Real Options Analysis and Strategic Decision Making

1. Real Options Analysis and Strategic Decision Making Authors: Edward H. Bowman and Gary T. Moskowitz Presenter: Cheng (Orange) Wang

2. The structure of this presentation • Introduction • The motivation of this paper • The definition of important terms in this paper • Valuing a Strategic Real Option • The project • Merck’s analysis • Limitations of the Quantitative Approach to Real Options • Modeling assumptions • Determining the inputs • Conclusions: The Role of Option Analysis in Strategic Planning • The Discussion and Future Research

3. Introduction - motivations • The investment decision represents how organizations commit resources to future growth; and real option offers a positive and radical reassessment of the value of risk and exploration; • However, organizational theories and financial theories are rarely considered in tandem; • How to allocate capital? • Traditional corporate finance – DCF • DCF does not account for flexibility of a project • Real Option assumes underlying source of uncertainty and accounts for the future flexibility • There is theoretical attractiveness; but limited in use • This paper: • Case study of Merck’s real options calculation • Illustrate the practical organizational issues using real options • Show how results of strategic analysis can differ from typical options model assumptions

4. Introduction - Definitions • Options: In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price (the strike). The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to fulfill the transaction. • The price of an option derives from the difference between the reference price and the value of the underlying assetplus a premium based on the time remaining until the expiration of the option. • Call option vs. Put option: A call optiongives the buyer the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or "writer") is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right. Vice versa for the put options. • Real option: It is used for firm’s investment decisions. It can be understand as an alternative or choice that becomes available with a business investment opportunity. Real options can include opportunities to expand and cease projects if certain conditions arise, amongst other options.

5. Introduction - Definitions • Patent: A patent gives the owner an exclusive right to prevent others from practicing the patented technology in the country issuing the patent for the term of the patent. The right may be enforced in a lawsuit for monetary damages and/or imprisonment for violation on the patent. • Patent Royalty: In accordance with a patent license, royalties are paid to the patent owner in exchange for the right to practice one or more of the four basic patent rights: to manufacture with, to use, to sell, or to advertise for sale of a patented technology. • Patent rights may be divided and licensed out in various ways, on an exclusive or non-exclusive basis. The license may be subject to limitations as to time or territory. The royalty rate varies depending on industries, whether the patent is issued or pending.

6. Valuing a Strategic Real Option • Corporate decisions and strategic options • Termination of joint ventures, Kogut 1991 • Venture Capital investment, Kogut and Kulatilaka 1994 • R&D programs, Brealy and Myers 1981, etc. • Capital Budgeting decisions, Dixit and Pindyck1994 • The common theme in these decisions – two stage process • First stage: the company made a small investment; it gives the company the right to participate in the projects (the purchase of the option) • Second stage: the company make a decision whether or not to make a larger investment in the project (the exercise the option) • Capital Budgeting, a real option need to be analyzed multiple times by the firm • Whether or not to purchase the real option • If the real options are purchased • Whether to exercise the real option or not • When to exercise the real option

7. Valuing a Strategic Real Option:The project • Merck used the real options to justify an investment in an R&D project – Project Gamma • The biotech company Gamma has patented its technology but has not developed any commercial applications from it. • Merck wants to enter a new line of business but needs the new technology from Gamma. • If Merck licenses the technology, it will take 2 years of research and development on the new tech; but it is uncertain whether the new tech product was commercially feasible or not; • If after 2 years, the new product is commercially feasible, it will take another year to do the start-up, e.g. build plants, marketing, working capital, etc. • The Proposed Gamma Agreement – resembles/ a call option • Merck pays Gamma $2 million license fee over 3 years period • Merck will pay Gamma Royalty fee if the product is commercially feasible • Merck can terminate the agreement anytime if Merck is dissatisfied with the process • The theoretical value should compare to the actual cost of the option: Σ(license fee + R&D cost) • Merck expects the start-up costs to be independent of the future value of the new tech.

8. Valuing a Strategic Real Option:Merck’s analysis • Important parameters in Black Scholes Model (Black and Scholes 1973) • Value of the option: C It is on the left side of the equation. • Stock price: S • Exercise price: K • Time to expiration: t • Volatility: N Use standard normal dist • Risk-free interested rate: r

9. Valuing a Strategic Real Option:Merck’s analysis using the Black-Scholes Model Merck agrees to license and the sensitivity cases are using a variety of less-favorable assumptions • Stock price: • The DCF value from the project, assuming project successful; • two categories of cost-CFs are excluded: • The start-up cost including building plant. • Upfront licensing and development cost. • Exercise price: • Cost of start-up cost including building plant if decides to commercialize the technology. • Time to expiration: • Based on expected time to develop product and build the factory • Volatility: • Based on annual standard deviation of returns of the biotechnology company • Risk-free interested rate: • Based on the then-prevailing yield on 2- to 4-year treasury bonds.

