Application Of Real Options Research Articles

'Flying with Heavy Loads' Capital Structure Considerations for the US Airline Industry

The paper discusses a hidden aspect of a firm's capital structure through the use of a real options application. It is applied to the US airline industry, characterized by over levered balance sheets, and one which on some estimates, has made zero cumulative profit taking the years of the last century together. The paper introduces the notion of flexibility, defined as the freedom (or flexibility) enjoyed by a conservatively geared firm to respond quickly and secure positive NPV projects, as opposed to an over levered firm. This is then valued as a real option using a model based on arithmetic Brownian motion involving a path dependant option pricing framework. It analyses the implications of debt financing in the US airline industry and develops a capital structure model that incorporates the value of enjoyed by conservatively geared carriers. This model essentially balances the quantified value of financial flexibility enjoyed by conservatively geared carriers against the relevant cost of obtaining this flexibility (i.e. the cost of carrying a sub optimal capital structure) and factors in the implications of fire sales (Pulvino, 1998) which is specific to the US airline industry. In its application to South West Airlines the paper concludes that the optimal capital structure, if the value of financial flexibility is incorporated - should move closer to the origin. A methodology of integrating the value of financial flexibility into the traditional theories of capital structure is proposed and demonstrated that (at least) in the US airline industry, failure to do so can result in a significant misstatement in a firm's value and its optimal capital structure. This paper makes two key contributions to the existing body of academic literature. The notion of valuing financial flexibility as a real option has been introduced previously by Beneda and Nelson (2003). However their quantification of the option value is through a standard Black Scholes equation where the underlying assumptions of this are not valid in quantifying a real option of this nature and this chapter makes a modification of the standard Black Scholes equation to reflect reality. Furthermore the paper applies the concept of financial flexibility specifically to the US airline industry and develops a conjecture on how this can be incorporated into the traditional theories of capital structure which is another contribution to the academic literature.

Integration of real options into short-term mine planning and production scheduling

Commodity prices have fallen sharply due to the global financial crisis. This has adversely affected the viability of some mining projects, including leading to the possibility of bankruptcy for some companies. These price falls reflect uncertainties and risks associated with mining projects. In recent years, much work has been published related to the application of real options pricing theory to value life-of-mine plans in response to long term financial uncertainty and risk. However, there are uncertainties and risks associated with medium/short-term mining operations. Real options theory can also be applied to tactical decisions involving uncertainties and risks. This paper will investigate the application of real options in the mining industry and present a methodology developed at University of Queensland, Australia, for integrating real options into medium/short-term mine planning and production scheduling. A case study will demonstrate the validity and usefulness of the methodology and techniques developed.

Real option application in PPP/PFI project negotiation

Over the past two decades, many developing countries have grown to become more familiar with the notions and the use of public–private partnership/private financing initiative (PPP/PFI) schemes in building large‐scale infrastructure assets. However, owing to higher levels of complexity and longer contractual durations, PPP/PFI projects are often embedded with higher risks. On the one hand, any private sector concessionaire would strive to secure some forms of subsidies or guarantees from the host government to alleviate its risk concerns. On the other hand, the host government would also attempt to counterbalance the grant of these incentives by introducing additional ‘repayment’ obligations, such as placement of a cap on the tariff or toll rates. Modelled as real options, support and repayment features found in the case of a wastewater treatment plant in Southern China are evaluated using a combination of Monte Carlo simulation and spreadsheet‐based cash flow models. The objective is to illustrate how a negotiation band incorporating these option values can be constructed, which would enlarge the feasible bargaining range for both parties. The risk implications of two disparate bidding scenarios found in the case will also be discussed.

Natural gas storage valuation and optimization: A real options application

AbstractIn this article, we present an algorithm for the valuation and optimal operation of natural gas storage facilities. Real options theory is used to derive nonlinear partial‐integro‐differential equations (PIDEs), the solution of which give both valuation and optimal operating strategies for these facilities. The equations are designed to incorporate a wide class of spot price models that can exhibit the same time‐dependent, mean‐reverting dynamics, and price spikes as those observed in most energy markets. Particular attention is paid to the operational characteristics of real storage units. These characteristics include working gas capacities, variable deliverability and injection rates, and cycling limitations. We illustrate the model with a numerical example of a salt cavern storage facility that clearly shows how a gas storage facility is like a financial straddle with both put and call properties. Depending on the amount of gas in storage the relative influence of the put and call components vary. © 2009 Wiley Periodicals, Inc. Naval Research Logistics 2009

Investment in a Methane Digester: An Application of Capital Budgeting and Real Options

Methane digesters may offer dairy producers a way to lower production costs by becoming self-sufficient in electricity production. In addition, the technology may offer additional income through surplus electricity sales and fertilizer and bedding savings as well. However, the typical methane digester is a large and irreversible capital investment characterized by value uncertainty. Analyzed in a real option framework, the theory suggests a potential explanation for why producers in states like Pennsylvania require significant grant funding to adopt the technology, namely, as monetary compensation for the uncertainty in the value of the completed project. The study presents an empirical application

