Investment decision techniques for long-term network planning: Real Options Valuation

1. Investment decision techniques for long-term network planning: Real Options Valuation Sofie Verbrugge Didier Colle, Mario Pickavet

2. Network planning process customer demand total traffic demand time existingnetwork technical constraints physical constraints new technology equipment cost equipment cost time old technology network planning network deployment plan Which investmentsshould be made at which points in time ? Ghent University – IMEC – IBBT

3. Outline • Classical investment decision rules • Real options valuation • Network planning problems to be seen as investment decision problems • Conclusions Ghent University – IMEC – IBBT

4. Present value of future cash flows Current value of 100euro to be spent in the future 120 100 80 60 40 20 0 now year 1 year 2 year 3 year 4 year 5 • Positive time value of money: • prefer receiving now • prefer spending later • Discount future expenses to present values where C = current valueF = future expensei = interest raten = years into the future Ghent University – IMEC – IBBT

5. Investment decisions 2004 2005 2006 2007 2008 2009 2010 time - 200 +40 +40 +40 +40 +60 +0 • “Should the investment be made or not?” • Consider all cash flows CF for the project • Initial investment (-) • Additional revenues (+) • Cash flows used: • Incremental, operational, after taxes, economical lifetime Annual revenue: sell produced goods Initial investment: buy a machine End of the project: resell the machine Ghent University – IMEC – IBBT

6. Net Present Value • Definition • Present value of all cash flows in the investment project, discounted using the minimum required return on investment • r = minimum required return for considered project, grows with project risk (riskless project: interest earned on bank account) • Objective • NPV >= 0 • Advantages • Takes into account all CFs • Takes into account timing • Takes into account size of the project Ghent University – IMEC – IBBT

7. Outline • Classical investment decision rules • Real options valuation • Network planning problems to be seen as investment decision problems • Conclusions Ghent University – IMEC – IBBT

8. Real Options compared to NPV • Net Present Value (NPV) • Discounts CFs using fixed discount rate • Evaluates now-or-newer investment decisions • For risky project: difficult to determine appropriate discount rate • Real Options Valuation (ROV) • Includes the options that may be present in an investment project with uncertain parameters • Includes flexibility in decision process • Uses risk-free discount rate • ROV is extension of NPV technique • Value of a project = NPV + value of the options Ghent University – IMEC – IBBT

9. Origin: financial options An option gives the buyer the right to buy or sell an asset fora predetermined exercise priceover a limited time period. • Right, not obligation • Asset: Asset for which the option holds, can be anything: stocks, real estate, precious metals, … • Exercise price = strike price: Price for which option holder can exercise the option, fixed over exercise time • Exercise date: option is no longer valid after this date (remaining time = Time To Maturity) Ghent University – IMEC – IBBT

10. Terminology • European option • can only be exercised on the exercise date • American option • can be exercised till the exercise data • Option price = option premium • Price to acquire the option, price to acquire to right • Exercise price = strike price • Price for which option holder can exercise the option (fixed) • Call option • option holder has right to buy the asset • Put option • option holder has right to sell the asset Ghent University – IMEC – IBBT

11. Value of call option on exercise date • Call option = right to buy (a stock) • Predetermined exercise price: X • Market value of the stock on exercise date: S • On exercise date • S < X • the option is useless • everyone buys on the market • S > X • the option is valuable • Value of the option:S - X • Option always has a positive value • Value calloption at exercise date = MAX(0,S-X) Ghent University – IMEC – IBBT

12. Value of option before exercise date • Value of option = end value + time value • End value • Value the option would have if today was the exercise date • Time value • Grows with a growing time to maturity • Over longer time chance is bigger that good changes will occur • Grows with volatility of share value • Big volatility, big chance the value will change a lot before exercise date, bigger option value • Remark: traditional valuation vs. option valuation • Small when difference between S and X is big • Big |S-X|: value of the option (+ or -) not likely to change, small time value • Small |S-X|: big chance the option value will change, big time value Ghent University – IMEC – IBBT

