Page 236 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 14: Real Options and Cross-border Investments

14.2.1 Applicability of Standard Techniques Notes

ROV is often contrasted with more standard techniques of capital budgeting, such as discounted
cash flow (DCF) analysis/net present value (NPV). Under this “standard” NPV approach, future
expected cash flows are present valued under the empirical probability measure at a discount
rate that reflects the embedded risk in the project. Here, only the expected cash flows are
considered, and the “flexibility” to alter corporate strategy in view of actual market realizations
is “ignored”. The NPV framework (implicitly) assumes that management is “passive” with
regard to their Capital Investment once committed. Some analysts account for this uncertainty
by adjusting the discount rate (e.g. by increasing the cost of capital) or the cash flows (using
certainty equivalents, or applying (subjective) “haircuts” to the forecast numbers). Even when
employed, however, these latter methods do not normally properly account for changes in risk
over the project’s lifecycle and hence fail to appropriately adapt the risk adjustment.
By contrast, ROV assumes that management is “active” and can “continuously” respond to
market changes. Real options consider each and every scenario and indicate the best corporate
action in any of these contingent events. Because management adapts to each negative outcome
by decreasing its exposure and to positive scenarios by scaling up, the firm benefits from
uncertainty in the underlying market, achieving a lower variability of profits than under the
commitment/NPV stance. Here the approach, known as risk-neutral valuation, consists in
adjusting the probability distribution for risk consideration, while discounting at the risk-free
rate.

Did u know? This technique is also known as the certainty-equivalent or martingale
approach, and uses a risk-neutral measure.
Given these different treatments, the real options value of a project is typically higher than the
NPV – and the difference will be most marked in projects with major flexibility, contingency,
and volatility. (As for financial options higher volatility of the underlying leads to higher

value).

14.2.2 Options-based Valuation

Although there is much similarity between the modelling of real options and financial options,
ROV is distinguished from the latter, in that it takes into account uncertainty about the future
evolution of the parameters that determine the value of the project, coupled with management’s
ability to respond to the evolution of these parameters. It is the combined effect of these that
makes ROV technically more challenging than its alternatives.
“First, you must figure out the full range of possible values for the underlying asset.... This
involves estimating what the asset’s value would be if it existed today and forecasting to see the
full set of possible future values... [These] calculations provide you with numbers for all the
possible future values of the option at the various points where a decision is needed on whether
to continue with the project.”

Notes When valuing the real option, the analyst must, therefore, consider the inputs to
the valuation, the valuation method employed, and whether any technical limitations
may apply.

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