10. Limitations of the Quantitative Approach to Real Options • Lander and Pinches 1998: there are three general categories of implementation problems when using quantitative model to value strategic real options • Finding a model whose assumptions match those of the project being analyzed; • Determining the inputs to the selected model; • Mathematically solve the option pricing algorithm • This paper discuss the first two problems in Merck case • Modeling assumptions • Determining the inputs

11. Limitations of the Quantitative Approach to Real Options: Modeling assumptions • The Black-Scholes’ model assumes lognormal distribution of underlying stock price with constant volatility: • Over time, the distribution of stock prices gets wider, as the path of potential stock prices increases exponentially at the high end and asymptotically approaches zero at the low end • The assumption can be misleading for Merck: • The longer Merck could wait to exercise its option, the more valuable the option is. • The increase in value is due to the lognormal assumption where price has more time to move to higher values. • The present value of the exercise price is lower for a longer option. • However, the longer Merck waits to exercise the option, the lower the value of the option: • The bulk of the value of the project comes from the patent protection. • The patent has expiration data. • Merck should adjust the model to account for the negative effects of having to wait longer to exercise the option. • Create separate set of inputs for the 2-year, 3-year and 4-year analysis.

12. Limitations of the Quantitative Approach to Real Options: Determining the inputs • Stock price: • In exchange-traded option, the current and future stock prices are readily observable to the option holder • Strategic options in the form of research projects do not have a readily observable stock price • The lack of visible stock price make it hard to draw conclusions about the appropriate course of action at the expiration date • Any errors make in the NPV becomes error in the option valuation • Exercise price: • Option valuation model assumes that the exercise price is fixed in advance • Many strategic investments do not have fixed exercise price • Merck use start-up costs as exercise price; but on the date to exercise, Merck could license the tech to another firm or to build a plant of a smaller or larger size, etc. • Time to expiration: • The research project could be extended to a long period of time; • Volatility: • Merck uses the volatility of stocks with similar risk profile as input • For strategic option, there are no publicly traded instruments whose risk profile matches that of the proposed investment • Risk-free interested rate: N/A

13. Conclusions: The Role of Option Analysis in Strategic Planning • Real options presents planners a Dilemma • Theoretically, good way to think about flexibility inherent in investment proposals; • Practically, many difficulties in making accurate calculations; and the errors are hard to find; • How to solve the dilemma? • Create more advanced and customized valuation models that better matches the characteristics of the investment proposal; • The benefit of real options wasn’t simply the improved estimation: • In the Merck case, the firm fail to correct for the shortfall in the equilibrium CF in the B-S model; • the firm does not consider the reasonableness of a random walk process to the CF; • Numerical results are unlikely to be very sensitive to reasonable mathematical specifications of CF’s dynamics; Whereas small deviations are worth fortunes in financial markets, they are fairly inconsequential in product market;

14. Conclusions: The Role of Option Analysis in Strategic Planning • For Merck’s case: • The key insight was to see the license as granting the rights to exercise a future investment; • Assign probabilities to good/bad decision and calculate CF is not accurate; • Investment decision is contingent on buying the option, therefore, it is not reasonable one must make the future investment; • To value the experimentation, the firm should break up the investment. • A formal quantitative valuation model is a part of strategic planning and capital allocation process • Firm need both financial and strategic analysis; • Use multiple models to check on each other; DCF relies sole on financial analysis while strategic analysis does not provide information of returns • Potential advantage of using the real option: • It may change the type of investment proposals that are reviewed; • An option perspective inverts the usual thinking about uncertainty absorption in the organizational literature (Kogut and Kulatilaka 2001) • An option approach encourages experimentation and the proactive exploration of uncertainty.

15. Discussion and Future Research • By analyzing the case of Merck, the paper shows us the potential practical difficulties of using real options to value investments; • The authors suggest that an advanced and customized model should be created when a firm tries to use real option; • There are opportunities to customize finance models and use them in strategic planning; • A dynamic view will be needed when customizing and using the finance model; • The future research can be done by finding out generalizable models for firms in specific industries

16. Thank You! Have a Good Day! Good Luck with the EXAM and your Fall Semester!