assumptions:
1. The stock underlying the call option provides no dividends or other distributions during the
life of the option.
2. There are no transaction costs for buying or selling either the stock or the option.
3. The short-term, risk-free interest rate is known and is constant during the life of the option.
4. Any purchaser of a security may borrow any fraction of the purchase price at the short-term,
risk-free interest rate.
5. Short selling is permitted, and the short seller will receive immediately the full cash proceeds
of today's price for a security sold short.
6. The call option can be exercised only on its expiration date.
7. Trading in all securities takes place continuously, and the stock price moves randomly.

The derivation of the Black-Scholes model rests on the concept of a riskless hedge. By buying shares of a
stock and simultaneously selling call options on that stock, an investor can create a risk-free investment
position, where gains on the stock are exactly offset by losses on the option. Ultimately, the Black-Scholes
model utilizes these three formulas:

V = P[ N (d1) ] - X e-r t [ N (d2) ] Note: r is the risk free rate, rRF.

d1 = { ln (P/X) + [rRF + s2 /2) ] t } / (s t1/2)

d2 = d1 - s (t 1 / 2)

In these equations, V is the value of the option. P is the current price of the stock. N(d1) is the area beneath
the standard normal distribution corresponding to (d1). X is the strike price. rRF is the risk-free rate. t is the
time to maturity. N(d2) is the area beneath the standard normal distribution corresponding to (d2). s, or
usually sigma, is the volatility of the stock price, as measured by the standard deviation.

Looking at these equations we see that you must first solve d1 and d2 before you can proceed to value the option.

This model is widely used by options traders and is generally considered to be the standard for option
pricing. Many hand-held calculators and computer programs have this formula permanently stored in.
We now use Excel to write a "program", if you will, for the Black-Scholes pricing model in Excel. We will
construct our "program" to price the option described in the text. The stock the option is written on has a
current market price of $20, the strike price is $20, the risk-free rate of interest is 12%, time to maturity
is 3 months (0.25 years), and the stock prices annual variance is 0.16. Using this information, we will use
the Black-Scholes model.

First, we will lay out the input data given to us in the setup of the problem.

P $20
X $20
rRF 12%
t 0.25 0.25
s2 0.16 0.16

Now, we will use the formula from above to solve for d1.

(d1) = 0.250

Having solved for d1, we will now use this value to find d2.

(d2) = 0.050

At this point, we have all of the necessary inputs for solving for the value of the call option. We will use the
formula for V from above to find the value. The only complication arises when entering N(d1) and N(d2).
Remember, these are the areas under the normal distribution. Luckily, Excel is equipped with a function that can
determine cumulative probabilities of the standard normal distribution. This function is located in the list of
statistical functions, as "NORMSDIST". For both N(d1) and N(d2), we will follow the same procedure of using
this function in the value formula. The data entries for N(d1) are shown below. (Nd2) would be identical except
that "D194" would be entered for "X", rather than "D190".

D190
 N(d1) = 0.5987

N(d2) = 0.5199

By applying this method for cumulative distributions, we can solve for the option value using the formula above.

V = $1.883

We see the actual market value of the option would be $1.883.

EFFECTS OF OPM FACTORS ON THE VALUE OF A CALL OPTION

Out of curiosity, let us now turn our attention to determining how sensitive the call option value is to the
five factors of the Black-Scholes OPM. We will set up data tables for each factor determining the call value
if the specified input is changed plus or minus 15% and 30%.

% change P $1.883 % change X $1.883

-30% $14 0.0705 -30% $14 6.4470
-15% $17 0.5512 -15% $17 3.8263
0% $20 1.8827 0% $20 1.8827
15% $23 4.0554 15% $23 0.7719
30% $26 6.7341 30% $26 0.2715

% change t $1.883 % change rRF $1.883

-30% 0.175 1.5379 -30% 8.4% 1.7930
-15% 0.213 1.7162 -15% 10.2% 1.8376
0% 0.250 1.8827 0% 12.0% 1.8827
15% 0.288 2.0397 15% 13.8% 1.9284
30% 0.325 2.1892 30% 15.6% 1.9747

% change s2 $1.883
-30% 0.112 1.6304
-15% 0.136 1.7620
0% 0.160 1.8827
15% 0.184 1.9947
30% 0.208 2.0996

