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Abstract
The IS research literature has tested the applicability of option pricing models
to IS projects mostly through detailed case studies. The current study
complements this literature by considering a wide set of IS projects and
assessing, albeit crudely, their optional value. We test the literature’s assumption that IS projects embed
significant optional value. Our research site is a European plant of a
leading multinational manufacturer of sophisticated products. The portfolio
of current and recent IS projects is studied through a questionnaire
administered to all project managers. Seventeen project managers were
interviewed concerning thirty-one projects with median cost of $325k and
median benefit of $1.2m. We find strong support to the prediction that IS
projects include considerable optional value. The thirty one projects we studied
embed forty seven options, many of them with benefits comparable to the
value of the original projects. Only four projects had no optional value. A
comparison between a subset of the portfolio and the corresponding scale-up
options shows that the exercise price of the options is 20% of the original
projects’ cost, and that the value of these options is about 70% of the
original projects’ value. This data also demonstrates the large return, of
scale-up options – the median return is 1500%, five fold the median return
of projects. The main practical implication of this study is that real
option evaluation is useful for IS projects in general, and should not be confined to
special cases. A further implication is that real option thinking may be of
particular value in recognising reduction and
deferral options. The project managers in our study found such options
difficult to identify and considered their time to expiration as relatively
short. Proactive management of reduction and deferral options should thus
increase the flexibility and value of IS projects.
Abstract
Firms’ intangible assets are becoming more and more relevant
in the different areas within the financial discipline. Its management, its
quantification and its valuation nowadays constitute one of the main
challenges which economy and business try to face. Through this paper we
will evaluate some models based on the
real options theory in order to estimate the intangible assets value of
certain firms, specifically I+D biotechnological firms projects. With this
aim, and after deep research on biotechnological industry, we will
establish the parameters regarding one model which can be considered as a
quantitative valuation method that we apply to a sample of biotechnological
European companies. The results obtained through the empirical analysis are
promising and they support the use of the real options theory to evaluate
biotechnological firms.
Abstract
This paper studies the relationship between multinationality
and performance under a real options lens. Based on a cross-sectional panel
of multinational corporations (MNCs) that are
likely to use real options reasoning for the management of their
operations, we test the impact of operating and strategic options on firms’
risk-returns parameters. Our evidence reveals that both multinationality
and flexibility enhance corporate performance and reduce downside risk.
Abstract
This paper studies how the information available from potential investors
determines an entrepreneur's choice of financing. In our two-period model,
which allows stage financing, the entrepreneur chooses financing for his
own new project from pool of potential investors. The pool includes
business angels, venture capitalists and traditional atomistic investors.
The entrepreneur's choice of financing depends on the additional value to
the project brought by the investors' abilities to resolve over time the
uncertainties about the project and by the actions they can take, such as
replacing the manager or cutting the investment. We obtain explicit
analytic solutions for the choice of investor and for the amount of
investment at each stage. Our results show that the entrepreneur chooses
angel or venture capital financing when the intertemporal
resolution of uncertainty creates value which exceeds the associated cost.
The venture capitalist emerges as the preferred investor when potential
manager replacement is an ex-ante valuable option. These results are
consistent with observed market practice.
Abstract
This research focuses on valuation models of restatement of ownership
clauses and termination clauses in joint ventures and strategic alliances.
Due to the special nature of this type of agreements, a methodological
approach has been developed to capture the underlying market as well as
strategic risk of these types of clauses. As these clauses become operative
if certain events (triggers) occur, this study develops valuation models
that take into account the contingent nature of these clauses. Based on
recent joint ventures and strategic alliances, this study presents
valuation models and algorithms as tools for designing and negotiating
agreements between parties. However, the scope of this research is beyond
this limited objective. The special nature of option models proposed in
this study provides a new approach for evaluating
a variety of strategic decisions.
Abstract
Given a noticeable degradation of patent quality, patenting has come to
resemble the purchase of a lottery ticket. Rising cost of engaging in
litigation over intellectual property (IP) assets substantially diminishes
their value as an incentive to invest in research (Lanjouw
and Schankerman, 2001). The author proposes an
option-based view (OBV) of imperfect patent protection as a formal
strategic model of so-called probabilistic patents (Lemley
and Shapiro, 2005), which may serve as a starting point for further investigations
into the impact of patent risk on firm values and research incentives. More
specifically, the real option approach is employed to demonstrate how, due
to increased litigation activity in red oceans, rising profit rates may
lead to falling patent values, calling for a careful tradeoff between
reliable patent protection in mature markets and seemingly attractive
business opportunities in industries such as pharmaceutical biotechnology.
Abstract
The main hypothesis examines whether real options logic is applied by
entrepreneurs in undertaking key organisational
change (e.g. ownership, technology, location, line of business etc.). This
is explored in a model of firm performance using data collected in
face-to-face interviews with entrepreneurs on the level and timing of
precipitating influences of organisational change
and the level and timing of consequential adjustments following organisational change. Two econometric estimation
techniques (e.g. Box-Cox regression with WLS correction and Heckman sample
selectivity correction) were employed. Firm performance is explained in
terms of a count of real options exercised, measures of the level and
timing of precipitators and consequential adjustments, plus interactions
between these measures to capture firm behaviour
through a real options lens. Evidence was found of the value of holding
real options until uncertainties are resolved. At this point the value of
waiting is at its lowest.