Investment under Uncertainty, Debt and Taxes

It is common practice in financial derivative valuation to use a discount factor based on the riskless debt rate. But, to what extent is this discount factor appropriate for cash flows emerging in capital budgeting? To answer this question, we introduce a framework for real asset valuation that considers both personal and corporate taxation. We first discuss broad circumstances under which personal taxes do not affect valuation. We show that the appropriate discount rate for equity‐financed flows in a risk‐neutral setting is an equity rate that differs from the riskless debt rate by a tax wedge due to the presence of personal taxation. We extend this result to the valuation of the interest tax shield for exogenous debt policy with default risk. Interest tax shields, which accrue at a net rate corresponding to the difference between the corporate tax rate and a tax rate related to the personal tax rates, can have either positive or negative values. We also provide an illustrative real options application of our valuation approach to the case of an option to delay investment in a project, showing that the application of Black and Scholes formula may be incorrect in presence of personal taxes.

Simulation–optimization mechanism for expansion strategy using real option theory

A right expansion strategy can bring a company more market shares and profits, and hence increase shareholders’ equities. However, limited financial resources and various uncertainties require business practitioners to achieve their goals while controlling the risks incurred at an acceptable level. Therefore, justification of expansion investments is an important and complex topic in industry. The traditional investment analysis tools such as net present value (NPV) often tend to undervalue investment decisions. We formulate the expansion investments using real options, and develop a financial model to assess the option value. Monte Carlo simulation is considered a good way to estimate the value of the option. This valuation gives decision makers a way to choose the appropriate expansion strategy based on an integrated view of the market dynamics, but optimization is still a difficult problem to resolve. This paper presents a model of optimization under uncertainty combining system simulation with GA-based optimization to resolve the expansion problem. An industry case is used to demonstrate the application of real options to value expansion investment by using simulation–optimization. This approach also provides some new insights for the real options theory.

E-Learning Investment Risk Management

E-learning markets have been expanding very rapidly. As a result, the involved senior managers are increasingly being confronted with the need to make significant investment decisions related to the elearning business activities. Real options applications to risk management and investment evaluation of Information and Communication Technologies (ICT) have mainly focused on a single and a priori known option. However, these options are not inherent in any ICT investment. Actually, they must be carefully planned and intentionally embedded in the ICT investment in order to mitigate its risks and increase its return. Moreover, when an ICT investment involves multiple risks, by adopting different series of cascading options we may achieve risk mitigation and enhance investment performance. In this article, we apply real options to the e-learning investments evaluation. Given the investment’s requirements, assumptions and risks, the goal is to maximize the investment’s value by identifying a good way to structure it using carefully chosen real options.

Opções reais e interações com a flexibilidade financeira

Este estudo tem dois objetivos principais. Primeiro, fornece um panorama abrangente da literatura e das aplicacoes existentes em opcoes reais, apresentando principios praticos para a quantificacao do valor das opcoes reais. Segundo, da um primeiro passo para ampliar a literatura sobre opcoes reais para que ela reconheca interacoes com a flexibilidade financeira. A revisao da literatura acompanha a evolucao da revolucao das opcoes reais com base em desdobramentos tematicos que tratam das criticas iniciais, das abordagens conceituais, das bases e blocos componentes, da valoracao neutra em relacao ao risco e do ajuste ao risco, das contribuicoes analiticas da valoracao de diferentes opcoes separadamente, das interacoes entre opcoes, das tecnicas numericas, das opcoes competitivas e estrategicas, das diversas aplicacoes e da direcao da pesquisa no futuro.

Crude Oil Exploration and Real Option Applications

Crude Oil Exploration and Real Option Applications

Dynamic market entry and the value of flexibility in transitional international joint ventures

The purpose of this study is to formalize the optimal choice of market entry strategy for an individual multinational enterprise (MNE) from a dynamic perspective. It is argued that incorporating a suitable treatment of irreversibility, uncertainty and flexibility related to an MNE's investment decision gives further insights into the expansion, dissolvement, and optimal timing of international joint ventures (IJVs). In most cases, the initial entry strategy serves as a platform allowing the firm to make subsequent investments to exploit host-country advantages and capabilities. We allow for this by taking a three-step expansion strategy explicitly into account. The evolutionary process of the value of the foreign direct investment can be interpreted as a compound complex chooser option. The results suggest that uncertainty, size of equity share and future investment/divestment opportunities play an important role when it comes to transit from export to the first phase of the foreign direct investment commitment. The paper underscores the importance of modeling the dynamics of market entry and helps to refine the application of real options in the alliance context by providing a closed-form solution in continuous time to value the overall strategic flexibility.