OPM Factors effects on call option value

$8.00
$7.00
$6.00
Stock Price
Option Value

$5.00
Time to Maturity
$4.00
Variance
$3.00 Strike Price
$2.00 Risk-Free Rate
$1.00 Input Data

$-
1 2 3 4 5
Percentage Change

From this graph, we see that the strongest influences on option value are the stock and the exercise prices.
Meanwhile, time to maturity, the risk-free rate, and variance have only marginally positive correlations with
the value of the option.
 -30% -15% 0% 15% 30%
0.0705 0.5512 1.8827 4.0554 6.7341
1.5379 1.7162 1.8827 2.0397 2.1892
1.6304 1.762 1.8827 1.9947 2.0996
6.447 3.8263 1.8827 0.7719 0.2715
1.793 1.8376 1.8827 1.9284 1.9746
 5/9/2002

Chapter 17. Tool Kit for Financial Options and Real Options

Note: This sheet contains the tool kit for Real Options. The tool kit for Financial Options is in the
sheet with the TAB labeled "Financial Options."

REAL OPTIONS: THE INVESTMENT TIMING OPTION

Murphy Systems is considering a project that will create a new type of hand-held device for connecting to the Internet.
The cost of the project is $50 million, but the future cash flows are uncertain. Murphy estimates a 25% probability that
the new Internet device will be very popular in which case the project will generate cash flows of $30 million each year
for three years. There is a 50% probability generating cash flows of $25 million each year for three years.
Unfortunately, there is a 25% chance that the Internet device will not be popular, which means that the project will
generate only $5 million per year in cash flows. The cost of capital for this project is 14%.

WACC= 14%
Risk-free rate = 6%
Initial cost of project= $50

DCF Analysis

Expected annual cash flows (in millions):

Probability Cash Flow Prob. x CF
25% $33 $8.25
50% $25 $12.50
25% $5 $1.25

Expected CF = $22.00

Time Line Year 0 1 2 3

Expected CF ($50) $22.00 $22.00 $22.00

NPV = $1.08

Figure 17-2 DCF and Decision Tree Analysis for the Investment Timing Option
(Millions of Dollars)

Part 1. Scenario Analysis: Proceed with Project Today

Future Cash Flows NPV of this Probability
2002 2003 2004 2005 Scenarioc Probability x NPV Std Deviation

$33 $33 $33 $26.61 0.25 $6.65

High
-$50 Average $25 $25 $25 $8.04 0.50 $4.02
Low
$5 $5 $5 -$38.39 0.25 -$9.60
1.00

Expected value of NPVs = $1.08

Standard Deviationa = $24.02

Coefficient of Variationb = 22.32

Part 2. Decision Tree Analysis: Implement in One Year Only if Optimal
Future Cash Flows NPV of this Probability
2002 2003 2004 2005 2006 Scenariod Probability x NPV Std Deviation

-$50 $33 $33 $33 $23.35 0.25 $5.84

High
Wait Average -$50 $25 $25 $25 $7.05 0.50 $3.53
Low
$0 $0 $0 $0 $0.00 0.25 $0.00
1.00

Expected value of NPVs = $9.36

Standard Deviationa = $8.57

Coefficient of Variationb = 0.92

Notes: a
The standard deviation is calculated as in Chapter 3.
b
The coefficient of variation is the standard deviation divided by the expected value.
c
The WACC is 14%.
d
The NPV in Part 2 is as of 2002. Therefore, each of the project cash flows is discounted back one more
year than in Part 1.

Figure 17-3 Sensitivity Analysis for the Investment Timing Option Decision Tree
(Millions of Dollars)

Part 1. Decision Tree Analysis: Implement in One Year Only if Optimal (Discount Cost at the Risk-Free Rate and
Operating Cash Flows at the WACC)

Future Cash Flows NPV of this Probability

2002 2003 2004 2005 2006 Scenarioc Probability x NPV Std Deviation

-$50 $33 $33 $33 $20.04 0.25 $5.01

High
Average -$50 $25 $25 $25 $3.74 0.50 $1.87
Low
$0 $0 $0 $0 $0.00 0.25 $0.00
1.00

Expected value of NPVs = $6.88

Standard Deviationa = $7.75

Coefficient of Variationb = 1.13

Part 2. Sensitivity Analysis of NPV to Changes in the Cost of Capital Used to Discount Cost and Cash Flows

Cost of Capital Used to Discount the 2003 Cost

$6.88 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0%
Cost of Capital Used to Discount the
2004-2006 Operating Cash Flows