Abstract
This paper introduces a theory of corporate announcements based on the new
concept of an announcement option which has not been previously recognized
in the literature as an independently valuable real option de-coupled from
strategy implementation. While contributing to the strategy and real
options literature, the paper also bridges the corporate disclosure
literature and theories of signalling. By conceptualising corporate announcements as real
options, the paper provides a framework and focuses on a methodology for
precisely valuing announcements. To illustrate the use and valuation of
announcement options, the historical case of Prudential plc’s
announcements concerning its internet venture Egg is analysed.
Abstract
Our paper models and empirically tests the model of firms operating under
uncertainty. The study compares firms operating in perfect competition with
those producing with product market power. Our model finds that they both
produce less under uncertainty from the cost of risk. In addition, our
model predicts that companies with market power have a greater market
value, face more product market uncertainty, use less leverage but have a
similar default risk to firms in perfect competition risk. We then
empirically test our model using manufacturing firms that operate in close
to perfect market competition having little product differentiation and
operating in low concentrated industries versus those that have product
market power using advertising and/or R&D and operating in highly
concentrated industries. The empirical evidence supports our hypotheses.
Our study includes the “option against value” that occurs from real product
market changes greatly reducing or even eliminating firms’ product markets.
Using default probability estimates based on Merton’s
Equity Option Pricing as the probability of an
“option against value” occurring, we find smaller companies, those
companies with less capital intensity and finally companies in perfect
competition more likely to experience this product market shift.
Abstract
The effects of strategic behavior on asset returns are studied in a model
of incremental investment with operating flexibility. We show how the
interaction of competition and production and investment decisions
influences the relation between industry structure and expected rates of
return. The effect of competition on asset returns depends on the level of
demand for the industry output. When demand is low firms in less
concentrated industries earn higher returns. As demand increases and growth
options become more valuable firms in more concentrated industries earn
higher returns. We compare the predictions of our model with recent
empirical evidence on industry structure and average rates of return by Hou and Robinson (2005).
Abstract
A firm has to decide when to scrap its technology and adopt a new one
chosen among a possibly increasing range over time when technological
process is uncertain. Under constant return to scale, optimally the firm
implements the best invented technology that may not be the latest. The gap
between the operated technology and the newly implemented one has to large
enough with respect to gap between the latest and state of the art
technologies in order to trigger replacement. This result shows that the
higher the threat a better technology may be released, the more reluctant
is the firm to replace its technology. Effects of the means and the
variance of technological progress on the adoption policy and frequency of
upgrades are also examined. JEL Classification: D81, D92, O33 Keywords:
Technological Uncertainty, Optimal Timing, Innovation Adoption, Option Value.
Abstract
Selecting between investing on R&D in incremental innovations and
radical innovations is particularly challenging. In this paper, we focus on
the problem of project selection under technical uncertainty and market
uncertainty. After motivating the challenges and decisions facing firms
using a real-life application from GM, we formulate a mathematical model of
a firm that must develop its products in the presence of uncertainty.
Specifically, the firm faces two options: (i) an
incremental innovation project that is known to be relatively easy to
develop and (ii) a radical innovation project that offers superior
performance but whose development is much more difficult. We examine how
characteristics of R&D projects such as projects’ relative efficiencies
and future benefits affect R&D investment policy, valuation and risk premia. Our analysis helps understand the
appropriateness of the different development approaches. We illustrate our
model with a Hybrid Electric Cars vs Hydrogen Fuel Cell Vehicles example as
pursued by GM and note the managerial implications of our analysis.
Keywords: Real Options, R&D Projects, Stochastic Differential Equation,
Managerial Flexibility, Project Management.
Abstract
This paper constructs a model of ICT network investment behavior by a
typical firm engaged in productive activity for which ICT serves as a GPT.
The firm has options to enter into activity facilitated by technological
advance. Investment is decomposed in a manner analogous to growth
accounting. The approach identifies factors that influence optimal
investment decision making as: profitable production; optimal portfolio
choice; strategic merger and acquisition; shareholder satiation; and
futures preparation. The model can identify technology / preference
parameters, business environment and potential government policy levers.
Interaction among factors may lead to complex and possibly undesirable
outcomes. In the simulation experiment parameters and functional forms are
specified for the production and utility functions. These provide a grid of
possibilities under which optimal choices of the control variables
determined. Results are computed under a range of outcomes for the model
stochastic processes. The experiments categorize optimal ICT network investment
behaviour into components and shed light on the
ability of this rational model to generate complex cyclical investment
activity.
Abstract
This paper describes a real options valuation method for situations where
the underlying asset may have negative values and the underlying project
present value distribution is something of the shape between normal and
lognormal distribution causing skewness and kurtosis
to the rate of return distribution. The underlying project value is assumed
to follow a dynamic path having up and down movements with properties of
both additive and multiplicative processes. This is described as a shifted
lognormal process. A binomial tree solution, which is an extension to the
common binomial tree models, is presented with an illustrative case
example. The underlying assumptions about applying the valuation model
follow the lines of consolidated volatility approach and marketed asset
disclaimer.
Abstract
Recent research has revealed the usefulness of Monte Carlo
simulation for valuing complex American options which depend on
non-conventional stochastic processes. This paper analyses the
possibilities to improve flexibility of traditional real options models by
the use of simulation. We combine simulation and dynamic programming for
valuing American real options contingent on the value of a state variable
which evolves according to a mixed Brownian-Poisson process. We estimate
the optimal exercise strategy using two alternative models, which are based
on algorithms developed for financial derivatives. We evaluate
both valuation proposals using a simple numerical example. The results
highlight the need to achieve a trade-off between the accuracy of the
estimations and the computational effort needed for this type of proposal.
