DAY 1 - Thursday July 4
7:15 -
8:00 Registration and
Continental Breakfast
8:00 - 8:40 Chairperson's Welcome & Address
Real Options and Investment Under
Uncertainty
Lenos Trigeorgis, U. Cyprus
and President, Real Options Group
9:00 -10:00
Ventures I: Introductory
Chair: Anthony Saunders, New York
University
Real Options Implications On
Venture Capitalist's Investment Decision-Making Behavior
Lip Soon (Andrew) Wong, Multimedia
University
Abstract
An overriding issue on the agenda of todayÓs venture capitalists concerns
their investment decision-making. Their fundamental concern is compounded by
methodological difficulties: a) traditional net present value (discounted
cash flow) evaluations are inadequate for
many risky projects, and b) the available methods for valuing these projects
are limited and often impractical. Good investment decision-making has often
been described as following: - an orderly and logical process from framing
investment decision-making problem, searching and evaluating
of alternatives, and choosing the best option to investment. Compressed
decision time and increase complexity are disturbing the orderly flow of
information and proper flow of investment decision-making authority
structure. Managers are turning to new approaches, emphasizing on options
thinking, managerial flexibility and resource flexibility. This paper
describes the implications of the presence of real options in investment
decision-making situations and how the presence of real options changes the
managers' investment decision-making behavior. Real options reasoning is a
logical for funding projects that maximizes learning and access to upside
opportunities while containing costs and downside risk. Although it has
considerable advantages over conventional approaches, the methodology to make
some intelligent conjectures remains scare. This paper describes and
illustrates a methodology to understand the behavior change of investment
decision-making with and without the presence of real options. The research
exercise demonstrates the behavioral changes implications with and without
the presence of real options. This paper seeks to develop theory or compare
patterns by looking at four main questions that will be answered through a
series of exercises. The 4 questions are stated below: - 1. Given the choice
to choose several investment decision-making options, will the investment
practitioners change their investment decision-making behavior? 2. Given the
choice to choose several investment decision-making options, how will the
investment practitioners change their investment decision-making behavior? 3.
How does the behavioral change evolved through proper learning of real
options flexibility, such as managerial flexibility and flexible resource
allocations? 4. How sustainable and adaptable will the behavioral change in
investment decision-making of the investment practitioners through the time?
This paper focuses on six aspects of the process that venture capitalist use
to select and structure investments: investment strategy, deal flow
generation, screening, due diligence, valuation, and investment structure.
Decision-making regarding these processes of selecting and structuring
investments also followed the standard model of decision-making: Investment
practitioners make assessment on the current issues or situations,
alternative decisions are listed and evaluated
as to the managers objectives, risk and reward factors and so on often using
traditional valuation methodology; a decision was made and implemented. In
this paper, I will describe a series of approach to evaluating
investment decision-making through experimental economics. For example,
controlled experiment will be use to ask respondents to score a series of statements
to understand and investigate their investment decision-making behavioral
changes. Given the relentless development of investment field, complexity in
investment decision-making can only be expected to increase. This promises
lead to more intense and complex challenges for decision makers, but through
the exercise and better understanding of their investment decision-making
behavior, investment practitioners will have equip themselves with powerful
understanding for addressing these complex and dynamic decisions. In this
paper, I will describe a series of approach to evaluating
investment decision-making through experimental economics. For example,
controlled experiment will be use to ask respondents to score a series of
statements to understand and investigate their investment decision-making
behavioral changes. Given the relentless development of investment field,
complexity in investment decision-making can only be expected to increase.
This promises lead to more intense and complex challenges for decision
makers, but through the exercise and better understanding of their investment
decision-making behavior, investment practitioners will have equip themselves
with powerful understanding for addressing these complex and dynamic
decisions.
Valuing a Private Equity Venture
Investment: The Case of a B2B Marketplace Start-Up
Anett Mehler-Bicher, European Business
School, Germany
Martin Ahnefeld, European Business
School, Germany
Abstract
The application of option theory to problems in information technology and
especially to e-business has been the subject of some research in the last
years. Prior research especially targeted the demonstration of the power of
real options through applying fundamental option pricing models, such as the
Black-Scholes or the binomial models, on real world cases. As a result,
option theory offers high potential for useful insights regarding the evaluation
of irreversible investments under uncertainty and requiring flexibility. A
great number of e-business investments is initiated by early stage companies
œ mostly financed by venture capital or private equity. Due to the sharp
declination of stock prices of new economy companies in 2000 venture
capitalists have realized that they have paid too high prices for their
equity stakes. They have to admit that new economy market was driven by
euphoria rather by fundamental values. By such a crash, the applied valuation
methods are questioned. Venture capitalists dealing with seed and startup
companies on their daily basis need realistic and sensible valuations in
order to make profitableinvestment decisions. However, the valuation of those
high growth companies is difficult and presents a big challenge. Most of
those companies have negative earnings and no or only small revenues. In
addition, comparable companies are rare or required information not
accessible to the public which makes it very difficult to apply multiple
valuation. Regarding the private equity market start-up venture consists of
many options due to high flexibility and uncertainty of their future
development. Also from an investorÓs perspective an investment in an early
stage company may incorporate several options such as future follow-up
investments, which will be carried out if the company proceeds successfully.
Traditional valuation methods such as DCF are not able to capture and price
such options, but with option theory it is possible to assign them a fair
value. As a consequence, the aim of this research paper is to apply and test
a variation of the real option method on private equity investments. Based on
the case study approach a fictive B2B marketplace at the start-up financing
round in the end of 2000 is discussed. On behalf of confidentiality
agreements signed within the venture capital market it is not possible to
access real world cases, which makes it compulsory to use a fictive case. The
goal is to precisely define and calculate the individual steps of the real
option approach in order to derive an accurate and correct valuation of the
B2B marketplace at the given financing round. This research paper makes three
important contributions in this context: (1) it systemizes the application of
real option models in the scope of private equity, (2) it demonstrates the
feasibility of option theory for assessing private equity investments and (3)
it shows a tendency concerning cost-benefit ratio if option theory is applied
on private equity investments.
