Real Option Valuation of Product Innovation 9783836627412, 9783836677417

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Yuanyun Kang

Copyright © 2009. Diplomica Verlag. All rights reserved.

Real Option Valuation of Product Innovation

Diplomica Verlag

Yuanyun Kang Real Option Valuation of Product Innovation ISBN: 978-3-8366-2741-2 Herstellung: Diplomica® Verlag GmbH, Hamburg, 2009

Copyright © 2009. Diplomica Verlag. All rights reserved.

Dieses Werk ist urheberrechtlich geschützt. Die dadurch begründeten Rechte, insbesondere die der Übersetzung, des Nachdrucks, des Vortrags, der Entnahme von Abbildungen und Tabellen, der Funksendung, der Mikroverfilmung oder der Vervielfältigung auf anderen Wegen und der Speicherung in Datenverarbeitungsanlagen, bleiben, auch bei nur auszugsweiser Verwertung, vorbehalten. Eine Vervielfältigung dieses Werkes oder von Teilen dieses Werkes ist auch im Einzelfall nur in den Grenzen der gesetzlichen Bestimmungen des Urheberrechtsgesetzes der Bundesrepublik Deutschland in der jeweils geltenden Fassung zulässig. Sie ist grundsätzlich vergütungspflichtig. Zuwiderhandlungen unterliegen den Strafbestimmungen des Urheberrechtes. Die Wiedergabe von Gebrauchsnamen, Handelsnamen, Warenbezeichnungen usw. in diesem Werk berechtigt auch ohne besondere Kennzeichnung nicht zu der Annahme, dass solche Namen im Sinne der Warenzeichen- und Markenschutz-Gesetzgebung als frei zu betrachten wären und daher von jedermann benutzt werden dürften. Die Informationen in diesem Werk wurden mit Sorgfalt erarbeitet. Dennoch können Fehler nicht vollständig ausgeschlossen werden und der Verlag, die Autoren oder Übersetzer übernehmen keine juristische Verantwortung oder irgendeine Haftung für evtl. verbliebene fehlerhafte Angaben und deren Folgen. © Diplomica Verlag GmbH http://www.diplomica-verlag.de, Hamburg 2009

Real Option Valuation of Product Innovation

Real Option Valuation of Product Innovation ⎯ with BlackBerry 9900 as an Illustration

Abstract

5

1.

7

Introduction

1.1. The Problem: Valuing Product Innovation

7

1.2. Goals of the Thesis

9

1.3. Methodology

10

2.

Basic Concepts of Valuing Product Innovation

13

2.1.

Definition and Character of Product Innovation

13

2.2.

Definition of Product Innovation

13

2.3.

Character of Product Innovation

15

2.4.

Product Innovation is a Complex Process

15

2.4.1.

Product Innovation is a Cross-functional and Contingent Process

17

2.4.2.

Product Innovation is a Risky Process

18

2.5. Main Challenges in Valuing Product Innovation

19

2.5.1.

Selection of the Adequate Methodology

21

2.5.2.

Net Present Value

21

2.5.3.

Other Traditional Approaches

23

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3.

Introduction of Real Option Valuation

26

3.1. Definition of an Option

26

3.2. Difference between Real Options and Financial Options

28

3.3. Value Drivers of Real Options

30

3.3.1.

Value Drivers Relating to the Underlying Asset and Financial Market

30

3.3.2.

Managerial Flexibility

31

3.3.3.

Uncertainty

33

3

Real Option Valuation of Product Innovation 3.4. Typology of Real Options

35

3.4.1.

The Option to Delay and the Valuing

37

3.4.2.

The Option to Expand and the Valuing

39

3.4.3.

The Option to Contract and the Valuing

40

3.4.4.

The Option to Abandon and the Valuing

42

3.4.5.

The Option to Switch and the Valuing

44

3.4.6.