They also reveal the existence of non-monotonous and occasionally
counterintuitive relations between the value of the growth option and the
volatility and frequency of discontinuous jumps, which should be explained
by the characteristics of the stochastic process under consideration.
Real Options Theory for Real Asset Portfolios: the Oil Exploration
Case Marco Antonio Guimaraes Dias, Petrobras
and PUC-Rio, Brazil
Abstract
This paper discusses a portfolio theory for real assets with main focus on
petroleum exploration and development assets. Exploratory assets are
prospects with chances to find out development assets (oilfields in this
case). By the real options point of view, exploratory assets are compound
options.
In opposition to financial assets portfolio theory, the paper shows that
positive correlation between exploratory assets is a desirable feature
because both it increases the learning option value and leverages the
synergy gain with development assets. In the first case due to the
sequential nature of learning with the ability to limit losses in case of
bad news. In the second case because a higher (positive) correlation
increases the probability of multiple success and
so the synergy gain by sharing the development infrastructure.
The analysis of the simplest portfolio, i.e., with only two exploratory
assets, provides important insights about learning, synergy and option to
defer exploration. The optimal intertemporal
distribution of projects shall use the concept of option to defer. A
necessary condition for the immediate exercise of an exploratory option
(wildcat drilling investment) is the existence of at least one scenario
where the development option is deep-in-the-money. For all projects which
deferring is optimal, we need to have an idea of both the probability of
later exercise and the expected time of exercise, conditional to option
exercise occurrence. This portfolio planning is necessary for resource
management purposes and is performed by real-world (and not risk-neutral)
stochastic processes simulation.
A multiple asset portfolio of exploratory prospects example is analyzed, highlighting
the learning processes modeled as information revelation processes, with
discussion of their properties.
Abstract
A stochastic forest rotation model in the Faustmann
tradition is presented and exemplified. The model combines harvesting
decisions with options to recover or clean up to restore the land after
very unfavorable evolutions of the stochastic growth process. Uncertainty
is shown to have a generally ambiguous effect on the optimal choice of
investment strategy. It is also shown how such models can be related to
theory of optimal inventory control.
Abstract
This paper studies the optimal acquisition of incremental information on an
irreversible investment opportunity that is subject to economic uncertainty
through a random payoff shock. Imperfect information is introduced by
assuming that the payoff and the investment cost are affected by distinct
multiplicative signals that at the outset are unobservable to the investor.
The problem of the investor then is to decide when, if at all, to acquire
the signals given that the alternative is to invest with the prior
estimates. The incurred costs being completely sunk, going ahead with an
acquisition translates to exercising an irreversible real option, a
learning option. We show that the optimal acquisition (learning) policies
are represented by two simple stopping times for the payoff shock. The
policies balance the trade-off between the acquisition costs and the fact
that postponing an acquisition increases the risk of learning information
that would have been more beneficial when incorporated into decision making
earlier. In particular, postponing increases the risk of forfeiting the
optimal perfect-information investment.
Abstract
In investment problems under certainty it is optimal to stop the program
such that net present value is maximized. An equivalent, r-percent stopping
rule suggests that the program should be stopped when the project’s rate of appreciation falls to the force of
interest. We extend the r-percent stopping rule to the case of uncertainty,
in which the program is again stopped once the project’s
rate of appreciation falls (in an expectations sense) to an adjusted force
of interest. This rule has all of the intuition of the rule under
certainty, and the adjustment to the force of interest reveals additional
insights.
10.20 - 12.00 I. Public Sector and Policy
Applications
Abstract
In this study we introduce the concept of maximum tolerable irreversible
social costs (MISTICs) as an indicator of
potential welfare impacts of introducing an agricultural innovative
technology. The MISTICs identify an upper bound
for irreversible social costs beyond which, it would not be socially
optimal to postpone the introduction of a new technology. The MISTICs including private as well as social costs and
benefits, supports decision making processes that need to consider economic
as well as social and environmental factors, offering a broader perspective
on potential impacts of introducing technological innovations with unknown
irreversible social costs. The MISTICs were
computed for the case of introducing genetically modified (GM) corn in France.
Abstract
In this paper, we study the problem of investing in sustainable transport
to relieve air pollution under both population-growth and investment cost
uncertainties. In such a case, the growth of the city population increases
the demand for a sustainable transport by increasing pollution, and, in the
same time, the investment cost is decreasing stochastically with time. This
corresponds to a hydrogen fuel infrastructure construction, whose
construction cost is continuously decreasing due to the worldwide R&D
effort. Using the real options method, we show how to maximize
inter-generational utility by choosing the optimal time to invest. We make
use of a dynamic programming approach to calculate the expected waiting
time until investing. Our numerical results show that we must wait a longer
time before investing when the uncertainty is high
Abstract
We study the effect of price cap regulation on investment in new capacity
in an oligopolistic (Cournot)
industry. We use a continuous time model with stochastic demand. The
contribution of this paper is both theoretical and practical. On the
theoretical side, we show that there exists an optimal price cap that
maximizes investment incentives. Just as in the case of deterministic
demand, the optimal price cap is independent of market concentration.
However, unlike the deterministic case, we show that this price cap does
not restore the competitive equilibrium; there is still under-investment
and companies are still enjoying positive rents. On the practical side, we
perform sensitivity analysis, comparative statics
and montecarlo
simulations to examine the effect of price cap regulation at different
levels of demand volatility, market concentration and lead times. The
findings demonstrate that price cap regulation is ineffective in increasing
investment in volatile markets, with high concentration and significant
lead times. This casts doubts to whether price cap regulation can be
effective in mitigating market power in liberalized electricity markets.