10:30 -
12:00 Ventures II: Design
and Contracting
Chair: David Robinson, Columbia
University
Optimal
Staging of Venture Investments
Hongjiang Li, Dalian
University of Technology, China
Abstract
Real options approaches can be employed to value the flexibility in the decision-making
courses of phased investments. This paper focuses on the two-stage investment
problems of venture firms. Firstly, two real options are recognized by real
options thinking. After that, based on the analysis of profit function,
stochastic models are proposed to describe the uncertainties those are
inherent in markets. Then the value function of decision-making flexibility
is derived as well as the vital executable probability of the two real
options. Finally numerical techniques are employed to calculate the optimal
proportions of a case and the influence of investment proportions upon the
flexibility value is also analyzed.
Understanding the Economic Value of
Legal Covenants in Investment Contracts
Didier Cossin, HEC, University
of Lausanne and IMD
Benoit Leleux, IMD- International Institute for
Management Development
Entela Saliasi, HEC, University
of Lausanne and
FAME
Abstract
Valuing early-stage high-technology growth-oriented companies is a
challenge to current valuation methodologies. This inability to come up with
robust point estimates of value should not and does not lead to a breakdown
of market liquidity: instead, efforts are redirected towards the design of
investment contracts which materially skew the distribution of payoffs in
favor of the venture investors. In effect, limitations in valuation abilities
are addressed by designing the investment contracts as baskets of real
options instead of linear payoff functions. This paper investigates four
common features (covenants) of venture capital investment contracts from a
real option perspective, using both analytical solutions and numerical
analysis to draw inferences for a better understanding of contract features.
The impact of the concept for pricing issues, valuation negotiation and for
contract design are considered. It is shown for example how ''contingent
pre-contracting'' for follow-up rounds is theoretically a better proposition
than the "rights of first refusal" commonly found in many
contracts.
Financial Contracting in
Biotech Strategies Alliances
David Robinson, Columbia
University
Toby Stuart, University
of Chicago
Abstract
We conduct a detailed, micro-level analysis of 126 strategic alliance
contracts, all of which were written to sponsor early-stage, genomics-based
biotechnology research at small R&D companies. All contracts prescribe
staged investment decisions to capture the option value associated with the
sequential resolution of uncertainty, but the contracts deal with agency
problems di
erently. Among pre-IPO companies, many alliances resemble venture capital
contracts: they involve convertible preferred equity and sometimes contain
anti-dilution provisions, warrants, and board seats. Contracts contain
explicit provisions linking equity participation to subsequent IPO activity,
and contain clauses designed to insulate both parties from multi-tasking
problems. Contrary to the standard assumptions of static contract theory,
contracts often specify provisions that are unobservable or diffcult to
verify. Equity participation is positively correlated with the ambiguity of
the contracting environment.
JEL Classification Codes: G30, G34, G39, M13, O39
1:30 -
3:00 Competition and
Strategy
Chair: Helen Weeds, Lexecon Inc.
Strategic Dynamic R&D Investments
Ruslan Lukach, University
of Antwerp
P.M. Kort, University
of Antwerp and Tilburg
University
J. Plasmans, University
of Antwerp and Tilburg
University
Abstract
In this paper we present a model, which describes firmsØ strategic R&D
investment under technological uncertainty. It assumes two symmetric firms
making strategic decisions about undertaking two-stage R&D subject to
uncertainty in the outcome of the first exploratory stage. The model
concludes that using real options to evaluate
the R&D investments allows the firm to undertake larger investment
projects when uncertainty is large. Also using the real options creates more
complex strategic interactions between the competing agents in a duopoly. If
the R&D is profitable for both agents, they will invest symmetrically and
compete later in production. But the technological uncertainty together with
the strategic interaction between two agents can lead to the outcome when it
is profitable for one agent to invest in R&D only when another agent does
not. The "leader" gets a largermarket share and is capable of
conducting the R&D in amounts, which otherwise are nonprofitable under
regular symmetric conditions or if the first-stage exploratory R&D did
not succeed. JEL Classification: C72, D21, O31 Keywords: Investment under
Uncertainty, Real Options, R&D, Competition
Timing Advantage: Leader/Follower Value
Functions if the Market Share Follows a Birth and Death Process
Dean Paxson, Manchester
Business School
Helena Pinto, Doctoral Programme-Manchester
Business School
Abstract
For a duopoly environment, we model the leader and follower value
functions assuming that the leader's' market share evolves according to an
immigration (birth) and death process. We derive explicit solutions for the
follower's option to invest, and numerical solutions for the leader's option
to invest. Then we calculate the partial derivatives of the leader and
follower value functions to market share, birth/death parameters, volatility
and market profitability. This model is possibly more realistic than that
proposed by some other authors studying the advantages of being first (and
also being a follower). We show that over certain ranges of the parameter
values, the leader and follower real options to wait to invest, and not to
wait to invest, are sometimes surprising and not immediately intuitive.
Real Options and Competition:
The Impact of Depreciation and Reinvestment
Alfons Balmann, Fachhochschule Neubrandenburg (Univ. of Applied
Sciences)
Oliver Musshoff, Humboldt University
Berlin
Abstract
Applications of the real options approach hardly consider investment
returns to be the result of competitive markets such as markets for
agricultural products. The reason is probably that Dixit and Pindyck (1994,
ch. 8) show in their very popular book "Investment under
Uncer-tainty" that the investment triggers of firms in competitive
markets are equal to those of firms with exclusive options. In this study,
however, it is shown that this result is restricted to mar-kets in which
assets have infinite lifetime. If assets are subject to depreciation and
subsequent reinvestment opportunities, competition leads to significantly
lower investment triggers. The reason is that depreciation of replaceable
assets allows to compensate the potential decline in returns after negative
demand shocks because of the non-replacement of depreciated assets.
Accordingly, applications of the real options approach to investments in e.g.
pig production should consider this effect. The results are obtained by an
agent-based simulation approach in which a number of competing firms derive
their investment triggers by a genetic algorithm. Since this method allows to
understand the resulting price dynamics, an alternative method is presented
that allows to simulate the identified price dynamics directly and which also
can be used to determine investment triggers for certain conditions.