8.0% $13.11 $13.46 $13.80 $14.14 $14.47 $14.79 $15.11

9.0% $11.78 $12.13 $12.47 $12.81 $13.14 $13.47 $13.78
10.0% $10.50 $10.85 $11.20 $11.53 $11.86 $12.19 $12.51
11.0% $9.27 $9.62 $9.97 $10.30 $10.64 $10.96 $11.28
12.0% $8.09 $8.44 $8.78 $9.12 $9.45 $9.78 $10.09
13.0% $6.95 $7.30 $7.64 $7.98 $8.31 $8.64 $8.95
14.0% $5.85 $6.20 $6.54 $6.88 $7.21 $7.54 $7.85
15.0% $4.79 $5.14 $5.48 $5.82 $6.15 $6.48 $6.79
16.0% $3.77 $4.12 $4.46 $4.80 $5.13 $5.45 $5.77
17.0% $2.78 $3.13 $3.47 $3.81 $4.14 $4.46 $4.78
18.0% $1.83 $2.18 $2.52 $2.86 $3.19 $3.51 $3.83

Notes: a
The standard deviation is calculated as in Chapter 3.
b
The coefficient of variation is the standard deviation divided by the expected value.
c
The operating cash flows in years 2004-2006 are discounted at the WACC of 14%. The cost in 2003 is
discounted at the risk-free rate of 6%.
Real Option Analysis

the project, so the time to maturity of the option is one year. If the company exercises the option, it must pay an exercise
price equal to the cost of implementing the project. If the company does implement the project, it gains the value of the
project. If you exercise a call option, you will own a stock that is worth whatever its price is. If the company implements
the project, it will gain a project, whose value is equal to the present value of its cash flows. Therefore, the present value
of a project's future cash flows is analogous to the current value of a stock. The rate of return on the project is equal to
its cost of capital. To find the value of a call option, we need the standard deviation of its rate of return; to find the value
of this real option, we need the standard deviation of the projects expected rate of return.

The first step is to find the value of the project's future cash flows, as of the time the option must be exercised. We also
need the standard deviation of the project's value as of the date it must be exercised. Finally, we need the present value
of the project's future cash flows.

Figure 17-4 Estimating the Input for "Stock Price" in the Option Analysis
of the Investment Timing Option (Millions of Dollars)

Future Cash Flows PV of this Probability

2002 2003 2004 2005 2006 Scenarioc Probability x PV Std Deviation

$33 $33 $33 $67.21 0.25 $16.80

High
Average $25 $25 $25 $50.91 0.50 $25.46
Low
$5 $5 $5 $10.18 0.25 $2.55
1.00

Expected value of PVs = $44.80

Standard Deviationa = $21.07

Coefficient of Variationb = 0.47

Notes: a
The standard deviation is calculated as in Chapter 3.
b
The coefficient of variation is the standard deviation divided by the expected value.
c
The WACC is 14%. All cash flows in this scenario are discounted back to 2002.

Figure 17-5 Estimating the Input for "Stock Return Variance" in the Option Analysis
of the Investment Timing Option (Millions of Dollars)

Part 1. Find the Value and Risk of Future Cash Flows at the Time the Option Expires

PV in 2003
Future Cash Flows for this Probability
2002 2003 2004 2005 2006 Scenarioc Probability x PV2002 Std Deviation

$33 $33 $33 $76.61 0.25 $19.15

High
Average $25 $25 $25 $58.04 0.50 $29.02
Low
$5 $5 $5 $11.61 0.25 $2.90
1.00

Expected value of PV2003 = $51.08

Standard Deviation of PV2003a = $24.02

Coefficient of Variation of PV2003b = 0.47

Part 2. Direct Method: Use the Scenarios to Directly Estimate the Variance of the Project's Return

Probability
Price2002d PV2003e Return2003f Probability x Return2003 Std Deviation

$76.61 71.0% 0.25 17.8%

High
$44.80 Average $58.04 29.5% 0.50 14.8%
Low
$11.61 -74.1% 0.25 -18.5%
1.00

Expected return = 14.0%

Standard deviation of returna = 53.6%

Variance of returng = 28.7%

Part 3. Indirect Method: Use the Scenarios to Indirectly Estimate the Variance of the Project's Return