Abstract
The traditional marshallian rule of investing
(abandoning) when the value of an underlying asset is above (below) the
cost of an alternative investment is modified in the presence of
uncertainty and irreversibility giving rise to an option component into
decisions. This component is affected by the degree of volatility of
underlying assets, which in turn can derive their volatility from the
economy as a whole, affecting the investment process and therefore the
accumulation of capital and future growth. In the same tense, the evidence
of volatility in the returns of the underlying assets of the economy
affects the market value of debt contracts, conveying recommendations
regarding the financial architecture of the economy and the type of
financial instruments better suited. The paper explores the application of
contingent claims analysis both to the potential effect of macro volatility
on aggregate investment, and to the effect on the presence of high levels
of indebtedness of the economy, with a special application to the
Argentinean economy where we obtain that economies with high level of
volatility would require a significant level of internal saving and capital
markets driven mainly by equity instruments of financing, which helps to
better accommodate uncertainty by means of the price of assets.
Abstract
In addition to the price risk, volumetric risks in electricity market play
a second important role. We discuss the various types of volumetric risks
which are related to specific constraints of power plant operation, and
asses their impacts on the valuation of a power plant. The results of Monte
Carlo simulations on spark spread options indicate that
considering these risk factors decreases the value of a power plant. The
decreasing effects of some risk factors, such as outages, maintenance and
spinning reserve, are significant. The impact from
the demand-side risk is not significant in magnitude, but it always jointly
works with price risks. The multiplying effect makes the demand-side risk unignorable. A predetermined forward charge price on
customer load cannot mitigate the demand-side risk properly.
Abstract
Real option models for valuating power plants are often criticised
for not taking into account important features of these physical assets
such as switching costs, minimum on-off times, ramp rates or non-constant
heat rates. Incompleteness of electricity markets is also an important
issue while valuating these kind of options. We
study the valuation problem of a power plant in a continuous time commodity
market, in the presence of frictions (production constraints and
incompleteness of the market). We use the utility indifference approach to
define the price of the associated real option. We provide a
characterization by means of a coupled system of reflected backward
stochastic differential equations. We derive the variational
inequalities associated to the reflected BSDE system. In the absence of
friction, we show that this utility-based value reduces to the classical
no-arbitrage valuation. We finally give a numerical scheme for both the BSDE
and the PDE and compute the value of a coal power plant.
Valuation
of Stochastic Power Storage Systems Sydney Howell, Manchester Business School, UK Peter Duck, University of Mancheste, UK Helena Pinto, University of Strathclyde, UK GoranStrbac,
Imperial College, UK
Abstract
Wind-generated electricity supply contains significant stochastic
fluctuations, which may be “smoothed” by electricity storage systems. The
economic value of such storage can be calculated using real-options
methods, in which we model the storage system as a perpetual,
dividend-paying Asian option. In contrast to standard option models, in
which the price is a stochastic variable but the physical quantity of the
underlying asset is one unit, our initial model assumes that the price of
electricity is one unit, and the physical flow rate of the underlying
variable, wind-generated electricity, is stochastic. The valuation can be
tackled by two methods: the first is a fully numerical (Monte
Carlo) simulation, which involves explicit treatment of the
stochastic fluctuations of three variables in time; the second is a PDE
(partial differential equation) approach, in which fluctuations in the time
domain need not be explicitly treated. The PDE approach requires the use of
non-standard numerical methods, involving the treatment of diffusion in two
opposing directions in different regions of parameter space. The agreement
between the two distinct methods is excellent, although the PDE approach is
considerably more efficient. The methodology (based on the PDE approach)
has strong potential for developing a useful tool in valuing numerous and
diverse storage systems (both physical and financial), and such possible
directions are detailed in the paper.
Abstract
This paper deals with the valuation of energy assets related to natural
gas. In particular, we evaluate a baseload Natural Gas Combined Cycle (NGCC) power plant
and an ancillary instalation, namely a Liquefied
Natural Gas (LNG) facility, in a realistic setting; specifically, these
investments enjoy a long useful life but require some non-negligible time
to build. Then we focus on the valuation of several investment options
again in a realistic setting. These include the option to invest in the
power plant when there is uncertainty concerning the initial outlay, or the
option's time to maturity, or the cost of CO2; emission permits, or when
there is a chance to double the plant size in the future. Our model
comprises three sources of risk. We consider uncertain gas prices with
regard to both the current level and the long-run equilibrium level; the
current electricity price is also uncertain. They all are assumed to show
mean reversion. The two-factor model for natural gas price is calibrated
using data from NYMEX NG futures contracts. Also, we calibrate the
one-factor model for electricity price using data from the Spanish
wholesale electricity market. Then we use the estimated parameter values
alongside actual physical parameters from a case study to value natural gas
plants. Finally, the calibrated parameters are also used in a Monte
Carlo simulation framework to evaluate
several American-type options to invest in these energy assets. We
accomplish this by following the least squares MC approach.
Abstract
In this paper we study the option to invest in a new international airport,
considering that the benefits of the investment behave stochastically. In
particular, the number of passengers, and the cash flow per passenger are
both assumed to be random. Additionally, positive and negative shocks are
also incorporated, which seems to be realistic for this type of projects.
Accordingly, we propose a new real options model which combines two
stochastic factors with positive and negative shocks. While the authors
developed this model having as reference the project for the new airport in
Lisbon, the model can be
applied to other airports investments, and, eventually with minimal
adaptations, it can also be applied to projects in different areas.