The Strategic Value of Flexible
Quality Choice
Grzegorz Pawlina, Tilburg
University, Dept.
of Econometrics and OR
Peter M. Kort, Tilburg
University, Dept.
of Econometrics and OR
Abstract
This paper analyzes the value of flexibility in quality choice using a
dynamic real-option framework. Firms decide about quality of their products
when they enter the market upon incurring a sunk cost. Flexibility in quality
choice induces (ceteris paribus) earlier investment, and the value of
flexible quality increases with demand uncertainty. We find that a possibility
of competitive entry more than doubles the relative value of flexibility.
Moreover, we show that flexible quality serves as an entry deterrent control,
while it can still be set at the optimal monopoly level. Furthermore, we
extend the theory of strategic real options from which it is known that the
follower's investment timing is irrelevant
for the decision of the leader. The addition of a second control (quality)
results in the leader's investment timing being influenced by the follower's
entry. It also holds that introducing the second control variable in
combination with strategic interaction results in the option value of the
leader decreasing in uncertainty. Finally, we show that the follower can be
driven out of the market due to "aggressive" quality choice of the
leader in high states of demand.
3:30 -
5:00 Asymmetric
Information, Auctions, and Games
Chair: George Constantinides, University
of Chicago
Asymmetric Information and
Irreversible Investments with Competing Agents: An Auction Model
Jøril Mæland, Norwegian School
of Economics and
Business
Abstract
In this paper real option theory and auction theory is combined. A
decision maker has a real option consisting of a right to implement an investment
project by paying an investment cost. Two or more agents have private
information about the constant investment cost. The owner of the project
organizes auction, where the privately informed agents participate. The
investment strategy, formulated as an optimal stopping problem, is delegated
to the winner of the contract. An optimal compensation function is found,
which induces the winning agent to follow the investment strategy preferred
by the project owner. It is shown that asymmetric information causes an
additional wedge between a
ecting the critical price of implementation, with the inverse hazard rate
being a key component.
Real Option Games with Incomplete
Information and Spillovers
Spiros Martzoukos, University
of Cyprus
Eleftherios Zacharias, University
of Cyprus
Abstract
We model in a game theoretic context managerial intervention directed
towards value enhancement in the presence of uncertainty and spillover
effects. Two firms face real investment opportunities, and before making the
irreversible investment decisions, they have options to enhance value by
doing more R&D and/or acquiring more information. Due to spillovers,
firms act strategically by optimizing their behavior, conditional on the
actions of their counterpart. They face two decisions that are solved for
interdependently in a two-stage game. The first-stage decision is: what is
the optimal level of coordination between them? The second-stage decision is:
what is the optimal effort for a given level of the spillover effects and the
cost of information acquisition? For the solution we adopt an option pricing
framework that allows analytic tractability.
Strategic Entry and Market
Leadership in a Two-player Real Options Game
Mark Shackleton, Lancaster
University
Andrianos Tsekrekos, Lancaster
University
Rafal Wojakowski, Lancaster
University
Abstract
We analyse the entry decisions of competing firms in a twoÐplayer stochastic
real option game, when rivals can exert different but correlated uncertain
profitabilities from operating. In the presence of entry costs, decision
thresholds exhibit hysteresis, the range of which is decreasing in the
correlation between competing firms. The expected time of each firm being
active in the market and the probability of both rivals entering in finite
time are explicitly calculated. The former (latter) is found to decrease
(increase) with the volatility of relative firm profitabilities implying that
market leadership is shorterÐlived the more uncertain the industry
environment. In an application of the model to the aircraft industry, we find
that Boeing's optimal response to Airbus' launch of the A3XX super carrier is
to accommodate entry and supplement its current product line, as opposed to
the riskier alternative of committing to the development of a corresponding
super jumbo.
5:00 - 6:00 Panel Discussion
Moderator: Gil Eapen, Principal,
Decision Options, ex Group Director of R&D, Pfizer
High Tech/Corporate Valuation:
Challenges and Prospects
Panelists Include
Rainer Brosch (Boston
Consulting Group)
Fabio Cannizzo (British Petroleum)
George Constantinides (University
of Chicago
Onno Lint (U. Leuven and Associate, Real Options Group)
Michael Raynor (Deloitte Consulting)
David Robinson (Columbia U.)
Rob Smith (Dell Computer Corp).
6:00 - 7:00 Welcome/Networking Cocktail
8:30 -
10:00 Dinner
DAY 2 - Friday July 5
7:45 -
8:30 Continental Breakfast
8:30 -
10:00 Contractual Options
and Agency/Incentives
Chair: Apostolos Burnetas, Case
Western Reserve University
Adverse Incentives and Real Options:
Determining the Incentive Compatible Cost-of-Capital
Carlton-James Osakwe , University
of Calgary
Abstract
In this paper, we examine the real options approach to capital budgeting
in the presence of managerial adverse incentives. We show that real options
have the potential to be value enhancing or value destroying depending on
managerial incentives. We further examine the possibility of using a generic
residual income based rule of managerial compensation to induce the proper
investment incentives and we seek to determine the cost-of-capital that must
be employed in such a rule.
Option Contracts in Supply Chains:
Retailer Reorder and Returns Options
Apostolos Burnetas, Case
Western Reserve University
Peter Ritchken, Case
Western Reserve University
Abstract
This article investigates the pricing of options when the demand curve is
downward sloping. Our specific application arises in a supply chain setting,
where a manufacturer offers the retailer the right to reorder items at a
fixed price and/or the right to return unsold goods for a predetermined
salvage value. We show that the introduction of option contracts causes the
wholesale price to increase and the volatility of the retail price to
decrease. Conditions are derived under which the manufacturer is always
better off by introducing options. In general, options are not zero sum
games. In some cases the retailer also benefits while in other cases the
retailer is worse off. If the uncertainty in the demand curve is sufficiently
high, the introduction of option contracts alters the equilibrium prices in a
way that hurts the retailer. Finally, we demonstrate that if either the
manufacturer or the retailer wants to hedge the risk, contracts that pay out
according to a quadratic function of the price of a traded security are
required.