Compound Options and the Valuing

46

3.5. Methodology of Real Option Valuation

49

3.5.1.

Black-Scholes Model

50

3.5.2.

Binomial Tree Model

51

3.5.3.

Selection of the Adequate Methodology

55

4.

Applying Real Option Valuation to the Illustration BlackBerry

57

4.1.

Introduction of the Product Innovation BlackBerry

57

4.2.

Valuing Process of the Chosen Example

58

4.2.1

First Step: Valuing without Flexibility ⎯ Traditional DCF Method

60

4.2.2

Second Step: Model the Uncertainty ⎯ Using Event Tree

63

4.2.3

Third Step: Identity and Incorporate Managerial Flexibility

65

⎯ Creating a Decision Tree 4.2.4

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5.

Fourth Step: Conduct Real Options Analysis Conclusion

69 74

5.1.

Thesis Summary

74

5.2

Limitation of Real Option Valuation

75

5.3

Possible Complementation of Real Option Valuation

77

5.3.1

Combining ROV and DCF

77

5.3.2

Other Possible Complementation

79

6.

Appendix

81

6.1

References

81

6.2

Website

82

6.3

Table of Figures

82

4

Real Option Valuation of Product Innovation

Abstract Global competition, emerging technologies, and an ever increasing need for superior products in shorter time frames all contribute to drive companies to adopt new and innovative approaches to product innovation. Effective product innovation is imperative for the survival, growth and profitability of most design and manufacturing enterprises (Cooper et al, 1998). In the current dynamic manufacturing environment, companies must innovate successfully if they wish to remain competitive. Product innovation is a complex, cross-functional and contingent, dynamic process, which is difficult to manage (Crawford, 1996). Anticipating change and expeditiously responding to the dynamics of the business environment via product innovation are important precursors for achieving sustainable competitive positions and exceptional performance1. The heart of a product innovation is its value. Traditional discounted cash flow approaches, such as net present value (NPV), have traditionally been the preferred methods for evaluating investments in product innovation. The traditional NPV method, which was initially developed to value bonds or stocks by passive investors, implicitly assumes that corporations hold a collection of real assets passively. Managerial choices (as delay, expand, switching etc.) are thus presumed to be limited to the initial decision2. Therefore, traditional valuation methods undervalue the product innovation because they are unable to capture the value of management flexibility. Recently, real options emerged as an alternative to simplistic discounted cash flow methods. Real option valuation (ROV) values the managerial flexibility to make ongoing decisions regarding implementation of investment projects and deployment of real assets. ROV extends valuation models used to price financial options and

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applies them to investments in real assets3. Black and Scholes (1973) developed the Black-Scholes model to value financial options that focus on factors affecting the value of the underlying financial asset over time. Proof by Cox, Ross, Rubinstein

1

2

3

http://www.cambridge.org/catalogue/catalogue.asp?isbn=9780521842754&ss=fro Rainey, D. “Leading Change through Integrated Product Innovation” Trigeorgis, L. 1997. Real Options – Managerial Flexibility and Strategy in Resource Allocation, p.151 Cobb, B., and Charnes, J. 2003. “Simulation and Optimization for Real Options Valuation”, p.1

5

Real Option Valuation of Product Innovation (1979), binomial tree model is simpler to understand for the practitioner and less elegant than Black-Scholes model. It uses the discrete mathematics to achieve the isomorphic results to the calculation used by Black-Scholes model4. From an intuition point of view, the managerial flexibility is easy to understand. But, how much it is worth is most difficult or even impossible to think about and measure with the traditional valuation methods. In this paper, we will use some concrete examples to illustrate the powerful ability to quantify the managerial flexibility and strategic interactions using real option valuation. The four-step process to evaluate the real options, explained by Tom Copeland in his book “Real Options”, makes the application of real option valuation more practical and traceable. In this paper, we set a fictive example with an illustration of BlackBerry 9900 to systematically clarify the framework and the process of real options method Real option valuation is theoretically the most advanced tool for the valuation of uncertainty and managerial flexibility. But the difficulties in estimating the input data, mathematical calculation, and understanding this concept by client limit the applicability of real option valuation5. To develop generic options based users friendly software package to reduce the mathematical difficulty6, to analyze more actual case

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applications would be the possible implementation in the future.