Abstract
The paper uses a real options valuation model with stochastic freight rates
to investigate market efficiency and the economics of switching between the
dry bulk and the tanker markets in international shipping. A dry bulk
carrier is replaced with a tanker when the expected net present value of
such a switch is optimal from a real options based decision rule. Depending
on the development of the markets a reversal may take place later. The cost
and demand parameters upon which the decisions to switch are made,
including the stochastic characteristics of freight rates, are estimated
from an empirical analysis that is updated every week throughout a 12-year
time period from 1993 to 2005. The second-hand market for bulk ships seems
to have been efficient most of these years in the sense that market
switching usually did not pay off, with one major exception: it seemed
profitable in expectation to leave the dry bulk market and enter the tanker
market over a significant period of time shortly after the millennium
shift, and to return to dry bulk market about three years later. These
points in time corresponded with an unprecedented boom period in the tanker
and drybulk freight markets, respectively, and
the result suggest that agents in the second-hand market were slow to
adjust their expectations. In retrospect, such an investment policy also
happened to be profitable compared to staying put in the tanker market,
even after accounting for transaction costs.
Abstract
In this paper, we characterize the optimal contract for investing in
transportation infrastructure and providing the associated service in the
presence of stochastic preferences. The relevant
decision variables are the timing of investment and the supply path (in the
limit of the installed capacity). Both variables depend on market dynamics.
The need to balance the budget of the investor in expectation (second best
environment) generates a trade-off between delaying investment and
rationing consumers, whenever the demand exhibits variable price
elasticity. We argue that the contract should end as soon as the firm
obtains a predetermined amount of market revenues. Whenever the firm bears
the market risk, the second-best duration of contract is expected to be as
long as the assets life, even though when the market goes down cost
recovery becomes impossible. On the other hand, when the firm is fully
insured, the supply path is distorted downwards from the second best case.
Consequently, the timing of investment is delayed and the expected
contracting period is reduced.
II. Capacity Investment
Capacity
Planning under Uncertainty Tarik Driouchi, Aston Business School, UK David Bennett, Aston Business School, UK GiulianaBattisti,
Aston Business School, UK
Abstract
This short paper introduces the concept of Asian options in the capacity
choice literature. We develop a simple model for optimal capacity setting
under average demand uncertainty for a single firm. When the firm faces
moderate or significant stochastic demands in its current product line,
expanding capacity is beneficial. If the demand is extremely stochastic, a
capacity lag or reduction is more profitable.
Abstract
In this work, we present a model to value capacity investment decisions
based on real options. In the problem considered we incorporate partial
reversibility by letting the firm reverse its capital investment at a cost,
both fully or partially. The standard RO approach
considers the stochastic variable to be normally distributed and then
approximated by a binomial distribution, resulting in a binomial lattice.
In this work, we investigate the use of a sparse Markov chain, which is
derived from demand data previously collected. The main advantages of this
approach are: i) the Markov chain does not assume
any type of distribution for the stochastic variable, ii) the probability
of a variation is not constant, actually it depends on the current value,
and iii) it generalizes current literature using binomial distributions
since this type of distribution can be modelled
by a Markov chain.
Abstract
This paper develops a general theory of sequential irreversible investments
in capital where a firm has the option to expand its current capacity or
just wait for better time. Facing economic uncertainty, the firm has an
operating function of the current capacity and an exogenous stochastic
factor modelled by semimartingale.
This general model encompasses all previously studied models, including the
deterministic case as well as the stochastic case with Geometric Brownian
motions, Levy processes and even with regime shift. In this paper, general
existence and uniqueness results are first provided for irreversible
investments with finite and infinite horizon, respectively. As the main
contribution of this paper, a new method is proposed to characterize the
optimal investment policy, the base capacity policy. Under the policy, the
capacity is kept always at or above the base capacity which is
characterized by a stochastic backward equation. This new method gives a
number of new qualitative insights into the nature of the irreversible
investment. It is demonstrated that the optimal policy equals the marginal
operating profit and the user cost of capital in those free intervals when
the irreversibility constraint does not bind. While, the equality holds
true only on average in block intervals when no investment occurs. Besides,
this method easily leads to some general comparative statics
results: When the operating profit function is supermodular,
the base capacity increases monotonically with the exogenous shock; and the
firm size always declines with the user cost of capital. Finally, explicit
solutions are derived when the exogenous economic shocks are modelled by Levy processes and the operating profit
function is of Cobb-Douglas style.
Abstract
This paper explores firms' incentives to engage in capacity preemption
using a continuous-time real options game. Two ex ante identical firms can
choose capacity and investment timing regarding the entry into a new
industry whose demand grows until an unknown maturity date, after which it
declines until it disappears. Previous literature usually predicts that the
Stackelberg leader, whether endogenously or
exogenously determined, is better off by building a larger capacity than
its rival. In contrast, this paper proves that, under certain conditions
about the demand function and the market growth rate, in equilibrium the
first mover enters with a smaller capacity. If it had chosen the larger
capacity, its competitor could, and in fact would use a smaller plant to
force it out of the market. The result is driven by two facts: first, the
large capacity firm lacks the incentive to preempt its competitor, because
of its higher option value, which tends to delay its investment; second,
the large firm also lacks commitment to fight for the market if its
leadership is challenged by a smaller firm, because the smaller firm can
credibly commit to stay in the market.