13. Option valuation U S D • Binomial method • for European call option • assumes 2 possible end values for the stock value • can be expanded for more time periods: software needed • Black-Scholes • formula • assumes arbitrage-free pricing, stock prices follow Brownian motion • Simulations • Monte Carlo simulation • Tools available: e.g. Crystal Ball Ghent University – IMEC – IBBT

14. Financial versus real options Ghent University – IMEC – IBBT

15. Outline • Classical investment decision rules • Real options valuation • Network planning problems to be seen as investment decision problems • Conclusions Ghent University – IMEC – IBBT

16. Apply ROV for long-term planning • ROV especially useful for • two-phase investment decisions • with an optional second phase (e.g. only performed if market situation is favourable) • OXC introduction in an existing network with growing traffic demand • can be seen as two-phase decision • phase 1: introduction of the OXC itself (only including interface cards needed to switch the current traffic) • phase 2: option to expand the OXC with extra interface cards if needed • Actual decision whether or not to really expand only taken in phase 1 (uncertainty reduced by then)!! Ghent University – IMEC – IBBT

17. Case study • European backbone network • 16 nodes and 22 links • initially WDM point-to-point systems are used on all links • if an OXC is introduced: transit traffic passes the node optically • time frame 2002 – 2008 • initial traffic: IP traffic from Lion-Cost266 model • afterwards: 70% annual growth • links filled to 60% of there capacity • network equipment costs: relative to the cost of a WDM mux/demux • linear price model • price is changing (in a random way) • In which nodes is OXC introduction beneficial? When? Ghent University – IMEC – IBBT

18. OXC introduction in Brussels best timing for upgrade: 2004 all > 0: OXC introduction should definitely be considered in Brussels installation of extra line cards in considered years installation OXC + needed interface cards 2002 optional installation of extra line cards in considered years Ghent University – IMEC – IBBT

19. OXC introduction in all nodes • NPV: no OXC introduced in the entire network • ROV: OXC introduction beneficial in half of the nodes • Negative ROV project value: OXC not beneficial • Prague, Vienna and Zagreb: overall traffic too low • Berlin, Munich, London, Lyon and Rome: too little transit traffic • Positive ROV project value: OXC introduction beneficial • Hamburg, Brussels, Frankfurt, Paris, Strasbourg, Zurich, Milan, Amsterdam • overall traffic big enough (exceeds router capacity within 2 years), transit traffic fraction > 60% Ghent University – IMEC – IBBT

20. Case study results • Net Present Value • unable to correctly evaluate projects that comprise an optional follow-up investment • project value for OXC introduction < 0 • Real Options Valuation • aimed to valuate projects where uncertainty is involved • project value for OXC introduction > 0 • optional character of second phase leads to bigger project value (postponing decision reduces uncertainty) • disadvantages: • often very difficult to detect a real option • correctly estimating the option value difficult (estimating CF) • Black and Scholes assumptions should be tested carefully Ghent University – IMEC – IBBT

21. Outline • Classical investment decision rules • Real options valuation • Network planning problems to be seen as investment decision problems • Conclusions Ghent University – IMEC – IBBT

22. Conclusions • Time value of money • Discount future expenses to present values • Always when comparing/ adding CFs for different time points • Classical investment decision rules • Net Present Value (NPV) best of classical investment rules • Need to estimate CFs • Need to estimate required interested rate (related to risk) • Real options valuation • Extension of NPV, to include optional future investments • Originates from world of stock options • Need to estimate CFs • Use of risk free discount rate • Several valuation techniques, best-known: Black and Scholes Ghent University – IMEC – IBBT

23. Conclusions • Network planning problems seen as investment decision problems • ROV can be used for two phase investment problems with optional second phase • disadvantages: • Correct estimation of needed parameters not always easy • Black and Scholes assumptions should be tested carefully • OXC introduction seen as real option • ROV leads to bigger project value in case of optional follow-up investment • According to ROV: OXC introduction beneficial if expected traffic demand exceeds router capacity within next 2 years and the transit traffic fraction surpasses 60% • Introduction in half of the nodes in considered European backbone • Future work: use simulations, to avoid B-S constraints Ghent University – IMEC – IBBT

24. Thanks for your attention! Ghent University – IMEC – IBBT