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PART
I The Real Options Potetial
Part
I of this book introduces the real options way of thinking
and demonstrates how it can be used in a wide range
of applications. The real options approach has a broad
reach, including important implications for corporate
strategy. Because the real options approach is disciplined
by the financial markets, we show how the logic behind
the Nobel Prize winning option breakthrough can be used
for real assets. Part I closes with a chapter on immediate
lessons, quick reference points for evaluation of new
investment opportunities.
Chapter
1 Introduction
Chapter 2 Uncertainty Creates Opportunities
Chapter 3 Option Valuation: The Nobel
Prize Winning Breakthrough
Chapter 4 From Wall Street to Main
Street: Options on Real Assets
Chapter 5 Disciplined Strategy
Chapter 6 Quick Lessons
PART
II The Real Options Soluntions Process
We
change our focus in the next few chapters, from the
broad implications and power of the real options approach
to the "how tos" of option valuation. We show how the
arguments behind the option valuation solution shape
the process of framing and implementation. A recurring
theme throughout Part II is the importance of the application
frame. New users often have many questions about the
details of option solution methods, and create modeling
error by focusing on these issues while neglecting the
application frame.
Chapter
7 The Four-Step Solution Process
Chapter 8 Calculating Option Values
Chapter 9 Adjusting for Leakage in
Value
PART
III A Portfolio of Applications
Part
III is a series of 10 case studies that apply the real
options approach to valuation and decision making. Each
case isolates a central issue of importance across many
industries, and abstracts other points that would be
relevant in an actual application. Good real options
results require a bit of tailoring to the application
specifics: developing inputs, checking for leakage in
value, etc. This tends to cloud insights that are valuable
in different applications. Consequently case studies
in Part III are stylized examples that keep the framing
focused on a few points. In actual use, more detail
would be required.
Chapter 10 Valuing a Startup
Chapter 11 Investing in a Startup
Chapter 12 Exploring for Oil
Chapter 13 Developing a Drug
Chapter 14 Investing in Infrastructure
Chapter 15 The Value of Vacant Land
Chapter 16 Buying Flexibility
Chapter 17 Combining Real and Financial
Flexibility
Chapter 18 Investing to Preempt Competitors
Chapter 19 Writing a License
Part
IV Conclusion
Our
final chapter is a guide to the questions that define
the real options way of thinking. We hope that this
chapter helps you to achieve the right balance in your
applications, to start on answers without crunching
a number, and to use the real options way of thinking
to shape investments, business strategy, and possibly
your industry. As a recent quote states, "To keep up,
you need the right answers. To get ahead, you need the
right questions."
Chapter 20 Changing the Questions
We Ask
Chapter
1 Introduction
The
current set of valuation and decisionmaking tools aren't
sufficient for the new business realities: strategic
investments with lots of uncertainty and huge capital
requirements; projects that must adapt to evolving conditions;
complex asset structures through partnerships, licenses,
and joint ventures; and the relentless pressure from
the financial markets for value-creating strategy. Real
options is an important way of thinking about valuation
and strategic decision-making, and the power of this
approach is starting to change the economic "equation"
of many industries.
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Chapter
2 Uncertainty Creates Opportunities
Managers
anticipate and respond to uncertainty when they make
mid-course corrections, abandon projects, or build in
reviews at milestones for projects and licenses. In
the language of real options, managers are making contingent
decisions - decisions to invest or disinvest that depend
on unfolding events. This chapter lays out the nature
of contingent investment opportunities in an uncertain
world.
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Chapter
3 Option Valuation: The Nobel Prize Winning Breakthrough
The
option approach to valuation is very different from
traditional tools. The value of an option is inferred
from the value of a portfolio of traded securities with
the same payoff as the option, and which mimics its
fluctuations in value over time. If the value of the
option and the portfolio are not equal, an opportunity
to profit from trading would exist. Financial markets
move quickly, and arbitrage opportunities are fleeting,
bringing discipline and precision to option valuation.
The option approach to valuation earned its authors
the 1997 Nobel Prize in Economics.
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Chapter
4 From Wall Street to Main Street: Options on Real Assets
The
option valuation breakthrough must be adapted for application
to the real assets of strategic investments. Real options
often depend on private risks as well as risks priced
in the financial markets. However, continued innovation
in the financial and product markets blurs the distinction
between real and financial options, providing better
valuations of real assets, and creating more opportunities
to manage the risks of strategic investments.
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Chapter
5 Disciplined Strategy
A
disciplined strategy fully uses financial market information
and transaction opportunities to align corporate investment
decisions with shareholder wealth creation. Twenty years
ago Stewart Myers of MIT wrote that corporate strategy
and corporate finance address the same issue -- obtaining
the highest return on risky investments -- and that
including real options in the analysis could be a valuable
bridge between the two disciplines. This argument is
immediate and compelling in today's business environment.
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Chapter
6 Quick Lessons
Part
II of this book outlines the real options solution process
and how to "crunch the numbers" and Part III provides
a collection of case studies. Before moving on, however,we
provide a useful summary of the immediate lessons of
the real options approach for valuation, analysis, and
implementation.
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Chapter
7 The Four-Step Solution Process
This
chapter is an overview of the four-step solution process
for real options applications. The process allows users
to build up to the "real options way of thinking" and
ensures that the right focus is maintained as the application
is developed. The chapter is also a roadmap for new
users, and a reference point for the case studies in
Part III.