Expected "price" at the time the option expiresh = $51.08

Standard deviation of expected "price" at the time the option expiresi = $24.02
Coefficient of variation (CV) = 0.47
Time (in years) until the option expires (t) = 1

Variance of the project's expected return = ln(CV2+1)/t = 20.0%

Notes: a
The standard deviation is calculated as in Chapter 3.
b
The coefficient of variation is the standard deviation divided by the expected value.
c
The WACC is 14%. The 2004-2006 cash flows are discounted back to 2003.
d
The 2002 price is the expected PV from Figure 15-4.
e
The 2003 PVs are from Part 1.
f
The returns for each scenario are calculated as (PV2003 - Price2002)/Price2002.
g
The variance of return is the standard deviation squared.
h
The expected "price" at the time the option expires is taken from Part 1.
i
The standard deviation of expected "price" at the time the option expires is taken from Part 1.

Figure 17-6 Estimating the Value of the of the Investment Timing Option Using
a Standard Financial Option (Millions of Dollars)

Part 1. Find the Value of a Call Option Using the Black-Scholes Model

Real Option
rRF = Risk-free interest rate = 6%
t= Time until the option expires = 1
X= Cost to implement the project = $50.00
P= Current value of the project = $44.80 a

s2 = Variance of the project's rate of return = 20.0% b

d1 = { ln (P/X) + [rRF + s2 /2) ] t } / (s t1/2 ) = 0.112

d2 = d1 - s (t 1 / 2) = -0.33
N(d1)= = 0.54
N(d2)= = 0.37

V = P[ N (d1) ] - Xe-rRF t [ N (d2) ] = $7.04

Part 2. Sensitivity Analysis of Option Value to Changes in Variance

Variance Option Value

$7.04
12.0% $5.24
14.0% $5.74
16.0% $6.20
18.0% $6.63
20.0% $7.04
22.0% $7.42
24.0% $7.79
26.0% $8.15
28.0% $8.49
30.0% $8.81
32.0% $9.13

Notes: a
The current value of the project is taken from Figure 17-4.
b
The variance of the project's rate of return is taken from Part 3 of Figure 17-5.

REAL OPTIONS: THE GROWTH OPTION (Note: see the Chapter 17 Web Extension for more details.)

Kidco Corporation designs and produces products aimed at the pre-teen market. Most of these products have a very
short life cycle, given the rapidly changing tastes of pre-teens. Kidco is considering one such project, which will cost $30
million to implement and will last only two years. Kidco believes there is a 25 percent chance that the project will catch
the fancy of pre-teens. In this scenario, it will generate cash flows of $34 million in each of the next two years, after
which pre-teen tastes are likely to change. There is a 50 percent chance of average demand for the new product, which
produces expected cash flows of $19 million annually for two years. There is a 25% chance that the pre-teens won’t like
the product, and it will generate cash flows of only $3 million per year. The cost of capital for this project is 14%.

WACC= 14%
Risk-free rate= 6%
Initial cost= $30

DCF Analysis

Expected annual cash flows (in millions):

Probability Cash Flow Prob. x CF
25% $34 $8.50
50% $20 $10.00
25% $2 $0.50

Expected CF = $19.00

Time Line Year 0 1 2

Expected CF ($30) $19.00 $19.00

NPV = $1.29
Figure 17E-1 Scenario Analysis and Decision Tree Analysis for the Kidco Project
(Millions of Dollars)

Part 1. Scenario Analysis of Kidco's First Generation Project

Future Cash Flows NPV of this Probability

2002 2003 2003 Scenarioc Probability x NPV Std Deviation

$34 $34 $25.99 0.25 $6.50

High
-$30 Average $20 $20 $2.93 0.50 $1.47
Low
$2 $2 -$26.71 0.25 -$6.68
1.00

Expected Value of NPVs = $1.29

Standard Deviationa = $18.70

Coefficient of Variationb = 14.54

Part 2. Decision Tree Analysis of the Growth Option

Future Cash Flows NPV of this Probability

2002 2003 2004d 2005 2006 Scenarioe Probability x NPV Std Deviation

$34 $4 $34 $34 $42.37 0.25 $10.59

High
-$30 Average $20 -$10 $20 $20 $1.57 0.50 $0.79
Low
$2 $2 $0 $0 -$26.71 0.25 -$6.68
1.00

