Real options analysis : applying real options with Monte Carlo simulation and portfolio optimization

393 Pages·2002·4.74 MB·English

by  Johnathan Mun

2
CHAPTER
Real Options
Analysis
Tools and Techniques
for Valuing Strategic
Investments and Decisions
JOHNATHAN MUN
John Wiley & Sons, Inc.
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Copyright © 2002 by Johnathan Mun. All rights reserved.
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Library of Congress Cataloging-in-Publication Data:
Mun, Johnathan.
Real options analysis : tools and techniques for valuing strategic
investments and decisions / Johnathan Mun.
p. cm. (Wiley finance series)
ISBN 0-471-25696-X (CLOTH/CD-ROM : alk. paper)
1. Real options (Finance) I. Title. II. Series
HG6042 .M86 2002
332.63—dc21 2002008978
Printed in the United States of America
10 9 8 7 6 5 4 3 2 1
about the author
D
r. Johnathan C. Mun is currently the Vice President of Analytical Ser-
vices at Decisioneering, Inc., the makers of Crystal Ball®Real Options
and the Crystal Ball® suite of products, including applications of
Monte Carlo simulation, optimization, and forecasting. He heads up the
development of real options and financial analytics software products, con-
sulting, and training. He is also a Visiting and Adjunct Professor and has
taught courses in financial management, investments, real options, econom-
ics, and statistics at the undergraduate and the graduate M.B.A. levels. He
has taught at universities all over the world, from the University of Applied
Sciences (Chur, Switzerland) to Golden Gate University (California) and St.
Mary’s College (California). Prior to joining Decisioneering, he was a Con-
sulting Manager and Financial Economist in the Valuation Services and
Global Financial Services practice of KPMG Consulting and a Manager with
the Economic Consulting Services practice at KPMG LLP. He has extensive
experience in econometric modeling, financial analysis, real options, eco-
nomic analysis, and statistics. During his tenure both at Decisioneering and
at KPMG Consulting, he consulted on real options and financial valuation
for many Fortune 100 firms. His experience prior to joining KPMG included
being Department Head of financial planning and analysis at Viking Inc. of
FedEx, performing financial forecasting, economic analysis, and market
research. Prior to that, he had also performed some financial planning and
freelance financial consulting work.
Dr. Mun received his Ph.D. in Finance and Economics from Lehigh Uni-
versity, where his research and academic interests were in the areas of Invest-
ment Finance, Econometric Modeling, Financial Options, Corporate Finance,
and Microeconomic Theory. He also has an M.B.A. from Nova Southeast-
ern University and a B.S. in Biology and Physics from the University of Miami.
He is Certified in Financial Risk Management (FRM), is Certified in Finan-
cial Consulting (CFC), and is currently a Level III candidate for the Char-
tered Financial Analysts (CFA). He is a member of the American Mensa, Phi
Beta Kappa Honor Society, and Golden Key Honor Society as well as several
other professional organizations, including the Eastern and Southern Finance
Associations, American Economic Association, and Global Association of
Risk Professionals. Finally, he has written many academic articles published
xxxxxiiiii
xii ABOUT THE AUTHOR
in the Journal of the Advances in Quantitative Accounting and Finance, The
Global Finance Journal, The International Financial Review, and The Jour-
nal of Financial Analysis.
Johnathan Mun, Ph.D.
[email protected]
table of contents
List of Figures xix
Acknowledgments xxv
Preface xxvii
PART ONE
Theory 1
CHAPTER SUMMARIES 3
Chapter 1: A New Paradigm? 3
Chapter 2: Traditional Valuation Approaches 4
Chapter 3: Real Options Analysis 5
Chapter 4: The Real Options Process 6
Chapter 5: Real Options, Financial Options, Monte Carlo
Simulation, and Optimization 7
CHAPTER 1 A NEW PARADIGM? 9
Introduction 9
A Paradigm Shift 9
Expansion and Compound Options: The Case of the
Operating System 11
Expansion Options: The Case of the e-Business Initiative 13
Expansion and Sequential Options: The Case of the
Pharmaceutical R&D 15
Expansion and Switching Options: The Case of the Oil
and Gas Exploration and Production 17
Abandonment Options: The Case of the Manufacturer 19
Expansion and Barrier Options: The Case of the Lost
Venture Capitalist 20
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xiv TABLE OF CONTENTS
Compound Expansion Options: The Case of the
Internet Start-Up 23
The Real Options Solution 24
Issues to Consider 24
Industry Leaders Embracing Real Options 26
What the Experts Are Saying 28
Summary 30
Chapter 1 Questions 31
