Prof. Dr. Stefan Spinler Director, Kühne Institute for Logistics Management Group speaker, Supply Chain Management Group WHU – Otto Beisheim School of Management Burgplatz 2 56179 Vallendar Phone: +49 261 6509 430 e‐mail:
[email protected] [email protected]
Real Options Analysis Options Analysis
1.
Content
This course will present the methodology to value Real Options and illustrate applications in in‐ vestment decision making in a variety of business contexts: exploitation of natural resources, in‐ ternational production networks, networks, flexibility in equipment and capacity, software upgrades etc. Tra‐ ditional valuation methods, such as Net Present Value, are not suited to account for managerial action in the presence of unfolding contingencies or the staged nature of a n investment project. An alternative for the decision maker that finds increasingly widespread use is Real Options Analysis, which will be introduced as an analogy to valuation of financial options. Diverse types of real op‐ tions will be discussed, for instance the option to defer, to switch, to abandon as well as compound options, related to investment decisions. The analysis builds mostly on lattice tree models, Monte Carlo simulation will allow the student to do numerical analysis. The student is expected to be somewhat familiar with the mathematical tools necessary to value financial options. Each session will consist of a theoretical part focused on one particular aspect of real options valuation and a corresponding business case, which makes explicit some of the issues when applying the valuation models in practical circumstances. An important aspect of this course is the use of Excel spreadsheets to carry out the valuation of real options re‐ quired in the case assignments. 2.
Grading
The course grade will be based on one set of exercises (see session 02) (25%) and three case as‐ signments (75%). The case assignments are to be done in teams of three to five students, make sure that visiting students are integrated into the case teams. The submission (electronic format only!) will typically consist of a spreadsheet that contains the valuation model with appropriate com‐ ments. Use the following file format: case #
.xls. Be prepared to discuss your group’s results in class. 3.
Literature
Relevant literature for each session indicated below is on moodle.
... when evaluating investments, optionality is ubiquitous and unavoidable. If modern fi‐ nance is to have a practical and salutary impact on investment decision making, it is now option pricing problems problems. obliged to treat all major investment decisions as option pricing S. Ross: “Uses, Abuses and Alternatives to the Net‐Present‐Value Rule,” 1995
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Schedule Lecture 1, October 31 The Net Present Value approach to valuation, basic Real Options valuation
Presents key advantages as well as shortcomings of traditional valuation methods and introduces real op‐ tions as an alternative decision making tool. Topics: DCF, WACC, IRR, NPV, mapping of financial options into real options, examples for real options. Reading: T. Copeland, P. Tufano: A real‐world way to manage real options. Harvard Business Review , March 2004.
Lecture 2, November 02 Real Options: Binomial Lattices
The binomial lattice method – pioneered by Cox, Ross and Rubinstein – as a tool for valuation of real options is introduced. We discuss how dividends and time‐varying interest rates can be incorporated into the valu‐ ation. Topics: Risk‐neutral probabilities, replicating portfolio; European and American Call and Put Individual assignment (due: November 08) Valuation of various puts and calls using binomial lattices, will be distributed in class. Reading: Mun (2006), ROA, Chapter 6, pp. 123 – 162. Bailey et al. (2003), Unlocking the value of Real Options, 2003, pp. 4 – 19.
Lecture 3, November 08 Real Options: The option to switch and interaction of multiple options
The option to switch is prevalent in, for instance, international production networks: based on the evolution of exchange rates, production capacity may be shifted to the less expensive country. The value of being able to switch will be determined. Topics: Switching options: costless and costly switching; interaction of multiple options Case: Merck and Co. (A), Cornell In the context of preparing to launch a new pharmaceutical product, the MK640, the Merck Manufacturing Division has to decide on the scale and type of production capacity. Real options analysis will be utilized to quantify the different scenarios. Assignment: (due November 16) Advise the management of Merck by providing an analysis on the following issues:
How much capacity should be built? Should the production facility (PF) be easily expandable? Should it be designed with additional flexibility features?
Reading: Mun (2006), ROA, Chapter 7, pp. 163 – 189.