Expected Value of NPVs = $4.70

Standard Deviationa = $24.62

Coefficient of Variationb = 5.24

Notes: a
The standard deviation is calculated as in Chapter 3.
b
The coefficient of variation is the standard deviation divided by the expected value.
c
The operating cash flows are discounted by the WACC of 14%.
d
The total cash flows in 2004 are equal to the operating cash flows for the first generation
product minus the $30 million cost to implement the second generation product, if it is
optimal to do so.

e
The operating cash flows in years 2003-2006, which do not include the $30 million cost of
implementing the second generation project in 2003 for the high demand and average
demand scenarios, are discounted at the WACC of 14%. The implementation cost in 2004
for the high demand and average demand scenarios is discounted at the risk-free rate of 6%.
Table 17E-1 Sensitivity Analysis of the Kidco Decision Tree Analysis in Figure 17E-1
(Millions of Dollars)

Cost of Capital Used to Discount the $30 Million Implementation

Cost in 2004 of the Second Generation Project

Operating Cash Flows (These do not include the

Cost of Capital Used to Discount the 2003-2006

$30 million implemetation cost of the second

$4.70 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0%
8.0% $10.96 $11.36 $11.76 $12.14 $12.51 $12.88 $13.23
9.0% $9.61 $10.01 $10.41 $10.79 $11.16 $11.52 $11.88

generation project in 2004.)

10.0% $8.30 $8.71 $9.10 $9.49 $9.86 $10.22 $10.57
11.0% $7.04 $7.45 $7.84 $8.23 $8.60 $8.96 $9.31
12.0% $5.83 $6.23 $6.63 $7.01 $7.38 $7.75 $8.10
13.0% $4.65 $5.06 $5.45 $5.84 $6.21 $6.57 $6.92
14.0% $3.52 $3.92 $4.32 $4.70 $5.07 $5.44 $5.79
15.0% $2.42 $2.83 $3.22 $3.61 $3.98 $4.34 $4.69
16.0% $1.36 $1.77 $2.16 $2.54 $2.92 $3.28 $3.63
17.0% $0.33 $0.74 $1.13 $1.52 $1.89 $2.25 $2.60
18.0% -$0.66 -$0.25 $0.14 $0.52 $0.90 $1.26 $1.61

Figure 17E2 Estimating the Input for "Stock Price" in the Growth Option Analysis
of the Investment Timing Option (Millions of Dollars)

Future Cash Flows PV of this Probability

2002 2003 2004 2005 2006 Scenarioc Probability x PV Std Deviation

$34 $34 $43.08 0.25 $10.77

High
Average $20 $20 $25.34 0.50 $12.67
Low
$2 $2 $2.53 0.25 $0.63
1.00

Expected value of PVs = $24.07

Standard Deviationa = $14.39

Coefficient of Variationb = 0.60

Notes: a
The standard deviation is calculated as in Chapter 3.
b
The coefficient of variation is the standard deviation divided by the expected value.
c
The WACC is 14%. All cash flows in this scenario are discounted back to 2002.

Figure 17E-3 Estimating the Input for "Stock Return Variance" in the
Growth Option Analysis (Millions of Dollars)

Part 1. Find the Value and Risk of Future Cash Flows at the Time the Option Expires

PV in 2004
Future Cash Flows for this Probability
2002 2003 2004 2005 2006 Scenarioc Probability x PV2003 Std Deviation

$34 $34 $55.99 0.25 $14.00

High
Average $20 $20 $32.93 0.50 $16.47
Low
$2 $2 $3.29 0.25 $0.82
1.00

Expected value of PV2004 = $31.29

Standard Deviation of PV2004a = $18.70

Coefficient of Variation of PV2004b = 0.60

Part 2. Direct Method: Use the Scenarios to Directly Estimate the Variance of the Project's Return

Probability
Price2002d PV2004e Return2004f Probability x Return2003

$55.99 52.5% 0.25 13.1%

High
$24.07 Average $32.93 17.0% 0.50 8.5%
Low
$3.29 -63.0% 0.25 -15.8%
1.00

Expected return = 5.9%

Standard deviation of returna = 42.3%

Variance of returng = 17.9%

Part 3. Indirect Method: Use the Scenarios to Indirectly Estimate the Variance of the Project's Return

Expected "price" at the time the option expiresh = $31.29

Standard deviation of expected "price" at the time the option expiresi = $18.70
Coefficient of variation (CV) = 0.60
Time (in years) until the option expires (t) = 2