Managerial Flexibility,
Agency Costs and Optimal Capital Structure
Ajay Subramanian, Georgia Institute of Technology
Abstract
This paper investigates the effect of managerial flexibility on the choice
of capital structure for a firm and the corresponding valuation of its long
term debt. We consider a general model in continuous time where the manager
(who is not a shareholder) of a firm with long term debt in place may
dynamically switch between different strategies at random times so as to
maximize his expected discounted compensation. The manager may bear personal
costs due to bankruptcy of the firm and the firm enjoys a tax shield on its
interest payments to creditors. Under general assumptions on the nature of
the strategies available to the manager, we show the existence of and derive
explicit analytical characterizations for the optimal policies for the
manager. We then derive the optimal policies for the firm that can
hypothetically contract for managerial behavior ex ante, i.e. before debt is
in place. We investigate the implications of these results for the optimal
capital structure for the firm in the presence of managerial flexibility and
the valuation of its long term debt. We also obtain precise quantitative
characterizations of the agency costs of debt due to managerial flexibility
in a very general context and show that they are very significant when
compared with the tax advantages of debt thereby implying that managerial
flexibility is a very important determinant of the choice of optimal capital
structure for a firm. We carry out several numerical simulations with
different choices of underlying parameter values to calculate the optimal
leverage, agency costs , corporate debt values and bond yield spreads and
study the comparative statics of these quantities with respect to the
parameters characterizing the strategies available to the manager. The
optimal leverage levels predicted by our model correspond very well with
average leverage levels observed in the marketplace.
10:30 -
12:00 Empirical Evidence
Chair: Stathis Tompaidis, University
of Texas, Austin
Exercising Real Options: The Case
of Voluntary Liquidations
Shumei Gao, Heriot-Watt
University School
of Management
Anna Eliasson, Hawaii
Pacific University
Jihe Song, University
of Wales,
Abersytwyth
Abstract
In this paper, we study the option of voluntary liquidations and test the
real option model predictions. The results broadly support the presumption
that it is performance variability not performance per se, that is important
for voluntary liquidation decisions. While evidence for the volatility efefct
is strong, evidence for the interest effect is mixed.
Option-based Bankruptcy Prediction
A. Charitou, University
of Cyprus
Lenos Trigeorgis, University
of Cyprus
Market Imperfections, Investment Optionality and Default
Spreads
Sheridan Titman,
University of Texas at Austin
Stathis Tompaidis, University of Texas at Austin
Sergey Tsyplakov, University of South Carolina
Abstract
This paper develops a structural model that determines
default spreads on
risky debt. In contrast to previous research, the value of
the debt's
collateral is endogenously determined by the borrower's
investment choice, as well as by a market demand variable that has permanent as
well as temporary components. The model also considers market
imperfections that
limit the borrower's ability to contract to undertake the
value-maximizinginvestment choice, and which may in addition limit the
borrower's ability to
raise external capital. The model is calibrated with data on
commercial
mortgages, and based on our calibration, we present
numerical simulations
that quantify the extent to which investment flexibility,
incentive problems and credit constraints affect default spreads.
Real
Options and Stock Market Anomalies
Han Smit, Erasmus
University
Pim van Vliet, Erasmus
University
Abstract
This study presents an intuitive explanation, based on insights of real
options theory, for the value size puzzle. Growth-based firms are not overvalued,
but priced for their upward risk. Small growth-based firms are especially
characterized by an asymmetric risk-return relation. Therefore, the
value-size premium comprises two parts: a distress premium and a growth
discount. Beta underestimates the risk of distressed firms and overestimates
the risk of growth firms caused by asymmetries in stock returns. We examine
the impact of growth options on equity returns within a panel of 7,167 listed
U.S. firms
(1981Ð 2000).
Keynote Luncheon Address
Will Real Options Get the Respect They
Deserve?
Gordon Sick, University
of Calgary
Professor Sick is Professor of Finance at the University
of Calgary. Previously he taught
at Yale University,
the University of British
Columbia, and the University
of Alberta. He received a Masters
in Mathematics from the University
of Toronto, and a Masters and PhD
in Finance from the University of British
Columbia. Dr. Sick has been a Fellow at the
Royal Netherlands Academy of Arts and Sciences (NIAS), and is the book review
editor for the Journal of Finance. Professor Sick made early contributions in
real options primarily in the area of urban land and natural resource
economics and published one of the first comprehensive monographs on real
options in 1989. He has made important contributions in the area of
certainty-equivalent valuation and capital budgeting, which are at the core
of real options. For example, he pondered how to value interest tax shields
in the presence of certainty-equivalents, and in his work on Tax-Adjusted
Discount Rates he develops the correct treatment for discounting
certainty-equivalents (including real options). On the practitioner side, Dr.
Sick was one of the founding members of the Real Options Group, and has
subsequently consulted independently, for Stern Stewart and Co. and others.
He has also been instrumental for the success of the annual real options
conference, helping out with the website, program and otherwise.
1:30 -
3:00 Valuation of
Electric Power/Infrastructure
Chair: Gordon Sick, University
of Calgary
Valuing
an Operating Electricity Production Unit
Sigbjørn Sødal, Agder
University College
Steen Koekebakker, Agder
University College
Abstract
In this paper we develop an equilibrium-based net present value model of
an operating electricity production unit whose supply is given by a
stochastic, mean-reverting process. The price process for electricity is
derived from an underlying pair of stochastic, aggregate supply and demand
processes that are also mean-reverting, while the instantaneous supply and
demand functions are iso-elastic. The model is illustrated by a set of
experimental data. iso-elastic. The model is illustrated by a set of experimental
data.
Real Option Models and Electricity
Portfolio Optimization
J. Hlouskova, Institute for Advanced Studies, Vienna-Austria
M. Jeckle, Institute for Advanced Studies, Vienna-Austria
S. Kossmeier, Institute for Advanced Studies, Vienna-Austria
Investments in Thermopower
Generation: A Real Options Approach for the New Brazilian Electrical Power
Regulation
Katia Rocha, IPEA, Brazil
Ajax Moreira, IPEA,
Brazil
Pedro David, FURNAS, Brazil
Abstract
One of the main questions in electricity market deregulation is the
aptitude of private capital for investments in power generation. This is
especially important in Brazil,
whose load has a strong growth trend (about 5% per year). Thermopower is an
attractive alternative for expanding generation, as it is complementary in
many aspects to hydropower, which supplies most Brazil's
power at a very low price most of the time, but makes the system vulnerable
to seasonal water variations. This paper studies the competitiveness of
thermopower generation in Brazil
under current regulations and assesses under the real options theory approach
the conditions for investments in thermopower generation.