Abstract
This paper examines strategic investment games between two firms that
compete for optimal entry in a project that generates uncertain revenue
flows. Under asymmetry on both the sunk cost of investment and revenue
flows of the two competing firms, we investigate the value of real
investment options and strategic interaction of investment decisions. We
provide a complete characterization of pre-emptive, dominant and
simultaneous equilibriums by analyzing the relative value of leader’s and follower’s optimal
investment thresholds. In a duopoly market with negative externalities, a
firm may prevent loss of real options value by selecting appropriate
pre-emptive entry. Under positive externalities, firms do not compete to
lead.
Industry
Dynamics and Limit Pricing under Uncertainty Sebastian Gryglewicz, Tilburg
University, Netherlands Kuno J.M. Huisman,
Tilburg University, Netherlands Peter M. Kort, Tilburg University and
University of Antwerp, Belgium
Abstract
This paper studies the entry deterring limit pricing model in a continuous
time and in the presence of market uncertainty. Strategic considerations
are reacher than in the standard two-period
model. Entry deterring limit pricing is only possible within lower and
upper bounds of the market size and if the incumbent is stronger than the
potential entrant. No limit pricing arises in separating equilibria. Moreover, higher uncertainty induces higher
incidence of entry deterrence.
Abstract
By adopting a real options framework we develop a production control model
that jointly incorporates process and market uncertainties. In this model,
process uncertainty is defined by random fluctuations in the outputs’ yield
and market risk through demand uncertainty for the output. In our approach,
production outputs represent commodities or items for which financial
contracts do not trade. Outputs are also functionally linked to the level
of input inventories. To extend the model’s
applicability to a wide range of production industries, inputs are modeled
to reflect either renewable, or partially renewable or non-renewable
resources. Given this setting, techniques of stochastic control theory are
employed to obtain value maximizing production policies in a constrained
capacity environment. The rate of production is modeled as an adapted
positive real-valued process and analogously evaluated
as a sequence of complex real options. Since optimal adjustments to the
rate of production also functionally depend on the outputs’ yield, we
optimally establish “trigger boundaries” justifying controlled variations
to the rate of production over time. In this context, we provide closed
form analytic results and demonstrate their robustness with respect to the
stochastic (including mean reverting) processes considered. Using these
results, we also demonstrate that the value (net of holding costs) accrued
to the producer from having an inventory of the output is equivalent to the
producer’s reservation price to operationally
curb its process yield. These generalizations extend the scope of model
applicability and provide a basis for applying the real options methodology
in the operations arena. The model is explored numerically using a stylized
example that allows for both output and demand uncertainty and achieves
greater realism by incorporating an element of smoothing into the sequence
of production decisions.
Abstract
Using the framework of real options, we develop a model and derive the
optimal solution for the case of asset renewal. In contrast to capital
replacement of physical assets, the applicable contexts for asset renewals
are those in the service sector such as hotels, commercial web-sites and
human resources, where the decision to renew depends on both the revenue
the asset generates and the operating and maintenance cost it incurs. An
analytical solution is derived for the model involving the two distinct but
stochastically dependent sources of uncertainty without recourse to
homogeneity of degree one to reduce the model’s
dimensionality. We find that under plausible conditions the value of the
existing asset plus its renewal option is an increasing function of the
underlying volatilities while the trigger level for revenue signalling renewal is a decreasing function. In the
presence of increasing uncertainty, patience has to be exercised before
making the renewal decision. Further, the capital outlay required for
renewal, the discount rate and the change rate for cost have a negative
effect on the value of the existing asset plus its renewal option and on
the trigger level for revenue while the starting revenue following renewal
and the change rate for revenue have a positive effect. Finally, we
determine the conditions under which homogeneity of degree one can be
justified and show that these conditions are not upheld for the present
analysis.
Abstract
Considering interest rate uncertainty to be a relevant
variable for the firm’s replacement decision
problem we show that standard textbook approaches for replacement
investment decisions can lead to non-optimal decisions in a stochastic
interest rate environment. The problem with traditional approaches is that
the real options related with subsequent replacement choices are not
considered, i.e., the managers’ flexibility to switch between assets or
equipments with different durability and expendability at each renewal time
in response to some stochastic feature are completely ignored from the
analysis. To overcome and highlight the shortcomings of the traditional
approach presented in the academic textbooks we tackle the replacement
investment problem in two ways. First, we consider the problem in a
deterministic interest rate economy assuming that the only source of
uncertainty is a permanent shock to a flat term structure of interest rates
at a specified future date. Then, we consider the replacement problem under
stochastic interest rates more explicitly in a CIR economy. The resulting
formulae are explicit and quite easy to implement involving only numerical
integration in the stochastic case. The solution to this problem seems to
be extremely useful for corporate and public institutions managers when
revenue or cost streams are relatively static and investment is driven by
interest rate uncertainty since depending on the interest rate levels,
interest rate volatility and the optionality to
switch between durable and expendable assets at each renewal time managers
may prefer to invest in long-lived but more expendable assets instead of
short-lived but less costly assets and vice-versa.
DAY 3 - SATURDAY, JUNE 17
8.30 - 10.10 I. Case/Industry Applications &
Modeling
Abstract
We first derive explicit formulas for a real perpetual American call option
assuming asset price follows a double-exponential jump diffusion process.
Similar analytical computation is extended and applied to a research and
development (R&D) effort with two stochastic factors. Both project
value and investment costs summarise our
uncertainties in creating investment opportunities. The presence
of Levy jumps underline significant positive and negative impacts on
the project's future cash flows and therefore the investment decision. We
then apply the theoretical models to an empirical biotechnological R&D
case scenario. In our gene-based drug application, we find that an R&D
project that experiences mixed-exponential jumps encourages postponement of
optimal timing to entry compared to its counterpart that follows a Poisson
jump process.
