Real Options Tutorial (page 2)

Managerial Freedom Degree, Real Options, and Timing:

In most real investment opportunities there are managerial flexibilities (real options) embedded into the projects. The higher the managerial freedom degree, the higher is the value of the investment opportunity. Examples of quantification of the timing freedom degree value for offshore petroleum leases: (a) Bjerksund, 1991, table p.121; and (b) Laughton, 1991, table 1, p.74).
Managers frequently must decide about resources allocation in general, which there are many options. For example, managers in petroleum offshore regions, must decide the future of many oil and gas wells, and they can decide to:
(a) expand the well production (by stimulation, or by artificial lift), with a sunk cost of investment;
(b) waiting, keeping the status quo (opened or closed), preserving the resources (expensive rig and others);
(c) reactivation, the well is opened by a sunk cost of workover;
(d) temporary suspension ("mothballing"), many times without direct cost for close the well, but frequently with reactivation costs to be considered;
(e) switching use, changing the producing zone of the well or even by turning a producing well to injection well, by a sunk cost of re-completion, and considering the irreversible abandon of a well's production or zone; and
(f) abandonment, in some cases with switching use, in others because the legislation or costs, also needs to pay a sunk cost (rig, cement, and so on).
See also the figure "The Managerial Decisions" (file gif with 9930 bytes).
At oil or gas field scale, also real options like investment timing option (for to exercise the right to invest in the field); option to expand the production (through an increase in the wells' grid density, or by a water/gas injection project or by special recovery project) , paying a sunk cost for the new wells, chemicals, etc.; option to abandon for an alternative value like switch use or for scrap (can be positive or negative scrap value). See also the figure "The Main Real Options" (file gif with 9930 bytes). For a detailing of real option types and correlated bibliography, see Trigeorgis (1995, p.3, table1.1), and for an economic introduction view, see Dixit & Pindyck (1994, chapter 1).

For most capital investment in petroleum industry, the timing is the main option to be considered. In many cases, for large sunk cost like investment in offshore petroleum fields, is possible to consider only the timing option, see Bjerksund & Ekern (1990, p.66, and exhibit 2) and for a general model of options interactions, see Trigeorgis (1993)
Investment in petroleum E&P (exploration & production) can be view as sequential options or as compound options: buying a lease rights, an oil company has the option to explore (and validate or not the oil potential) the field. By exercising its option, paying the sunk cost of exploration (wells, seismic, etc.), the company can get the option to develop (or exploit) the field, and paying the larger sunk cost of the process, the development cost, the company gets, besides. the operational cash flow, the option to expand, close, switch use of some equipments, temporary suspension or abandon. See these sequential options, in the figure "Real Options in Petroleum E&P" (file gif with 24 KB)
In presence of intense competitive rivalry, like some markets of gasoline (or others products) distribution, the waiting value can be eroded, see Kester (1984, specially the exhibit III), and for a model using the game theory and real options approach, together, for the competitive case, see Smit & Ankum (1993) .

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Investment Rules: DCF versus Real Options

The decision approach for investments using the traditional discounted cash flow (DCF), relies in the net present value (NPV) rule: invest if NPV > 0; reject projects with NPV < 0; and for mutually exclusive projects, choose the higher NPV one.
These rules can mean very wrong decisions, investing in projects which waiting is better, or not investing in good R&D (or others with high technical uncertainty or growth options) because the static NPV is negative, or even choosing large projects to the detriment of small ones, because higher NPV (high absolute NPV doesn't mean "deep in the money").
See the figure "NPV Rules and Real Options" (file gif with 15243 bytes)
The real options approach rules: the investment opportunity needs to be "deep in the money", so NPV positive is not sufficient because there are probabilities the prices fall and the project would turn unprofitable. So the waiting for better information is valuable and can prevent decisions mistakes. At a sufficient high price ("critical price") will be optimal the investment. This critical value can point the project value needs to be two or three times the investment value (not equal, as the traditional DCF rules).
See the figure "The Options Approach Rule" (file gif with 7601 bytes), for the critical price P* of petroleum lease rights, as function of expiration time of the rights
For R&D projects, or petroleum exploration projects, or any project with high technical uncertainty or growth option, even with negative NPV would be optimal to begin the project, because the sequential investment decreases the variance of the technical uncertainty, and this (shadow) benefit value is not considered into cash flows. The technical uncertainty can only be resolved by undertaking the project: the information is endogenous to the project. Technical uncertainty makes investment more attractive if the investment can be performed in a step-by-step (staged) process. See also, in tutorial, the technical uncertainty item.

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Theory of Valuation:

There are two main kinds of valuations theories, that differ on the basic assumptions about investor preferences and/or market equilibria. For ease and generality, most real options models has been derived from the assumptions of the preference-free theory, like non-arbitrage condition. However, similar valuations results may be obtained without explicit arbitrage, by using equilibrium models such as the Intertemporal Capital Asset Pricing Model (ICAPM) developed by Merton (1973b) (see for example Bjerksund & Ekern, 1990, footnote 6).
The two types of valuation theories are:

1) Preference-free Valuation Theories:

This theory relies on the equilibrium condition that there exist no arbitrage opportunities. This modern and consolidated class of valuation theories, pioneered by Modigliani & Miller (1958) with their famous MM's propositions and by Black & Scholes (1973), are essentially preference-free theories and, as pointed out by Constantinides (1989), "generate results of great generality without necessitating the specification of the equilibrium in its full detail.".

2) Preference-dependent Valuation Theories:

This second class of valuation theories, important but with less practical perspectives, makes assumptions on investor (or consumer) preferences and derives more specific price restrictions than do the preference-free theories.
The notable example is the CAPM (Capital Asset Pricing Model), that implies in restrictions such as normal probabilities distributions or quadratic utility for the investor (sufficient conditions).

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Modigliani & Miller (MM) Propositions:

Modigliani & Miller showed that the capital structure is irrelevant for investment decisions, in a perfect capital market. So, the dividend policy and debt policy don't matter: "the capital structure is fundamentally a marketing problem" and "The firm's value is determined by its real assets, not by the securities it issues" (Brealey & Myers, 1991, p.397).

Proposition I: The market value of any firm is independent of its capital structure, or the "visual version": The firm value is determined on the left-hand side of the balance sheet by real assets - not by the proportions of debt and equity securities issued by the firm.
The investors can borrow or lend on their own account on the same terms as the firm: they can "undo" the effect of any changes in the firm's capital structure. So, the firm's financial leverage has no effect on shareholders' wealth.

Proposition II: The expected rate of return on equity increases as the firm's debt-equity ratio increases, however any increase in expected return is exactly offset by an increase in risk and therefore in shareholders' required rate of return, leaving the shareholders no better or worse off.
For low or moderate financial leverage level (or risk-free debt level), the expected return on equity increases linearly with the debt/equity ratio. For high debt level, that increases is not linear (is concave), because the default risk increases the debt cost.

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