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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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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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:
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.".
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 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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