Appendix 1A The Timken Company on Real Options in
R&D and Manufacturing 33
Appendix 1B Schlumberger on Real Options in Oil and Gas 36
Appendix 1C Intellectual Property Economics on Real Options
in Patent and Intangible Valuation 42
Appendix 1D Gemplus on Real Options in High-Tech R&D 45
Appendix 1E Sprint on Real Options in Telecommunications 49
CHAPTER 2 Traditional Valuation Approaches 55
Introduction 55
The Traditional Views 55
Practical Issues Using Traditional Valuation Methodologies 57
Summary 66
Chapter 2 Questions 66
Appendix 2A Financial Statement Analysis 67
Appendix 2B Discount Rate versus Risk-Free Rate 74
CHAPTER 3 Real Options Analysis 77
Introduction 77
The Fundamental Essence of Real Options 77
The Basics of Real Options 79
A Simplified Example of Real Options in Action 79
Advanced Approaches to Real Options 81
Why Are Real Options Important? 82
Comparing Traditional Approaches with Real Options 85
Summary 92
Chapter 3 Questions 92
Table of Contents xv
CHAPTER 4 The Real Options Process 93
Introduction 93
Critical Steps in Performing Real Options Analysis 93
Summary 96
Chapter 4 Questions 98
CHAPTER 5 Real Options, Financial Options, Monte Carlo
Simulation, and Optimization 99
Introduction 99
Real Options versus Financial Options 99
Monte Carlo Simulation 102
Summary 107
Chapter 5 Questions 109
Appendix 5A Financial Options 111
Appendix 5B Simulation 114
Appendix 5C Forecasting 124
Appendix 5D Optimization 126
PART TWO
Application 133
CHAPTER SUMMARIES 135
Chapter 6: Behind the Scenes 135
Chapter 7: Real Options Models 136
Chapter 8: Advanced Options Problems 136
Chapter 9: Real Options Analysis Toolkit Software (CD-ROM) 137
Chapter 10: Results Interpretation and Presentation 137
CHAPTER 6 Behind the Scenes 139
Introduction 139
Real Options: Behind the Scenes 139
Binomial Lattices 143
The Look and Feel of Uncertainty 146
A Firm’s Real Options Provide Value in the Face of Uncertainty 149
Binomial Lattices as a Discrete Simulation of Uncertainty 151
xvi TABLE OF CONTENTS
Granularity Leads to Precision 154
An Intuitive Look at the Binomial Equations 158
Frolicking in a Risk-Neutral World 163
Summary 168
Chapter 6 Questions 168
CHAPTER 7 Real Options Models 171
Introduction 171
Option to Abandon 171
Option to Expand 175
Option to Contract 178
Option to Choose 181
Compound Options 185
Changing Strikes 188
Changing Volatility 189
Sequential Compound Option 191
Extension to the Binomial Models 194
Summary 195
Chapter 7 Questions 195
Appendix 7A Volatility Estimates 197
Appendix 7B Black-Scholes in Action 203
Appendix 7C Binomial Path-Dependent and
Market-Replicating Portfolios 205
Appendix 7D Single-State Static Binomial Example 210
Appendix 7E Sensitivity Analysis with Delta, Gamma, Rho,
Theta, Vega, and Xi 215
Appendix 7F Reality Checks 220
Appendix 7G Applying Monte Carlo Simulation to
Solve Real Options 223
Appendix 7H Trinomial Lattices 230
Appendix 7I Non-Recombining Lattices 232
CHAPTER 8 Advanced Options Problems 241
Introduction 241
The Advanced Problems 241
Decision Trees 242
Exit and Abandonment Options 245
Table of Contents xvii
Compound Options 246
Timing Options 247
Solving Timing Options Calculated Using Stochastic
Optimization 247
Switching Options 252
Summary 256
Chapter 8 Questions 256
Appendix 8A Stochastic Processes 257
Appendix 8B Differential Equations for a Deterministic Case 260
Appendix 8C Exotic Options Formulae 263
CHAPTER 9 Real Options Analysis Toolkit Software (CD-ROM) 277
Introduction 277
Introduction to the Real Options Analysis Toolkit
Software CD-ROM 277
Creating and Solving a Customized Option Using the Software 281
Advanced Real Options Models in the Software 285
Summary 291
Chapter 9 Exercises 291
Appendix 9A Real Options Analysis Toolkit’s Function
Description for Excel 293
Appendix 9B Getting Started with Crystal Ball® Monte
Carlo Simulation 305
Appendix 9C Resource Optimization Using Crystal Ball’s®
Opt-Quest Software 312
CHAPTER 10 Results Interpretation and Presentation 317
Introduction 317
Comparing Real Options Analysis with Traditional
Financial Analysis 318
The Evaluation Process 321
Summary of the Results 324
Comparing across Different-Sized Projects 325
Comparing Risk and Return of Multiple Projects 326
Impact to Bottom Line 327
Critical Success Factors and Sensitivity Analysis 328
Risk Analysis and Simulation on NPV 329
xviii TABLE OF CONTENTS
Break-Even Analysis and Payback Periods 329
Discount Rate Analysis 331
Real Options Analysis Assumptions 332
Real Options Analysis 333
Real Options Risk Analysis 334
Summary 335
Chapter 10 Questions 335
Appendix 10A Summary of Articles 337
Case Studies and Problems in Real Options 345
Answers to Chapter Questions 355
Endnotes 363
Index 371