Keywords: Stochastic Dynamic Programming; Real Options Theory; Investments
in Power Generation.
Optimal Investment Management of
Harbour Infrastructures: A Simulation Approach
Carmen Juan, Universidad de Valencia
Fernando Olmos, Universidad de Valencia
J. Carlos Perez, Universidad de Valencia
Abstract
Most real problems need to be modeled using multiple state variables,
combine multiple Real Options (very often american-style ones) and have
complex cash flow functions. In this paper we present a new Scenarios-Monte
Carlo method to approach this kind of high-dimensional Real Options problems.
The method is based on scenarios spaces built at each exercise date so that
the payoff function can be modified at each scenario depending on the
optionallity. Then scenarios are related in order to calculate the expected
value of continuation. The main contribution of the algorithm is that it
allows us to price american-style real options while solving decision
problems of optimal investment policy.
3:30 -
5:00 Valuation of Flexible
Plants and Global Networks via Switching Options
Chair: Ajay Subramanian, Georgia Institute of Technology
(Numerical)
Valuation of a Flexible Manufacturing Plant (or FMS): An Overview Using Cost Volume
Profit (CVP) Analysis
Giuseppe Alesii, Universita' de L'Aquila, Facolta' di Economia
Abstract
In this short paper, (Kulatilaka 1988) model of FMS management is
reinterpreted as a real options dynamic programming (DP) version of
traditional Cost Volume Profit (CVP) analysis. Numerical examples replicate
results reported in chapter 4 example 1.H. and chapter 7 of (Dixit and
Pindyck 1994). Moreover, a different version of (Kulatilaka 1988) numerical
example is analyzed. Results include not only the value of the flexible
plant, decomposed into its base value and the value of the flexibility
options (namely abandonment option, production mode switching option,
mothballing option and waiting to invest option), but also mode bounds
(threshold curves) are derived not only for the beginning time but for the
whole life of the project. In conclusion, this paper shows how much powerful
is Kulatilaka's General Real Option Pricing Model (GROPM) in reaching through
simple numerical methods results that others, (e.g. Dixit and Pindyck 1994),
get through very difficult symbolic stochastic algebra.
Valuation of a Flexible Plant with
Staging Flexibility and Multiple Production Modes
Spiros Martzoukos, University
of Cyprus
N. Pospori, University
of Cyprus
Lenos Trigeorgis, University
of Cyprus
Real Switching Options and
Equilibrium in Global Markets
Ajay Subramanian, DuPree
College of
Management, Georgia Institute of Technology
Nagesh Murthy, DuPree
College of
Management, Georgia Institute of Technology
Milind Shrikhande, J. Mack Robinson College of Business, Georgia
State University
Abstract
This paper proposes and investigates a theoretical model in continuous
time to analyze the real switching options that an economic entity in
relationships with multiple external economic agents holds and the
corresponding implications for equilibria between the entity and the agents
if they are active. Although our basic model is generally applicable in several
widely different economic scenarios, for expositional simplicity, we consider
the specific problem of a firm and its global suppliers. We begin by
considering the optimal dynamic policy problem for the firm where it may face
different exogenously specified relationship specific fixed costs and random
variable costs vis-›-vis each supplier and its goal is to dynamically choose
a supplier over time so as to maximize its expected discounted cash flows. At
any instant of time, the firm therefore holds compound real options of
entering the market with a particular supplier, switching to another supplier
or exiting the market. In the case where the firm has two suppliers, we
derive necessary and sufficient conditions on the fixed and variable cost
structures of the firm vis-›-vis the suppliers for the switching option of
the firm to have strictly positive value. These also represent necessary and
sufficient conditions for each supplier to have strictly positive expected
cash flows. Either one of the two suppliers captures the market if these
conditions do not hold. We illustrate our analytical results through several
numerical simulations. Next, we investigate the equilibria between the firm
and its suppliers when both suppliers are in the same foreign country (or,
more generally, in two countries with pegged currencies) with uncertainty
driven by fluctuations in the exchange rate process. The prices quoted by the
suppliers and, therefore, the variable costs of the firm are now determined
endogenously in equilibrium where the suppliers and the firm respond
rationally and optimally to each other's policies. We devise a procedure to
derive equilibria between the firm and its suppliers where a leader-follower
game between two competing suppliers allows the firm to maximize value given
its bargaining power. We provide sufficient conditions for both suppliers to
co-exist in any possible equilibrium with the firm. We identify equilibria
between the firm and its suppliers for several different values of underlying
parameters that illustrate the impact of competition in global markets.
8:00 - 8:30 Welcome/Overview Talk (by Paphos port & castle)
Overview of Cyprus Financial System & European Prospects
Dr. Marios Clerides, Chairman,
Cyprus
Securities & Exchange Commission
8:30-10:00 Reception by Paphos port &
castle, followed by free stroll near Paphos port & downtown
DAY 3 - Saturday July 6
7:45 -
8:30 Contintental Breakfast
8:30 -
10:00 Conceptual I:
Overview, Track I Akamas Ballroom A
Chair: Richard Schockley, Indiana
University
Real Options Analysis and the
Assumptions of the NPV Rule
Richard Schockley, University
of Indiana
Tom Arnold, Louisiana
State University
Abstract
The point of this paper is to spell out in layman's terms the assumptions
that underlie DCF analysis, the NPV rule, and the 'unanimity' result. In
order to use financial-market prices to value new corporate investments, we
have to assume that the financial markets are free of arbitrage opportunities
and that the new investment does not change the equilibrium price
system. This latter assumption was called the 'competitivity' assumption
in the unanimity literature, and it amounts to an assumption that the financial
markets are complete and that the new investment does not change aggregate
consumption in a material way (if either is violated, the new investment
changes the equilibrium in the financial markets and hence changes all
prices, so the NPV rule is not the unanimous decision rule - see Baron's
review article in JF, 1979). Of course if markets are complete and free
of arbitrage opportunities, then a unique EMM prices all assets. Hence,
the assumptions needed to apply the NPV rule are sufficient for application
of option pricing techniques to real assets.
Extended NPV and Real Options with
Information Uncertainty: Applications for R&D and Ventures
Mondher Bellalah, (Universite Cergy and Universite
Paris-Dauphine, France
Abstract
This paper presents a survey of some results regarding the standard
discounted cash flow techniques, the economic value added and real options.