Abstract
The paper focuses on wireless data services and its importance in
enterprise segment market. Currently operators offer wireless services
using different technologies to their customers. We look at the problems
faced by services providers in provisioning of services in
difficult-to-reach areas of tall buildings. Operators are deploying ad-hoc solutions
for example; dedicated base stations antenna systems to extend the coverage
areas while incurring additional expenses. We propose four alternative
deployment solutions from both the corporate customer and service provider
point of view. The objective is to maximize the revenues and reduce risk
for operators and improve customer satisfaction levels within the budget
constraints of the customer. The paper uses real options technique to evaluate
the proposed business models. Our analysis suggests savings due to
improvements in productivity are much higher than revenues perceived by
service provider.
Investment
in Hightech Industries: An Application in the LCD
TV Industry Pauline 't Hart, EIM BV, Netherlands KunoHuisman,
Tilburg University, Netherlands Peter Kort, Tilburg University and
University of Antwerp, Belgium Joseph Plasmans, Tilburg University and
University of Antwerp, Belgium
Abstract
In this paper we study investments of firms in hightech
industries. Typical examples are producers of consumer electronic products
such as dvd players, LCD television sets, digital
photo cameras, and mobile phones. There are two important characteristics in
these markets. The first is (sharply) decreasing sales prices and the
second is decreasing production costs. The introduction of new technologies
shortens the life cycle of products. Furthermore, innovations in the
production process reduce production costs and prices. The latter effect is
strengthened by competition. First we develop a standard real options
investment model in which the sales price and the unit production costs per
unit both follow geometric Brownian motions. However, using real life data
from the LCD industry, we show that the sales price can not be described by
a geometric Brownian motion. Consequently, a new real options model in
discrete time is developed that fits to the real life data. Finally, the
two resulting investment strategies of the models are compared.
Lease Contracting and Licensing Agreements: Application to Retailing Timothy Riddiough, University
of Wisconsin -
Madison Joeseph Williams, Professors
Capital
Abstract
A model of bilateral trade between an upstream supplier and a downstream
producer is constructed, in which the upstream supplier confers long-term
property usage rights to the downstream supplier in return for a base
rental fee plus a percentage of verifiable sales production. Our model
allows for the possibility that downstream sales production complements
other activities of the upstream supplier to increase its total revenues.
An optimal contract is designed that balances ex ante investment incentives
of the downstream producer with ongoing reinvestment incentives of the
upstream supplier. A number of important stylized facts associated with
retail lease contracting are addressed, including why: i)
retail leases contain base rents and often (but not always) contain an
overage rental feature, ii) stores that generate greater externalities pay
lower base rents and have lower overage rent percentages than stores that
generate fewer externalities, iii) the overage rent option is typically
well out-of-the-money at contract execution, and iv) stand-alone retail
operations often sign leases that contain an overage rental feature.
Abstract
Managers participate in identifying and selecting projects and retain a
strong direct control over important decisions of the project: active
management may allow a project defer, expand, contract, abandon, or
otherwise alter a project at different stages during its operating life,
whereas venture capitalists only have the information provided by firms,
but they do not know the intimate details of project. The objective of this
paper is to demonstrate how flexibilities and uncertainties (real options)
faced by projects affect the agency problem, and thus the incentives that
principal must put in place to achieve optimal project value. Ours model
differs from other similar models in a number of ways. To begin with, our
model is theoretical instead of empirical, because option pricing is based
on theoretical models. Second, our model is very simple but useful to
understand how real options impact the agency problem, incorporating moral
hazard in the different alternatives that managers have to invest (real
options). In projects under a well-defined line of decisions (projects
without real options), agency problem is a concern derived from the
information asymmetry, the bounded rationality, and the different utility
functions of agent and principal. However, managers may allow a firm defer,
expand, contract, abandon, or otherwise alter a project at different stages
during its operating life. Hence, the information asymmetry, bounded
rationality and differences in utility functions may result in a more
noticeable issue in projects facing real options. We concluded that the
greater the number of real options embedded in the project, the greater the
agency problem involved in it. Accordingly, manager must be encouraged to
make decisions that maximize the principal interest, with a higher
percentage of project final value.
Abstract
This paper develops a rewarding system aiming to ensure accountability and
accuracy in projects and programs cost estimation by encouraging the
appraisers to bet on their estimate, and to reward them fairly. Fair
compensation is defined as the payoffs that one would obtain from the
market when taking the same risk. Butterfly spread strategy is used to
account and to price this risk using Black and Scholes
option pricing model. A set of 72 programs executed by NASA from 1977 to
2003 is used to illustrate the model. The main contribution of the article
is to bring together fair valuation and real options for improving cost
estimation accuracy and resource allocation efficiency.
Abstract
This paper analyzes investment timing in the presence of agency conflicts
and information asymmetries. It is assumed that an owner of an investment
project (a real option) needs specialized expertise in order to make the
investment. There are n firms with the required knowledge, and these
"expert firms" compete about a contract that gives the contract
winner the right to manage the investment. Each competitor chooses an
unobserved effort that influences the probability of its investment cost
level. When effort is made, each expert firm privately observes its own
investment costs, but not the competitors. The winner of the contract is
the firm that (truthfully) reports the lowest investment cost. The private
information problem increases the critical price of investment compared to
the case of no inefficiency. When moral hazard is included in the model,
the effect on the trigger value is ambiguous: For a low investment cost,
the moral hazard problem mitigates the inefficiency effect due to private
information. On the other hand, for high investment cost levels the
critical price of investment may increase further. Only in a situation in
which there is one expert firm (n=1), does the moral hazard problem always
mitigate the inefficiency cost due to private information. The last result
is consistent with findings in Grenadier and Wang.