4 5 6

6

Copeland, T., and Antikarov, V. 2001. Real Options – A Practitioner’s Guide, p.193 Selchert, M., The script for lecture operational consulting I, p. 3-9 Trigeorgis, L. 1997. Real Options – Managerial Flexibility and Strategy in Resource Allocation, p.375

Real Option Valuation of Product Innovation

Real Option Valuation of Production Innovation

⎯ with BlackBerry 9900 as an Illustration 1.

Introduction

1.1. The Problem on the Valuing Product Innovation Nowadays change in business environment is incessant and ubiquitous. Globalization; social, political, and economic pressures; technological innovation, turbulent market conditions and trends have shortened product life cycles and created demands for better, cheaper, cleaner, safer, and more effective products. Innovation is the key driver of competition advantage, growth, and profitability. It is one of the most important tools for a company to ensure the survival and leading position in changing market. There are many parts of the whole field of innovation: strategy innovation, new product development and innovation, creative approaches to problem solving, idea management, suggestion systems, etc. All of them are important. Product innovation involves developing new solutions that provide positive benefits to customers and stakeholders. It is the fundamental management construct used for creating new products, reinvigorating existing products, and solving product-related difficulties with customers and stakeholders7.

A report in the McKinsey Quarterly in April 2006 of a McKinsey Global Survey shows that an executive taken on the top business trends cited a broad range of factors that they look as contributing most to the accelerating pace of change. Among them, the innovation in products, services, business models shows most prominently, with 24 percent of the responses. The following graphic8 shows a part of results from the

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Survey.

7

8

Rainey, D.,Product Innovation: Leading Change through Integrated Product Development (Cambridge University Press) http://www.mckinseyquarterly.com/article_page.aspx?ar=1754&L2=21&L3=114&pagenum=1

7

Real Option Valuation of Product Innovation Innovation in products, services and business models contributes most to the accelerating pace of change in the global business environment because that: •

Product/service innovation is the result of bringing to life a new way to solve the customer's problem – through a new product or service development – that benefits both the customer and the sponsoring company

•

Through providing new, improved, or cheaper products, company could either raise the quality of product or decrease its costs. Therefore, a successful product innovation strengthens company’s competitiveness in market.

•

In order to capture the market opportunity, old products must be innovated or replaced on time. If exists, with the new product,. The product innovation could reduce the existing strategic gap in the market development.

•

The increasing application of new technology spaces the product innovation. A product innovation keeping pace with technology could strengthen the company’s core competence, so that the potential threats for the company would be reduced.

What does a single factor contribute most to the accelerating pace of change in the global business environment today? Innovation in products, services, business models Create ease of obtaining information, technological knowledge Plentiful cheap, mobile capital Reduction in trade barriers Expanded access to talent and labor pools

24%

12% 11% 11%

Rate of technological change

10%

17%

8%

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More capable competitors Rising consumer awareness And activisum

5%

As for any innovation, changing market and non-plentiful information from environment surrounding the company, product innovation and product innovation process are always under uncertainty. For example, how do we forecast the market 8