Variance of the project's expected return = ln(CV2+1)/t = 15.3%

Notes: a
The standard deviation is calculated as in Chapter 3.
b
The coefficient of variation is the standard deviation divided by the expected value.
c
The WACC is 14%. The 2005-2006 cash flows are discounted back to 2004.
d
The 2002 price is the expected PV from Figure 17E-2.
e
The 2004 PVs are from Part 1.
f
The returns for each scenario are calculated as (PV2004/ Price2002)0.5 - 1.
g
The variance of return is the standard deviation squared.
h
The expected "price" at the time the option expires is taken from Part 1.
i
The standard deviation of expected "price" at the time the option expires is taken from Part 1.

Figure 17E-4 Estimating the Value of the of the Growth Option Using
a Standard Financial Option (Millions of Dollars)

Part 1. Find the Value of a Call Option Using the Black-Scholes Model

Real Option
rRF = Risk-free interest rate = 6%
t= Time until the option expires = 2
X= Cost to implement the project = $30.00
P= Current value of the project = $24.07 a

s2 = Variance of the project's rate of return = 15.3% b

d1 = { ln (P/X) + [rRF + s2 /2) ] t } / (s t1/2 ) = 0.096

d2 = d1 - s (t 1 / 2) = -0.46
N(d1)= = 0.54
N(d2)= = 0.32

V = P[ N (d1) ] - Xe-rRF t [ N (d2) ] = $4.34

Part 2. Sensitivity Analysis of Option Value to Changes in Variance

Variance Option Value

$4.34
11.3% $3.60
13.3% $3.98
15.3% $4.34
17.3% $4.68
19.3% $4.99
21.3% $5.29
23.3% $5.57
25.3% $5.84
27.3% $6.10
29.3% $6.35
31.3% $6.59

Notes: a
The current value of the project is taken from Figure 17E-2.
b
The variance of the project's rate of return is taken from Part 3 of Figure 17E-3.

Total value = NPV of first generation project + Value of growth option

Total value = 1.29 + 4.34
Total value = 5.63

REAL OPTIONS: THE ABANDONMENT OPTION (Note: see the Chapter 17 Web Extension for more details.)

Intial Cost= $26

WACC= 12%
Risk free rate = 6%
After-tax salvage value = $14

DCF Analysis

Table 17E-2 Expected Operating Cash Flows for Project at Synapse Systems
(Millions of Dollars)
Operating Cash Flow
Demand Probability 2003 2004 2005 2006
High 25% $18 $23 $28 $33
Average 50% $7 $8 $9 $10
Low 25% -$8 -$9 -$10 -$12

Expected operating cash flow = $6.00 $7.50 $9.00 $10.25

Time Line Year 2002 2003 2004 2005 2006

Expected CF ($26) $6.00 $7.50 $9.00 $10.25

NPV = ($1.74)
Figure 17E-5 Scenario Analysis and Decision Tree Analysis for the Synapse Project
(Millions of Dollars)

Part 1. Scenario Analysis of the Project (Ignoring the Option to Abandon)

Future Cash Flows NPV of this Probability

2002 2003 2003 2004 2005 Scenarioc Probability x NPV Std Deviation

$18 $23 $28 $33 $49.31 0.25 $12.33

High
-$26 Average $7 $8 $9 $10 -$0.61 0.50 -$0.31
Low
-$8 -$9 -$10 -$12 -$55.06 0.25 -$13.77
1.00

Expected Value of NPVs = -$1.74

Standard Deviationa = $36.92

Coefficient of Variationb = -21.17

Part 2. Decision Tree Analysis of the Abandonment Option

Future Cash Flows NPV of this Probability

2002 2003d 2004e 2005e 2006e Scenariof Probability x NPV Std Deviation

$18 $23 $28 $33 $49.31 0.25 $12.33

High
-$26 Average $7 $8 $9 $10 -$0.61 0.50 -$0.31
Low
$6 $0 $0 $0 -$19.94 0.25 -$4.98
1.00

Expected Value of NPVs = $7.04

Standard Deviationa = $25.65

Coefficient of Variationb = 3.64

Notes: a
The standard deviation is calculated as in Chapter 3.
b
The coefficient of variation is the standard deviation divided by the expected value.
c
The operating cash flows are discounted by the WACC of 12%.
d
The cash flow in 2003 for the low demand scenario is equal to the -$8 million operating
cash flow plus the after-tax salvage value of $14 million, since Synapse will abandon the
proejct in this scenario.
e
The cash flows in 2004-2006 for the low demand scenario are zero, because Synapse
abandons the project immediately after the -$8 million operating loss in 2003.
f
The operating cash flows in years 2003-2006, which do not include the $14 million after-tax
salvage value, are discounted at the WACC of 12%. The $14 million salvage value in the low
demand scenario in 2003 is discounted at the risk-free rate of 6%.

