Real Options Techniques Research Articles

Dark Fiber Valuation

ABSTRACT Valuation of dark fiber has recently generated controversy, sparked particularly by the large sums booked for swaps of dark fiber between companies. One of the issues raised is valuation: i.e., what is the value of an asset that generates no revenue now and may do so at some unknown point in the future but only after investment, in an uncertain business climate, and where prices are dropping? The picture is further complicated because the result of investing to bring the asset to market (i.e. lighting the fiber) changes the supply and demand conditions of the market itself and hence invalidates price predictions. A realistic and consistent valuation methodology is necessary for increasingly cautious companies, auditors, and investors. In this paper we describe such a valuation methodology for dark fibre based on real options. Publicly available bandwidth price services start to make this practical by providing market price information. For dark fibre valuation the real option to be valued are the lighting decisions. We specifically include the effect on the market of adding new capacity by using the price-elasticity of demand within the stochastic price process itself, conditional on lighting decisions. Prices are generally volatile and decreasing with time. The evolution of lighting costs and maintenance are included in the valuation. The real options technique used here is novel in that it combines economic and market factors explicitly with mathematical finance to arrive at a valuation and optimal decisions. We found that the optimal lighting riming and capacity decisions to depend on many of the factors included in the analysis with no simple triggers: the details really matter.

Estimating volatility and dividend yield when valuing real options to invest or abandon

The opportunity to invest in or abandon a project can in principle be valued using real options techniques. In practice, option pricing has as inputs the volatility and dividend yield of the project, which are in most cases not observable via market data. Current methods of estimating these parameters are largely ad hoc, introducing potential error into the valuation process. This paper uses simple production models to formalize concepts for estimating project volatility and dividend yield, in single stochastic variable option models, and provides an example of how these estimates can be used in a real option valuation exercise.

The Value of Flexibility: The Case of a Dual-Fuel Industrial Steam Boiler

0 It is now widely understood that conventional economic analysis based on discounted cash flow (DCF) methods fails to capture the strategic impact of projects. In particular, DCF methods ignore the flexibilities that give project managers options to revise decisions in response to changing exogenous economic conditions. importance of such operating options becomes critical when the environment is highly volatile and the technology is flexible, thus permitting managerial intervention at little cost. For example, when facing exogenous stochastic prices a project with operating options can protect itself against some of the adverse price movements by switching into an alternative mode of operation that is less affected by the adverse price realizations. In effect, the irreversibility assumption of conventional investment analysis is violated. Real options techniques, by endogenizing the optimal operating rules and explicitly capturing the flexibility and its effects on uncertainty, provide for a consistent treatment of risk in the valuation of flexible projects. growing literature on real options has revealed several important lessons:1 (i) the volatility of prices becomes an important determinant of investment, both in terms of the type of investment (e.g., rigid versus flexible technologies) and in terms of the quantity of investment (in that high volatility increases the value and Tobin's q of flexible systems); (ii) the value of flexibility per se may be determined explicitly, given the dynamics for relative model described in this paper is based on an earlier working paper entitled The Value of Flexibility, MIT-EL 86-014WP. empirical results are extensions of the results from an unpublished research project that I conducted with David Wood, with the assistance of Michael Provance and Yoshiki Ogawa at the Center for Energy Policy Research at the MIT Energy Laboratory. project was interrupted by the untimely death of David Wood. paper would not be possible without his contributions, and hence is really a joint product. However, I am solely responsible for any errors. 1See Pindyck [ 13] for a review of the literature on irreversible investments under uncertainty. Kulatilaka and Marcus [9] provide a more intuitive discussion of real options and their implications. Mason and Merton [10] contains a general technical discussion of issues related to the use of options techniques in capital budgeting.