Since the standard literature ignores the role of market frictions and the
e¥ect of incomplete information, we rely on MertonÕs (1987) model of capital
market equilibrium with incomplete information to introduce information costs
in the pricing of real assets. Using this model instead of the standard CAPM
allows a new definition of the weighted average cost of capital and o¥ers
some new tools to compute the value of the firm and its assets in the
presence of information uncertainty. Using the methodology in Bellalah (2001
a,b) for the pricing of real options, we propose some new results by
extending the standard models to account for shadow costs of incomplete
information. The extended models can be used for the valuation of R&D
projects as well as projects with several stages like joint ventures.
Real
Options and Game Theory: When Should Real Options Valuation be Applied?
Helen Weeds, Lexecon
Abstract
In recent years there has been considerable interest in real options as a
valuation method and investment appraisal technique. In addition to a multitude
of specialist textbooks (see, among others, Trigeorgis (1996), Amram and
Kulatilaka (1999) and Copeland and Antikarov (2001)), the real options
approach is also now covered in standard texts such as Brealey and Myers
(2000). The technique has been applied to a number of areas including
valuation of oil leases, patents and real estate.
Despite initial enthusiasm, real options valuation has proved difficult to
put into practice. The techniques are significantly more complex than the
established investment appraisal methods of discounted cashflow (DCF), return
on capital employed (ROCE) or payback period. Real options valuation requires
detailed analysis of all possible future developments, and the degree of
uncertainty surrounding these possibilities, not just the expected outcome.
Managers are also required continuously to monitor the development of the
business environment, considering whether conditions merit the exercise of a
further investment opportunity, or whether they have deteriorated so far that
abandonment of the project is now advisable.
Even assuming that these practical difficulties can be overcome, a
fundamental issue remains to be resolved. When exactly should real options be
applied? Is it always relevant, or are there
situations in which the established DCF-based methods are superior? There
are, even consultants selling the technique will admit, situations where real
options could lead a firm seriously astray. In a setting where there are
strategic advantages to acting quickly and seizing the advantage over oneÕs
rivals, the use of real options could cause a firm to miss important an
opportunity and relinquish its position in the market.
How can we identify the situations in which real options should be
abandoned in favour of more established techniques? Difficulties arise
particularly when real options interact with strategic interactions between
firms. There is a crucial gap in this area, causing considerable confusion.
This article aims to shed some light on this issue and provide some guidance
as to the market conditions under which real options valuation, or a
DCF-based technique, should be applied.
8:30 -
10:00 Conceptual II:
General Perspectives, Track II (Akamas Ballroom C)
Chair: Lawrence
Kryzanowski, Concordia
University
Action Flexibility or the
Option to Use Real Options: A Neo-institutional Economics Perspective
Marcus Dimpfel, University of St Gallen,
Switzerland
Rene Algesheimer, University of
Mainz, Germany
Abstract
Neither the theoretical nor the more practice oriented publications in the
field of real options theory attach much value to the preliminary decision
whether or not to apply real options theory in principal to a specific
context. Most often it is assumed that action flexibility is indeed of great
importance for a setting and that therefore corporations have already voted
for the implementation of real option theory. As a consequence most of the
contributions focus on the detailed execution of the real options approach.
Only a minority of authors comprises the preliminary decision, but most often
remains on a very abtract level, stating that the relevance
of action flexibility and therefore the principal application potential of
real options theory is the higher, the higher an investment context's
uncertainty is.
In this paper we therefore first of all substantiate the abstract
constructs of uncertainty and irreversibility which together drive the relevance
of action flexibility in principal. Furthermore we outline that the relevance
of the different categories of action flexibility, respectively real options,
are influenced in different manners by the determinants uncertainty and
irreversibility.
On the basis of this paper, companies have a much better guideline to
assess the principal application potential of real options theory for an
investmentÓs context. Furthermore they get valuable insights with respect to
the categories of real options they should focus on. This fact seems
especially important as the different real option categories require diverse
models and approaches.
Real Options Valuation of Companies
Run by Theory of Constraints
Ricardo Rochman, FGV-EAESP,
Brazil
Abstract
The valuation of companies managed by theory of constraints is difficult
due to the flexibilities inherent to the system, like the exploration of new
markets, the expansion or shrinkage of production, the modification made in
the products, etc. Traditional valuation models like the net present value or
discounted cash flow do not work suitably because they ignore the flexibility
management has to revise its decisions. So we present a framework using real
options valuation, more specifically the binomial model, to value the company
because it considers the flexibilities of the system and has the assumption
that management is proactive. The correct use of both theories together
result in optimization of decision making in the short and long run and the
consequent creation of value for the shareholders.
On Property Rights and
Appropriation of Real Options
J.P. Dapena Fernandez, Universitad del CEMA,
Argentina
Abstract
Property in financial options (derivatives) is stated and transferred
through contracts, while in real options property may arise from assets under
the management of the firm, without a formal contract properly defining
property. Furthermore, in some situations the asset can be public, and its property
shared among different agents or firms. The present paper intends to work on
the mechanisms of appropriation (and hence transferability) of real options
exploring the assets that give rise to them, and proposing the concept of
indirect property of complementary assets. The meaning of property is
explored, and also the dynamic of change between public and private assets.
Finally, we develop on the features that define real options stemming from
the indirect property of complementary assets.
10:30 -
12:00 Economic Models of
Real Options Valuation, Track I Akamas Ballroom A
Chair: Tim Folta, Purdue
University
Valuation of Football Players
R. Tunaru, Middlesex
University
Ephraim Clark, Middlesex
University
H. Viney, Middlesex
University
Timing and Scaling Options for Market
Power with Application to Real Estate: When and How Much to Invest?
Sigbjørn Sødal, Agder
University College
Abstract
We develop a model of the investment behavior of a firm that faces a
stochastic, downward-sloping demand curve. The firm's challenge is to
determine the optimal scale and time of an investment, so there is a
potential for market power in the sense of markup pricing along two
dimensions: static market power along a quantity dimension, and dynamic
market power along a time dimension. Depending on the specific assumptions,
either dimension will be more or less relevant.