Table 17E-3 Sensitivity Analysis of the Synapse Decision Tree Analysis in Figure 17E-5
(Millions of Dollars)

Cost of Capital Used to Discount the $14 Million After-tax Salvage Value in the Low Demand
Scenario of 2003.
Cost of Capital Used to Discount the 2003-
2006 Operating Cash Flows (These do not
include the $14 million after-tax salvage

$7.04 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0%

8.0% $10.18 $10.15 $10.12 $10.08 $10.05 $10.02 $9.99
9.0% $9.38 $9.34 $9.31 $9.28 $9.25 $9.22 $9.19
10.0% $8.60 $8.57 $8.54 $8.50 $8.47 $8.44 $8.41
value in 2003.)

11.0% $7.85 $7.82 $7.79 $7.76 $7.73 $7.70 $7.67

12.0% $7.13 $7.10 $7.07 $7.04 $7.01 $6.98 $6.95
13.0% $6.44 $6.41 $6.38 $6.34 $6.31 $6.28 $6.25
14.0% $5.77 $5.74 $5.71 $5.67 $5.64 $5.61 $5.58
15.0% $5.13 $5.09 $5.06 $5.03 $5.00 $4.97 $4.94
16.0% $4.50 $4.47 $4.44 $4.41 $4.37 $4.34 $4.31
17.0% $3.90 $3.87 $3.84 $3.80 $3.77 $3.74 $3.71
18.0% $3.32 $3.29 $3.25 $3.22 $3.19 $3.16 $3.13
Real Option Analysis Where Firm Has the Option to Abandon

Break the project into two projects plus an option to abandon the second project. Project A starts at time zero and lasts
one year. It has the initial cost and first-year operating cash flows of the original project. Project B begins at Year 2
and last through Year 4. It has no initial cost, but has the Year 2 through 4 operating cash flows of the original project.
There is also a real option that allows you to abandon Project B if the value of B at time 1 is less than the abandonment
amount.

Figure 17E-6 Breaking Synapse's Project into Two Separate Projects

of the Investment Timing Option (Millions of Dollars)

Part 1. DCF Analysis of Project A that Lasts One Year

Future Cash Flows NPV of this Probability
2002 2003 Scenarioc Probability x NPV Std Deviation

$18 -$9.93 0.25 -$2.48

High
-$26 Average $7 -$19.75 0.50 -$9.88
Low
-$8 -$33.14 0.25 -$8.29
1.00

Expected value of PVs = -$20.64

Standard Deviationa = $8.26

Coefficient of Variationb = (0.40)

Part 2. DCF Analysis of Project B that Starts in 2004, If Project A is Already in Place
Future Cash Flows NPV of this Probability
2002 2003 2004 2005 2006 Scenarioc Probability x NPV Std Deviation

$23 $28 $33 $59.24 0.25 $14.81

High
Average $8 $9 $10 $19.14 0.50 $9.57
Low
-$9 -$10 -$12 -$21.92 0.25 -$5.48
1.00

Expected value of PVs = $18.90

Standard Deviationa = $28.69

Coefficient of Variationb = 1.52

Notes: a
The standard deviation is calculated as in Chapter 3.
b
The coefficient of variation is the standard deviation divided by the expected value.
c
The WACC is 12%. All cash flows in this scenario are discounted back to 2002.