Real Option Valuation of Product Innovation potential? How much is the market volume? How would competitors influence the market? What is a suitable price? How about the risk to develop a product and to go on the market? Normally, a product innovation process takes a long time from creating a new idea to bringing a new product into market. There is plenty of predictable and unpredictable uncertainty in a more and more complex market. Throughout anticipation in product innovation managers often have a wide range of possibilities to react flexibly to the fast changing business environment. Managerial flexibility can be created if managers capture the area of tolerance in investment decisions based on company’s resources. Thus, it is a great challenge how to value a product innovation project before we start to do it. 1.2. Goal of the Thesis Usually, managers try to capture a future development with “static” methods of capital budgeting, i.e. future cash flows are discounted with a fixed risk-adjusted discount rate. This method ignores the value of management flexibility and the affect of company’s resources on management decisions (would be illustrated in section 2.3). It only assumes a “now” or “never” approaches in undertaking a project. With these traditional instruments of investment evaluation, the value of modification and managerial flexibility could not be captured. Therefore, the investment decision is often undervalued with traditional valuation method. Real option valuation and its “forward-looking” character is an improvement of traditional valuation tools. It evaluates future projects with more accuracy and methods that are approved by financial markets. The goal of this paper is to show you the advantages of real option valuation over traditional methods for investment decisions regarding product innovation and to Copyright © 2009. Diplomica Verlag. All rights reserved.

introduce you some useful tools in real option valuation. Start with analyzing product innovation process in chapter 2, we will illustrate why real option valuation is more suitable for valuing a product innovation project. In chapter 3, we will explain how real option valuation and its “forward-looking” character improves the traditional valuation method, how real option valuation introduces additional value drivers. With some concrete examples in section 3.4 we will demonstrate the powerful ability to quantify managerial flexibilities using real option valuation and explain how to 9

Real Option Valuation of Product Innovation value a single real option using replicating portfolio. Thereafter we will spread the real option from one step per time to many by using binomial tree method. In chapter 4, with a chosen example from BlackBerry 9900, we will illustrate how to systematically complete a real option valuation using the four-step valuation process. 1.3. Methodology Net Present Value method (NPV): Net Present Value method is a common method used to value a product innovation project. It measures the excess or shortfall of cash flows in present value terms by using a discount rate. This method takes some uncertainty into account through using the weighted average capital costs (WACC). WACC represents the correlation of an asset’s value with the broader economic system. For example, the systematic risk in a chemical plant expansion is the correlation of the plant’s value with a broad-based stock market index such as the S&P 5009. In this valuation method, the assumption of WACC keeps constant during the whole product innovation process. Real Option Valuation: As the extension of financial option theory of options, the real options approach focuses on total risk and decides on real (non-financial) assets. A real asset is a resource that is controlled by the enterprise as a result of past events (for example, purchase or self-creation) and from which future economic benefits (inflows of cash or other assets) are expected. 10 Real Option Valuation allows adaptation and revision of future decisions in order to get managerial flexibility and to finally capitalize on any possible future development11. Real options limit losses and offer a vital contribution to long-term corporate success, especially in those marketplaces characterized by uncertainty and rapid change. Incorporating this method could possibly lead to a better understanding of the importance of resource allocation, the Copyright © 2009. Diplomica Verlag. All rights reserved.

value of strategic investments and the interdependencies between uncertainty and irreversibility of a project12. Through identification of additional value drivers and 9

10 11

12

10

Amram, M., and Kulatilaka, N. 1999. Real Options – Managing Strategic Investment in an Uncertain World, p.27 Definition in International Accountant Standard Paragraph 38. Trigeorgis, L. 1997. Real Options – Managerial Flexibility and Strategy in Resource Allocation, p.121 Müller, J. 2000. Real Option Valuation in Service Industries, p.66

Real Option Valuation of Product Innovation proper management, the resources are allocated optimally, contributing to the overall goal of formulating a strategy to product innovation in an uncertain environment. In real option, managers are making contingent decisions – decisions to investment or disinvest that depend on unfolding events. A project has real option characteristics when management has the ability to change the initial strategy for a project under uncertainty, involving irreversible investment, based on new information about an uncertain factor that affects the project valu. The following example shows one of differences between net present valuation and real option valuation. Suppose you are going to invest $150 million over the next 2 year ($50 million immediately and $100 million next year) to build a new product plant that will last 8 years, generate a new stream of revenues that starts at $80 million at the end of the second year and grows at 8 percent. The total costs of $60 million start in the second year and grow at 6 percent annual. There are no other costs. The average cost of capital is 10 percent. 1