Structural estimation of real options models

We propose a numerical approach for structural estimation of a class of discrete (Markov) decision processes emerging in real options applications. The approach is specifically designed to account for two typical features of aggregate data sets in real options: the endogeneity of firms’ decisions; the unobserved heterogeneity of firms. The approach extends the nested fixed point algorithm by Rust [1987. Optimal replacement of GMC bus engines: an empirical model of Harold Zurcher. Econometrica 55(5), 999–1033; 1988. Maximum likelihood estimation of discrete control processes. SIAM Journal of Control and Optimization 26(5), 1006–1024] because both the nested optimization algorithm and the integration over the distribution of the unobserved heterogeneity are accommodated using a simulation method based on a polynomial approximation of the value function and on recursive least squares estimation of the coefficients. The Monte Carlo study shows that omitting unobserved heterogeneity produces a significant estimation bias because the model can be highly non-linear with respect to the parameters.

Using Scenario Thinking to Make Real Options Relevant to Managers: A Case Illustration

This paper argues the advantages of Real Options thinking and by means of examples, exhibits the types of decision-making calculations that are distinctive to Real Options. However, in the process of clarifying the application of Real Options analysis to real decision making, a strong dependency upon scenario thinking is established. The value to decision makers of Real Options depends crucially on the substance and use of the scenarios on which it rests. The distinctive contribution of this paper consists in substantiating this view. By forging a critical link between Real Options analysis and scenario thinking, this paper illustrates how the beneficial application of Real Options to decision making brings it down from the esoteric heights of mathematics, converts it into a technique readily accessible to managers and qualifies it for inclusion in the curriculum of management education. Two cases drawn from personal experience are used to illustrate the approach recommended by the authors.

Analysing mergers and acquisitions in European financial services: An application of real options

This paper applies real option pricing theory to the analysis of a sample of 15 recent mergers and acquisitions in the European financial services industry. Overall, it is found that those acquisitions were not on average overpaid. Nevertheless, further analysis, assuming the option premium equalled the takeover premium, shows that either the implicitly assumed volatility was too low, the assumed time to maturity was very short and/or the assumed subsequent market performance was too optimistic.

Sequential International Joint-Ventures and the Option to Choose

The paper underscores the importance of modeling the dynamics of market entry and helps refine the application of real options in the alliance context by providing a closed-form solution in continuous time to value the overall strategic flexibility.

MAKING USE OF REAL OPTIONS SIMPLE: AN OVERVIEW AND APPLICATIONS IN FLEXIBLE/MODULAR DECISION MAKING

This article focuses on how the use of real options can be made simple, providing an overview of the power of flexible and modular decision making and its use in various applications across industries. After common real options are discussed through a comprehensive example, the article reviews the key lessons and implications of real options thinking for flexible decision making. It then proceeds to propose a modular problem structuring approach that allows simplifying of complex real option problems by decomposing them into a few basic building-block option types (reviewed) connected by some basic decision operators. The resulting problem-structuring option map is depicted in a range of illustrative applications in various industries. Past areas of application of real options as well as research challenges ahead are also discussed.

License valuation in the aerospace industry: A real options approach

This paper discusses a practical case application of real options applied to license valuation in the aerospace maintenance, repair, and overhaul industry. After categorizing the available licensing opportunities of the firm, four distinct licensing classes are identified: traditional delay licenses, contingent investment licenses, licenses with cost uncertainties, and indefinite delay licenses. Due to the varying nature of the classes, accepted real option valuation techniques are applied to include the European call, dual asset, exchange, and perpetual option. Appropriate sensitivity analyses and discussion for each license class provide guidelines for decision-making. In general, it is shown that the real options framework captures value overlooked by discounted cash flow approaches.

An Application of Real Options to The Phased Construction Plan of Infrastructure Investment

An Application of Real Options to The Phased Construction Plan of Infrastructure Investment

A Real Options Application to the Fishing Vessel Scrapping Decision of Vessel Buyback Programs

This paper adopts the real options approach to examine vessel owners behavior in deciding whether to participate or not in the vessel buyback programs. The model allows us to investigate profit uncertainty in a decision to retire an aged vessel and the underlying value of waiting for new information about the profitability of such a change, which may affect the willingness of vessel owners to participate in the vessel buyback programs. Our analysis shows that the government needs to pay more attention to profit uncertainty, which may invalidate the vessel buyback program that does not take it into account. This also contributes to explain the failure of most of the vessel buyback programs aimed at encouraging the retirement of aged vessels in Taiwan. We also evaluate the value of willingness to accept of vessel owners and its policy implications are discussed.

What IsNotA Real Option: Considering Boundaries for the Application of Real Options to Business Strategy

We argue that the greater the extent to which choice sets evolve as a consequence of firms' exploration activities, the less structured the firms' abandonment decisions become and, in turn, the less distinguishable a real option is from more generic notions of path dependence—a sequential stream of investment in and of itself does not constitute a real option. While organizational adaptations can extend the applicability of real options, they impose tradeoffs that may lead to the underutilization of discoveries made in the course of exploration.