For example, the option to wait may be useless if the uncertainty of demand
is low and the demand curve is not very elastic. Then the decision of the
firm simplifies to that of a standard monopoly model. In other cases, the
option to wait prevails. Typically, the
latter happens when there is much uncertainty and the demand curve is fairly
elastic. The formal model is illustrated by decisions in the real estate
industry.
Investment and Abandonment
Under Economic and Implementation Uncertainty
Andrianos Tsekrekos, Lancaster
University
Abstract
We examine the optimal investment and abandonment policy for a firm that
contemplates a project exposed to two sources of uncertainty: one over the
economic returns of the venture and the second concerning the actual
implementation of the project. We provide a general way of introducing
implementation uncertainty which includes prior research as special cases.
The generality of our treatment stems from the fact that implementation
uncertainty is allowed to affect both the level and the timing of project
profitability. When compared to their Marshallian counterparts, the optimal
policy thresholds can imply earlier or later investment and abandonment,
depending on parameter values. In two simplified cases explicitly addressed,
a firm might invest earlier or abandon a project later depending on whether
implementation uncertainty is expected to be resolved favourably or not.
Entry Timing in the Presence of
Growth Options
Tim Folta, Purdue
University
Jonathan O'Brien, Purdue
University
Abstract
This paper investigates the influence of industry uncertainty on the
decision by established firms to enter a new industry. Specifically, we
examine the tension between the option to defer, which discourages entry in
the presence of uncertainty, and the option to grow, which may encourage
entry in the presence of uncertainty when there are early mover advantages.
Empirical analysis on data from a broad array of industries revealed that the
effect of uncertainty is not monotonic, and that inflection points are
influenced by factors that should theoretically influence the value of the
option to grow and the option to defer.
Keywords: uncertainty, growth option, real option, entry, early mover
advantages
10:30 - 12:00 Theoretical Issues I, Track II (Akamas Ballroom C)
Chair: Manuel Rocha Armada, U. Minho,
Portugal
Fuzzy Real Option Valuation
M. Collan, IAMSR/Abo Akademi U.,
Finland
P. Majlender, IAMSR/Abo Akademi
U., Finland
An
Extension of Least Square Monte Carlo Simulation for Multi-option Problems
Andrea Gamba, University
of Verona
Abstract
This paper provides a new approach for valuing a wide set of capital budgeting
problems with many embedded real options dependent on many state variables
and a related valuation algorithm based on Monte Carlo simulation. The
valuation approach decomposes a complex real option problem with many options
into a set of simple options, and properly taking into account deviations
from value additivity due to interaction and strategical interdependence of
the embedded real options, as noted by Trigeorgis (1993). The valuation
approach presented in this paper is an alternative method to the general
switching approach for valuing complex option problems, as proposed by
Kulatilaka and Trigeorgis (1994) and Kulatilaka (1995). The related numerical
algorithm is based on simulation, along the lines of Longstaff and Schwartz
(2001), and is extended in order to implement the decomposition approach. We
provide also an array of numerical results to show the convergence of the
algorithm and a few real life capital budgeting problems, to see how they can
be tackled with our approach.
Real Investment Opportunity
Valuation and Timing with Finite-Lived American Exchange Options
Paulo J. Pereira, U. Minho,
Portugal
Manuel Rocha Armada, U. Minho,
Portugal
Lawrence Kryzanowski,
Concordia University
Abstract
In practice, the investment opportunities that can be delayed are more
like exchange than simple call options, because there are uncertainties both
in the gross project value (underlying asset) and in the investment cost
(exercise price). Companies that have the option to invest at anytime until a
certain date (the maturity), also often have some opportunity costs (the lost
cash flows) in holding the option instead of the project. Incorporating these
aspects leads to a more realistic evaluation
process. In this research, we value three real investment projects as
finite-lived American exchange options, correcting and applying the Carr
(1988) model. We conclude that, as expected, the traditional Net Present
Value method substantially undervalues projects with this kind of flexibility
(excluding those that are deep in-the-money). This leads to wrong decisions
about the timing of these investments. We also conclude that the results from
using the corrected 1988 Carr model differ substantially from those that we
obtain from using the uncorrected version. As expected, the corrected model
gives results that are higher in value.
Keywords: Real Options; Investment Under Uncertainty; Deferment Option;
Exchange Options.
1:30 -
3:30 Valuing Natural
Resource Investments, Track I Akamas Ballroom A
Chair: Marco A.G. Dias, Petrobras
Real Options Analysis of the Capital
Structure of East Rand Proprietary Mine: A Case Study
M. Samis, Kuiseb Consulting
Valuation of Commodity
Projects and the Option to Invest with Stochastic Prices and Incomplete
Information
Mondher Bellalah, Universite Cergy and Universite
Paris-Dauphine, France
Abstract
This article extends the three models in Schwartz (1997) to describe the
stochastic behavior of commodity prices in the presence of mean reversion and
shadow costs of incomplete information. The implications of the models are
studied with respect to the valuation of financial and real assets. We extend
the analysis in Schwartz (1997) to account for the effects of shadow costs of
incomplete information as defined in Merton (1987).
The first one-factor model assumes that the logarithm of the spot
commodity price follows a mean reverting process. The second model is a
two-factor model in which the convenience yield is stochastic. The third
model accounts for stochastic interest rates. The implications of the models
are studied for capital budgeting decisions.
We develop also a one-factor model for the stochastic behavior of commodity
prices which preserves the main properties of more complex two-factor models.
When applied for the valuation of long-term commodity projects, the model
gives practically the same results as more complex models.
Investment in Information in
Petroleum: Real Options and Revelation
Marco A.G. Dias, Petrobras
Abstract
A firm owns the investment rights over one undeveloped oilfield with
technical uncertainty on two parameters, the size and quality of the reserve.