B

C

D

E

F

2

G

H

I

J

7

8

unit: million dollars

3

Year

4

Investment

0

1 -50

2

3

4

5

6

-100

5

Revemue

80,00 86,40

93,31 100,78 108,84 117,55 126,95

6

Cost

60,00 63,60

67,42

71,46

75,75

80,29

85,11

7

Depreciation

22,50 22,50

22,50

22,50

22,50

22,50

22,50

9

Cash Flow

20,00 22,80

25,90

29,32

33,09

37,25

41,84

10

discounted

11

factor

0,75

0,68

0,62

0,56

0,51

0,47

12

discounted

13

Cash Flow

16,53 17,13

17,69

18,20

18,68

19,12

19,52

-50,00 -100,00 1,00

0,91

-50,00 -90,91

0,83

NPV = Sum (B13:J13) = -14,05

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Figure 1: Calculation of net present value

The net present value in Figure 1 is –14.05 million dollars, and its logic suggests that the project should be rejected. Real option valuation takes the future events into account. Suppose that we are just planning the investment. We get the information that the risk-free interest rate from 11

Real Option Valuation of Product Innovation the second year may decline to 5%, therefore the average cost of capital may decline to 6%, so, we decide to wait until that the risk-free interest rate from second year is sure to decline to 5%. Then we start to invest. The value of the project would be calculated as in Figure 2: 1

B

C

D

E

F

G

H

I

J

K

unit: million dollars

2 3

Year

4

Investment

5

Revemue

80,00

86,40

93,31 100,78 108,84 117,55 126,95

6

Cost

60,00

63,60

67,42

71,46

75,75

80,29

85,11

Depreciation

22,50

22,50

22,50

22,50

22,50

22,50

22,50

-50,00 -100,00 20,00

22,80

25,90

29,32

33,09

37,25

41,84

0,84

0,79

0,75

0,70

0,67

0,63

0,59

-47,17 -89,00 16,79

18,06

19,35

20,67

22,01

23,37

24,76

8 9

0

1

2 -50

Cash Flow

3

4

5

6

7

8

9

-100

10 discounted 11 factor

1,00

0,94

0,89

12 discounted 13 Cash Flow

NPV = Sum ( C13 : K13 ) / ( 1+10% ) =8,04

Figure 2: Calculation of real option valuation

The net present value is $8.04 million dollars. According the investment logic this investment is feasible if we start to invest in one year. Comparing the different results in Figure 2 and Figure 1, the increased NPV 22,09 million dollars is from the management decision to capture the flexibility due to change of interest rate. This is only an oversimplified example. In chapter 3 we will clarify differences

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between NPV and ROV more clearly.

12

Real Option Valuation of Product Innovation

2.

Basic Concepts of Valuation on Product Innovation

2.1. Definition and Character of Product Innovation A product is an output provided from a company into the market. A product satisfies the concrete customer demand through its special functionality and attributes. This satisfaction for a marketable product is often measured by the customer utility. The proposition of the customer utility is composed of the following three components (see Figure 3) •

Product/service attributes

•

Image

•

Customer relationship

Generic Model

The Product involves total necessary customer utility

Customer Utility

Functionality

=

Product/Service Attributes

Quality

+

Image

Time, Availability

+

Customer Relationship

Esthetic, Design

Figure 3: The Customer Utility Proposition Source: Kaplan, Robert S. The balanced scorecard, page 74,

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adopted from the script Marketing from Prof. Dr. Martin Selchert

2.1.1. Definition of Product Innovation Product innovation is defined to increase any consumer utility in order to create more value for company. It is one of technological innovations which are involved in use of new knowledge to create and implement some new technologies13. The utility can be 13