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Chapter
8 Calculating Option Values
This
chapter is a brief survey of the solution methods available
for calculating option values. These methods use mathematical
techniques developed in other fields, but their implementation
for the option valuation is guided by the no-arbitrage
arguments behind the Black-Merton-Scholes breakthrough.
While the solution methods differ in approach, in many
cases they will give the same option value if the inputs
and application frame are appropriately structured.
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Chapter
9 Adjusting for Leakage in Value
Many
real assets experience leakage in value, in the form
of explicit cash flows and/or an implicit convenience
yield. These features change how the value of the underlying
real asset evolves, and hence affect the value of the
option and the timing of the optimal investment decision.
The necessary of adjustment to the option valuation
model is covered in this chapter.
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Chapter
10 Valuing a Startup
Portlandia
Ale was two guys and a dream. The company was started
by two brewers who wanted to develop their own products.
The company needed $4 million to begin product development
and manufacturing and another $12 million in two years
for its marketing launch. The entrepreneurs were very
optimistic about their business opportunity, despite
considerable uncertainty about the value of the market
opportunity they were chasing. In other words, Portlandia
Ale was a typical start-up. How much was it worth?
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Chapter
11 Investing in a Startup
Redwood
Ventures, a venture capital fund, is evaluating the
business plan of Lighthouse Services, a start-up company
providing web page design tools in the exploding Internet
market. Lighthouse is asking for a $10 million investment.
Venture capitalists have a few "rules of thumb" that
they often use to evaluate prospective deals: their
investment should be doubled in the next round of financing;
the size of the market opportunity must be large enough
to justify the investment and risk; and there must be
an exit opportunity - a way for the venture capital
fund to liquidate its holdings - within six years. Redwood
uses an in-house real options tool to evaluate whether
startup business plans meet the required terms.
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Chapter
12 Exploring for Oil
Houston
Oil had leased a large tract of land on the Alaskan
North Slope, and was evaluating alternate exploration
strategies. Seismic investments would provide additional
information about the amount of oil in the ground, while
drilling would add information about the amount of oil
and resolve whether the oil could be produced. Should
Houston begin exploration? Which exploration investment
strategy should they use?
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Chapter
13 Developing a Drug
Recent
academic research only confirmed what Mega-Pharm already
knew: that the NPV of an investment in drug development
was nearly zero. It now costs over $300 million to develop
and take a drug through the FDA approval process, and
nearly $500 million to market it. Drug sales vary widely;
a blockbuster like Prozac could earn billions, but many
drugs have life-cycle revenues of only $100 million.
Drug development and marketing goes through well-established
phases, and Mega-Pharm wondered how they could use the
real options approach to better manage the process.
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Chapter
14 Investing in Infrastructure
The
Chief Information Officer (CIO) of National Mortgage
Trust (NMT) had been arguing with senior management
for $5 million for a new document imaging system. Other
managers were worried about the assumptions in his analysis
that justified the investment - an increase in the number
of mortgages processed and a reduction in processing
costs. What if the mortgage market did not grow as expected?
The result was a divided team.
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Chapter
15 The Value of Vacant Land
The
city of Metropolis had been expanding for years, coming
out to the peach orchards. Laga Realty, a developer,
owned two orchards: one was overgrown long ago, but
the other continues to produce a harvest generating
profits of $10,000 per year. It was estimated that,
at current values, the properties can be developed immediately
for a net profit. Should the property be developed immediately
or should development be postponed?
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Chapter
16 Buying Flexibility
MidAmerica
Manufacturing was choosing between three industrial
boilers to generate steam. The first boiler burned natural
gas, the second burned No. 2 fuel oil, and the third
could switch between the two inputs. The price of the
third boiler was $5000 more than the others, a premium
for the built-in flexibility. Which boiler should MidAmerica
buy?
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Chapter 17 Combining Real and Financial
Flexibility
New
Jersey Refining had been watching the new financial
products available on the crack spread, the gross profit
margin for oil refiners. Currently it operated its plant
using a dynamic programming algorithm, temporarily shutting
down whenever the crack spread was too low, after accounting
for shutdown and startup costs. New Jersey Refining
thought that its competitors were using the new financial
contracts to avoid temporary shutdowns, and wondered
whether it should adopt this approach as well.
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Chapter
18 Investing to Preempt Competitors
GoodTech
was nearing the end of product development for its latest
electronic product, a personal digital assistant (PDA).
GoodTech usually introduced its new products once a
year in October, just before the big Christmas selling
season. The size of the market for PDAs was very uncertain,
and the PDA product introduction would be very expensive.
Senior management at GoodTech was divided over which
strategy to take: hold back the product one year and
wait to see how this season developed; or introduce
the product this year, using it to set industry standards
on PDA features.
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Chapter
19 Writing a License
Bonzyme,
a "virtual" biotech firm, is constructed by licensing
arrangements. It has contracts with academic researchers,
supplying part of their funding in exchange for rights
to patents. It contracts with firms specializing in
running clinical trials to get the drugs through testing.
In the late stages of clinical tests, Bonzyme gets its
payoff: BG Pharma, a large pharmaceutical company, may
acquire a license from Bonzyme giving them the rights
to sell the drug. Bonzyme must negotiate a license knowing
that the terms of the contract give options to BG Pharma.
The terms may even influence BG Pharma's decisions regarding
the launch and marketing of the drug.
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Chapter
20 Changing the Questions We Ask
The
previous chapters have demonstrated the power and breadth
of the real options approach and have shown that it
is a disciplined way of thinking about the consequences
of uncertainty. It changes what questions you ask when
making strategic investment decisions. This chapter
presents 10 questions you should ask to guide you through
the real options approach.
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