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Lecture 4, November 16 Investments into renewable energy and flexible generation assets
The risk of climate change makes it mandatory to introduce greater shares of renewable energy into gener‐ ation portfolios. Two issues will be studied in this session: How can Feed‐in Tariffs foster investment into renewable energy and at what cost? Given the intermittency of most renewable energy sources (wind, solar power), conventional flexible generation assets such as gas power stations are needed to smoothen supply. How can investments into such flexible power generation assets be incentivized? Topics: Real options in the electric power sector Case: Bidding for Antamina HBS (9‐297‐524) In June 1996, executives of the multinational mining company RTZ‐CRA contemplate bidding to acquire the Antamina copper and zinc mine in Peru. The Antamina project is being offered for sale by auction as part of the privatization of Peru's state mining company. RTZ‐CRA has to determine what the mine is worth and decide whether and how it should bid in the upcoming auction. The bidding rules put in place by the Peru‐ vian government dictate that each company's bid contain two components: an up‐front cash amount and an amount the bidder will invest to develop the property if development is warranted after further exploration is completed. Assignment: (December 01) • • •
In what way is the development of a copper mine such as Antamina a real option? In what way is the bidding structure put in place by the Peruvian government a real option? Build a spreadsheet to value the Antamina project. What are key assumptions and limitations of your model? Based on your model, prepare a bid under the following scenarios: If the winning bidder was legally forced to develop Antamina after completing the explora tion phase, and was required to pay the Peruvian government up‐front for this project, what is the most they would be willing to pay? If the winning bidder could choose to whether or not to develop Antamina at the end of two years, but was required to pay the Peruvian government a single up‐front fee for the right to develop the project, what is the most they would be willing to pay? Under the current bidding rules, the winning bidder states both an initial cash payment as well as an investment commitment that is paid only if they choose to develop the field. Bids are evaluated by summing up‐front amount and 30% of the investment commitment. If you proceed with development but fail to spend the full investment commitment, the govern‐ ment will fine you 30% of the difference. What is the most you would be willing to bid un‐ der these rules? How would you trade off these two components of the bid?
Reading: T. Couture, Y. Gagnon (2010): An analysis of feed‐in tariff remuneration models: Implications for renewable energy investment. Energy Policy 38, 955 – 965.
Lecture 5, December 01 Real Options: Monte Carlo simulation, rainbow options
Rainbow options are options that are valued on multiple underlyings, e.g., the sales of a new product may depend on price and quantity. The binomial approach will be enhanced to the quadranomial approach to value this kind of options. Monte Carlo simulation and the tools that come with it are shown to be a useful component of a real options analysis. Topics: Rainbow options with uncorrelated and correlated underlyings; foreign exchange rate risk.
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Case: Lufthansa Cargo AG: Capacity Reservation and Dynamic Pricing, WHU Presents a discussion of how to optimally structure flexibility contracts between the freight forwarder and the airline. Introduces options on capacity as a way to properly price the flexibility. Assignment: (due December 06)
How does Air Cargo differ from passenger business in terms of Revenue Management? What are the purposes of selling long‐term contracts? Does Lufthansa Cargo achieve its goals? Interpret the capacity reservation contracts in terms of real options. Provide a Monte – Carlo simulation to answer the following questions: The forwarding company TransAsia Inc. has regular customers that ship stuff from Ger‐ o many to Thailand. Total weekly demand averages 50 tons (normally distributed with standard deviation of 30 tons). Implement a newsboy model i n Excel with @risk that sim‐ ulates a CPA between TransAsia and LCAG. Make the following assumptions: TransAsia is paid $205/ton by its customers LCAG charges $160/ton under the CPA TransAsia can find additional capacity at $180/ton (spot market) LCAG’s variable cost is $100/ton. How much capacity should TransAsia optimally reserve? What are the expected profits of LCAG and TransAsia, respectively? Do the same for an option contract with a reservation fee of $60/ton and an execution fee o of $100/ton. Suppose that spot price is longer deterministic but rather normally distributed with a o mean of $180/ton and a standard deviation of $100/ton (make sure that negative values are truncated). Evaluate both types of contracts with this new data.
Reading: R. Hellermann, A. Huchzermeier, S. Spinler (2013): Options Contracts with Overbooking in the Air Cargo Industry. Decision Sciences 44 (2), 297 – 327.
Lecture 6, December 06 Further applications of real options: migration to electric vehicles, risk management via capacity options.
In this session, we discuss applications of real options to decisions on software upgrades. Moreover, a val‐ uation methodology for options on capacity is provided and properties of contingency contracts in the con‐ text of risk management are discussed. Topics: Software investment decisions, capacity option, flexibility contracts Reading: P. Kleindorfer, A. Neboian, A. Roset, S. Spinler (2012): Fleet renewal with electric vehicles at La Poste. Inter‐ faces, 42 (5), 465 – 477.
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