Müller, C. 2002. Productinnovation durch Projectmanagement, p.143

13

Real Option Valuation of Product Innovation effective only if the innovating firm invests also in marketing, so that consumers become aware of the newly developed product. There are two dimensions in product innovation definition: one is that innovation is related to the product. Another dimension is that the product innovation must be introduced to markets where products can be sold. Thus, the marketing of product innovation and the introduction of a product innovation are sequential steps of an effort to maximize the profit14. Product innovation is concerned with change. Depending on the degree of change and novelty, product innovation can be differentiated between original product innovation and adopted product innovation15. Original product innovation is transformational innovation. It is to create a new product with new function, or apply new principles for functionality. Through original product innovation the product attributes will be fundamentally changed, for example, Windows Vista versus Windows 95. Normally, there is no predecessor in the market. The company has to build new markets. We call this innovation product-diversification. If the company provides the new product in an old market, we call this innovation product-differentiation. Adopted product innovation concentrates on improving a product in the old market. It is often a substantial innovation. There are four different sorts of adopted product innovation: product-modification, product variation, product standardization, and copying. Product modification improves concrete product function or changes the customer utility in consideration of market demand16. In contrast, product variation is only a small adjustment to the customer demand. On the basis of an output-orientated prospect, product innovation in this paper is understood

as

product

diversification, product differentiation and product

modification, - transformational product innovation process. A graphical presentation Copyright © 2009. Diplomica Verlag. All rights reserved.

for the classification of product innovation is given in Figure 417 . There is, however, no sharp distinction among different classes. If, for example, a company makes radical improvement of a product which has been developed and 14 15 16 17

14

Müller, C. 2002 Productinnovation durch Projectmanagement, p.144 Holt, K. 1988. Product Innovation Management, p.15 Meyer, J.W. 2000. Produktinnovationserfolg und Target Costing , p. 7 Meyer, J.W. 2000. Produktinnovationserfolg und Target Costing , p. 6

Real Option Valuation of Product Innovation introduced by another company, it may be difficult that such an innovation should be called as an original or adopted innovation. existing product program

Market 1

P1

Market 2

Market 1

P1

P3

P2

Market 2

P3’

P2

Market 1

Product modification

product innovation process

P1

P3

P2

P4

Product differentiation

Market 3

Product diversification

Market 2

P4

Market 1

P1

Market 2

P3

P2 Figure 4: Classifying of product innovation orientated by output and process

2.1.2. Character of Product Innovation 2.1.2.1. Product innovation is a complex process Product innovation is a complex process, requiring the use of knowledge in order to create and apply something new. Product innovation process takes a relative long time until it has significant influence on the market and production potential. This process

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can be divided into four stages18:

18

•

Generation of ideas

•

Utilization of ideas

•

Preparation for implementation

•

Manufacturing and marketing

Holt, K. 1988. Product Innovation Management, p.6

15

Real Option Valuation of Product Innovation

Growth of market and technology New customer demand, new problem

Awareness of problem, analysing problem

Strategy

problem

strategic

to solute

orientation

first stage

Creating new idea for solution Valuing and choosing idea release not suitable idea innovation project

Project and programme plan Economic calculation

release not suitable project set up goal and task / conceptual formulation

second stage

Research & Development Technology transfer

release unsuccessful research invention Introducing production release unsuccessful product

third stage

marketable product

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Introducing new product to market unsuccessful on market Adoption by customer Diffusion

Figure 5: Product innovation process Source: Pleschak, F./Sabisch, H.: Innovationsmanagement, 1996, P24