In addition, the long run expected oil price follow a stochastic process. The
modeling of technical uncertainty uses the practical concept of revelation
distribution, which works directly with the possible new expectations after
the information revelation. Expectations drive the valuation of the
development option exercise. With a partial revelation of uncertainty of a
technical parameter, is necessary to know only the initial uncertainty (prior
distribution) and the expected reduction of the uncertainty caused by the
information, in terms of percentage of variance reduction. After the
information revelation, the development threshold decision depends on the
value of the project level normalized by the development cost, and this
normalized threshold is the same for any technical scenario revealed by the
new information when the oil prices follows a geometric Brownian motion. In
addition, there is a time to expiration of the rights for development, so
that the normalized threshold is a free boundary obtained from the optimal
stochastic control theory. The model includes a penalty factor for the lack
of information, which causes non-optimized development. It is quantified
using discounted cash flow and this factor is introduced into the dynamic
real options model. The model outputs are the real options value with and
without the technical uncertainty, and with and without the information. This
permits to estimate the dynamic net value of information. Keywords: value of
information, dynamic value of information, real options, investment in
information, information revelation, revelation distribution, Monte
Carlo simulation, optimization under uncertainty, valuation of
projects.
Real Options for the
Release of New Crude Mixtures in Mexico
Angel Soriano-Ramirez, Mexican Institute of Petroleum
Myriam Cisneros-Molina, Mexican Institute of Petroleum
Carlos Ibarra-Valdez, Autonomous Metropolitan
University, Mexico
Abstract
Blending operations are widely used in industrial plants including oil
refineries, chemical plants, and cement plants. The operation mixes two or
more streams with different properties to a given specification (e.g.
temperatures, quality, etc.). The problem of optimal blending has been widely
treated, mainly with a mathematical control theory point of view. In Mexico,
blending problem is of utmost importance. The three types of crude that PEMEX
(a government-run company in charge of oil extraction, commercialization,
management and administration of oil and its derivatives) currently delivers
are: Olmeca, Itshmus and Maya. They all are mixtures and their sales
represent an important income for the country. The differences between them
are mainly in the API gravity characteristic among others. Up to date, the
mixture procedure in PEMEX has not been fully systematized and it still
requires partially processes of a handicraft nature. A recent work
(Alvarez-Ramirez et al, 2001) has shown a better procedure for optimizing the
way the mixture can be done keeping the desired characteristics. This
methodology is based on the introduction of Robust Updating Controllers.
Approaching the basic scheme in the above mentioned work, there are some
points at which seems to be worth considering real options techniques,
namely, for introducing new crude oil mixtures for commercialization in
Mexico and getting optimal timing for release. The aim of this work is
applying real options techniques to obtain conclusion about the optimal
release timing of feasible new crude oil mixtures of Mexico
crudes. This includes modeling some of the principal variables involved in
the commercialization of a crude oil mixture. On one hand, the consideration
of the problem involves taking into account the uncertainty of the Mexican
crude mixture prices, the possible price dynamics of new products, their
possible demand and supply, the characteristics of inputs, and considering
the inventories. On the other hand, it requires the assessment of the
following investment decision options: deferring, expanding, contracting,
shut down, restarting, abandonment, switching, and relinquish, among others.
These options are considered in the blending procedure as well as in the
commercialization for the new products. Keywords. Crude oil blending; Crude
oil commercialization; real options.
1:30 -
3:30 Theoretical Issues II,
Track II Akamas Ballroom C
Chair: Spiros Martzoukos, University
of Cyprus
Limits of Integrating Taxes in Real Option
Theory
Caren Sureth, University
of Bielefeld
Rainer Neimann, University
of Tübingen
Abstract
It is well known in the theory of capital budgeting that taxes may have a
significant impact on investment decisions. Since real options are now widely
accepted for assessing investment projects in financial theory as well as in
business practice, it is straightforward to integrate taxation into real
option-based models. By doing so, it is possible to derive a post-tax
investment rule and to identify tax-induced investment distortions.
Consequently, real options literature has been enriched by some recent
publications on taxational issues [e.g., Mauer and Ott (1995), Harchaoui and
Lasserre (1996), Alvarez and Kanniainen (1997), Jou (2000), Pennings (2000),
Agliardi (2001)]. Nevertheless, neither the pre-tax models nor the
integration of taxes follow a unified pattern. Therefore, these approaches
are not applicable to draw general conclusions concerning the influence of
taxation on investment behavior.
Real Options with Incomplete
Information and Time-To-Learn
N. Koussis, University
of Cyprus
Spiros Martzoukos, University
of Cyprus
Lenos Trigeorgis, University
of Cyprus
Valuing Projects with Stochastic Asset
Life
Jihe Song, The University
of Wales,
Aberystwyth
Huw Rhys, The University
of Wales,
Aberystwyth
Abstract
In this paper we propose a stochastic model of asset life under
unceratinty when there is a resale option. We distinguish asset activity
life, economic life and physical life and model activity life as the expected
first passage time distribution for geometric Brownian motion to an optimal
resale boundary. We also establish three convergence results on asset
economic life as the sum of (1) Independent inverse lognormal distributions;
(2) Inverse lognormal and Poisson distributions; (3) Dependent random
variables. Using real options theory and generlaised Central Limit Theorems,
we demonstrate the expected economic life of a durable asset. We have extended
the deterministic model of asset life to the uncertainty case. Our results
throw new lights on the market for used goods and extend the applicability of
real options approach.
Valuation of Options on Multiple
Operating Cash Flows
Antonio Camara, Strathclyde
University
Abstract
This paper establishes a risk neutral valuation relationship (RNVR) for
the pricing of options on multiple operating cash flows assuming that there
is a representative agent who has an extended power utility function.
Aggregate consumption and the underlying operating cash flows are
multivariate displaced lognormal distributed. This RNVR is applied to obtain
closed-form expressions for the value of a new class of investment options,
the event-contingent options. The formulae maintain the risk neutrality
characteristic of the Black-Scholes model, and depend on the threshold
parameters of the underlying cash-flows. The threshold parameter is the lower
bound of the underlying stochastic variable. A negative threshold parameter
assigns a positive probability to both inflow and outflow events. The paper
also offers examples of event-contingent options in a global context.
3:30 -
4:30 Panel Discussion
Moderator: Gordon Sick, University of Calgary
Current State, Challenges and Future Prospects
Panelists Include:
Marco A.G. Dias (Petrobras)
Tim Folta (Purdue U.)
Arnd Huchzermeier (WHU Koblenz)
John Kensinger (U. N. Texas)
Lawrence Kryzanowski (Concordia
U.)
Lenos Trigeorgis (U. Cyprus
and ROG)
Helen Weeds (Lexecon Inc.)
4:30 Closing Remarks/Conference Concludes
8:30 -
10:30 Traditional Dinner
with Music (downtown)