Firm-Specific Human Capital as a Real Option Mark Cassano, University of Calgary,
Canada Tom Cotrell, University of Calgary,
Canada
Abstract
The purpose of this paper is to derive an optimal decision rule for
investment in a finite life project. Extending the standard real option
framework, we impose that the firm is ambiguous about the development of
profit over time in the sense that it has no perfect information about
parameter values governing the profit dynamics. The analysis is based on
Knight's distinction between risk and uncertainty and is carried out by
dynamic programming in continuous time. We find that ambiguity aversion
affects the value of waiting equivocally and thus may accelerate
investment. Yet, in the long run a large degree of Knightian
uncertainty results in foregoing investment with greater probability than
in the absence of Knightian uncertainty.
Abstract
Recent literature on optimal investment has stressed the difference between
the impact of risk compared to Knightian
uncertainty - also called ambiguity - on an investor’s
decisions. However, the decision maker’s attitude
towards uncertainty is crucial when analyzing his investment decisions
given an uncertain environment. By introducing an individual parameter
reflecting personal characteristics of the entrepreneur, our simple
irreversible investment model helps to explain differences in investment
behavior in situations which are objectively identical. This paper shows
that the presence of Knightian uncertainty leads
in many cases to an increase in the subjective project value, and
entrepreneurs are more eager to invest.
Abstract
This paper employs real option approach (ROA) to study the decision of ABC
adoption and discontinuation under uncertainty. The general idea behind is
that investing in ABC system is an option-rights as in financial American
call option. The proposed model takes the total annual number of production
of a firm as the primary decision variables. The added annual net profits
after establishing ABC are considered in deciding the optimal threshold for
adoption or discontinuation. Moreover, the difference between the ROA and
the net present value (NPV) method is compared. We found that the optimal
entry threshold for adoption obtained by the ROA is higher than that
obtained by the NPV method. Conversely, the optimal exit threshold for
discontinuation obtained by the ROA is less than that obtained by the NPV
method. Thus, ROA is more conservative than the NPV method. The difference
between these two methods is primarily driven by the option value of
waiting before implementing the entry/exit project in the ROA. Keywords:
Activity based costing; Management accounting innovations; Real option
theory; Investment under uncertainty.
Abstract
This paper develops a real options model in which the interaction between
debt, liquidation policy and fraud is studied. A firm, being financed by
issuing debt and equity, is allowed to inflate profits engaging in
fraudulent behaviour at the cost of being
detected, in which case liquidation is forced. It is shown that risky debt
always speeds up closure, fraud influences firm value and delays
liquidation; moreover, fraud affects the value of risky debt, which
increases with fraud intensity. A generalization of the model to the choice
of different fraud intensities is also examined.
Abstract
Interactions between financing and investment decisions in a context of
real options represent a challenging field of research (e.g. Trigeorgis
(1993) and Mauer and Triantis (1994)). The
inclusion of agency conflicts is supported by overwhelming empirical
evidence (Long and Malitz (1985), Rajan and Zingales (1995),
Mackay (2003)). Although there have been recent important (Childs et al.
(2005), Mauer and Sarkar
(2005)) there is still much to be done. In this paper we analyse a model of the conflicts between equityholders and debtholders
regarding the optimal exercise moment of an investment option partially
financed by a commitment loan. We assume time constraints for both the
investment option and the subsequent firm. For the firm we consider a fixed
maturity irrelevant of the moment when the
investment option is exercised, aiming at a better reflection of the
reality of many real options projects (e.g. petroleum explorations, mining
firms, pharmaceuticals). Our results support the
coexistence of two different incentives (overinvestment and
underinvestment) in one single type of real flexibility (option to invest)
evidencing why perpetual models tend to fail in capturing the true
complexity of agency conflicts. Furthermore, we show how overinvestment
incentives clearly dominate underinvestment incentives, in terms of their
impact in the option value, and how they tend to occur at or close to
maturity of the investment option. We present competing predictions for the
size of the agency costs and reiterate the impact of the agency conflicts
in lowering optimal debt levels. Finally we demonstrate why different
measures for the agency costs must be considered (in an approach similar to
Leland (1998) and Mauer and Sarkar
(2005)) in order to correctly capture their full implications.
Abstract Building on the Mauer
and Sarker (2005) model that captures both
investment flexibility and optimal capital structure and risky debt, we
study the impact of debt financing constraints on firm value, the optimal
timing of investment and other important variables like the credit spreads.
The importance of debt financing constraints on firm value and investment
policy depends largely on the relative importance of investment timing
flexibility and debt financing gains. In cases where investment flexibility
has high relative importance the firm can mitigate the effects of debt
financing constraints by adjusting its investment policy. We show that
these adjustments are non-monotonic and may create a U shape of the
investment trigger as a function of the degree that debt is constrained. We
show that in a reduced investment horizon, constraints have a more
significant impact on firm value. We also consider managerial
pre-investment risky growth options (e.g. R&D, or pilot projects). We
see that they reduce the maturity effect, and (in contrast to the Brownian
volatility) they tend to reduce expected credit spreads.