Figure 15E-7 Estimating the Input for "Stock Return Variance" in the
Abandonment Option Analysis (Millions of Dollars)

Part 1. Find the Value and Risk of Future Cash Flows at the Time the Option Expires

PV in 2003
Future Cash Flows for this Probability
2002 2003 2004 2005 2006 Scenarioc Probability x PV2003 Std Deviation

$23 $28 $33 $66.35 0.25 $16.59

High
Average $8 $9 $10 $21.44 0.50 $10.72
Low
-$9 -$10 -$12 -$24.55 0.25 -$6.14
1.00

Expected value of PV2003 = $21.17

Standard Deviation of PV2003a = $32.14

Coefficient of Variation of PV2003b = 1.518

Part 2. Direct Method: Use the Scenarios to Directly Estimate the Variance of the Project's Return

Probability
Price2002d PV2003e Return2003f Probability x Return2002

$66.35 251.1% 0.25 62.8%

High
$18.90 Average $21.44 13.4% 0.50 6.7%
Low
-$24.55 -229.9% 0.25 -57.5%
1.00

Expected return = 12.0%

Standard deviation of returna = 170.0%

Variance of returng = 289.2%

Part 3. Indirect Method: Use the Scenarios to Indirectly Estimate the Variance of the Project's Return

Expected "price" at the time the option expiresh = $21.17

Standard deviation of expected "price" at the time the option expiresi = $32.14
Coefficient of variation (CV) = 1.52
Time (in years) until the option expires (t) = 1

Variance of the project's expected return = ln(CV2+1)/t = 119.5%

Notes: a
The standard deviation is calculated as in Chapter 3.
b
The coefficient of variation is the standard deviation divided by the expected value.
c
The WACC is 12%. The 2004-2006 cash flows are discounted back to 2003.
d
The 2002 price is the expected NPV from Part 2 of Figure 17-12.
e The 2003 PVs are from Part 1.
f
The returns for each scenario are calculated as (PV2003/ Price2002) - 1.
g
The variance of return is the standard deviation squared.
h
The expected "price" at the time the option expires is taken from Part 1.
i
The standard deviation of expected "price" at the time the option expires is taken from Part 1.

Figure 17E-8 Estimating the Value of the of the Abandonment Option Using
a Standard Financial Option (Millions of Dollars)

Part 1. Find the Value of a Put Option Using the Black-Scholes Model

Real Option
rRF = Risk-free interest rate = 6%
t= Time until the option expires = 1
X= Salvage value if abandon = $14.00
P= Current value of the Project B = $18.90 a

s2 = Variance of Project B's rate of return = 175.0% b

d1 = { ln (P/X) + [rRF + s2 /2) ] t } / (s t1/2 ) = 0.934

d2 = d1 - s (t 1 / 2) = -0.39
N(d1)= 0.82
N(d2)= 0.35

V of Call = P[ N (d1) ] - Xe RF [ N (d2) ]

-r t
= $10.99

V of Put = Call - P + X e-rRF t

V of Put = $10.99 - $18.90 + $13.18
V of Put = $5.28
Part 2. Sensitivity Analysis of Put Option Value to Changes in Variance

Variance Option Value

$5.28
55.0% $2.29
75.0% $2.94
95.0% $3.51
115.0% $4.02
135.0% $4.48
155.0% $4.89
175.0% $5.28
195.0% $5.63
215.0% $5.96
235.0% $6.27
255.0% $6.56

Notes: a
The current value of the project is taken from Figure 17E-7.
b
The variance of the project's rate of return is taken from Part 3 of Figure 17E-7.

Total NPV= NPV of A + NPV of B + Value of abandonment option

Total NPV= -$20.64 + $18.90 + $5.28
Total NPV= $3.53
 Data for
Std Deviation

163

24

389

577 =Variance of PV
 Data for
Std Deviation

49

22

73 =Variance of PV

Data for
Std Deviation

43

12

60 =Variance of PV
 Data for
Std Deviation

125

19

300

444 =Variance of PV

Data for
Std Deviation

163

24

389

577 =Variance of PV
 Data for
Std Deviation

8.1%

1.2%

19.4%

28.7% =Variance of PV
 Data for
Std Deviation

153

196

350 =Variance of NPV

Data for
Std Deviation

355

247

606 =Variance of NPV

 Data for
Std Deviation

90

116

207 =Variance of PV

Data for
Std Deviation

153

196

350 =Variance of PV
 Data for
Std Deviation

5.4%

0.6%

11.9%

17.9% =Variance of PV
 Data for
Std Deviation

652

711

1,363 =Variance of NPV

Data for
Std Deviation

447

29

182

658 =Variance of NPV

 Data for
Std Deviation

29

39

68 =Variance of PV

Data for
Std Deviation

407

417

823 =Variance of PV

Data for
Std Deviation

510

522

1,033 =Variance of PV
 Data for
Std Deviation

142.9%

0.0%

146.3%

289.2% =Variance of PV