16

fourth stage

Real Option Valuation of Product Innovation Creativity, or a creative thinking, which results in novel and worthwhile ideas, is required at all stages. However, it is most important at the first stage, the generation of the basic idea, as this determines the course of other stages. Generation of ideas represents a coupling of a perceived need and a technological opportunity that satisfies the need. The appropriate tool groups at this stage are needrelated intelligence, technology-related intelligence, forecasting techniques, methods for development of creativity, preliminary studies and project formulation. This stage ends with an idea that is evaluated and accepted for further processing. Utilization of ideas is basically a problem-solving process aiming at an optimal technical solution for the problem specified or implied by the accepted idea. It is brought about by acquisition of the appropriate technology or by developing it inside the company. The tool groups for this stage are preliminary project analysis, market research, cost estimates, design, design evaluation and design calculation. Preparation for implementation is concerned with planning the manufacturing and marketing operations of the new or improved product. It involves a number of tasks in connection with finalizing the design of the product, planning of plant, equipment and manufacturing operations, as well as planning of the introduction and marketing operations. Manufacturing and marketing starts with market introduction and continues with regular manufacturing and marketing. It involves the break-in and debugging of the manufacturing operation, marketing plans and the introduction at the market place. 2.1.2.1.

Product Innovation is a cross-functional and contingent process

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Product innovation process takes a long time. The result of the innovation activities depends on a number of factors. A successful product innovation depends on a successful systematic integration of technology, organization, market and so on. Managers manage the product innovation process with analyzing the resources all along. Such a flexible way of management plays an important role in innovation process. The following brain-map illustrates the possible factors influencing innovation activities: 17

Real Option Valuation of Product Innovation

resources

internal factors

tangible resources intangible resources System

competence

Structur Process Intergration

capital

Equity Debt Profitability

Product Innovation

Technology change macro environment

Policy Sociality Ecology Economy

external factors

Competitors micro environment

Suppliers Customers Potential substitute Competitiveness

Figure 6: Possible factors which influence innovation activities

2.1.2.2.

Product Innovation is a risky Process

The investment on a product innovation project is a risky process. On one hand, the

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investment to introduce new product and develop market is enormous. On the other hand, the possibility of failure in the development of a new product is very high. According to the study of Arthur D. Little (a counselor), only one of 100 new product ideas can become successful in reality. The cost increases progressively with the increasing grade in process of new product innovation. One goal of product innovation is earning economic and technological 18

Real Option Valuation of Product Innovation power in the future. But the precondition is that the company has to afford a great deal of financial and human resources first. In addition to the investment in R&D and market research, there are also the costs for product-attendant process innovation and market introduction so far the new product has been launched in market successfully. Moreover, there is a risk that the commercializing time is not long enough to re-win the previous investment as the life cycle of product has been shorten by the innovation.

15% Market success, meet expectation

25%

Decide to introduce product in market

Filter 1

New business (diversification)

Attractive for company, engagement of

(bottom-up)

50%

Flow of innovation ideas

Matching to vision, mission, innovation justify

1%

Filter 2

Filter 3

Filter 4

3%

Productinnovation & market exploration

6% Intensified marketing

Figure 7: Expectation and chance of successful innovation Source: A.D.Little 1988, S.113; zitiert nach Haedrich/Tomczak 1996, S.156 Adopted from Meffert, Heribert, Marketing, page 378-379

2.2. Main Challenges in Valuing Product Innovation

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Product innovation is a multiple phased process influenced by numerical internal and external factors. Because the internal and external environment of the company changes constantly, the product innovation process is therefore uncertain. There often exist two kinds of risks in product innovation project19.

19

Neely, J. E. 2001. Hybrid real options valuation of risky product development project, p. 9

19

Real Option Valuation of Product Innovation One kind of risk concerns the uncertainties associated with the project itself20. For example, how will its actual costs compare with estimates? How will performance compare with forecasts?. These are called project risks. Managers and investors can usually avoid such risks by diversifying their investments and hence unexpected losses in one project could be compensated 21 . The other kind of risk stems from external markets and cannot be avoided by the way of diversification22. These risks are called market risks. It concerns the uncertainties in the value of the product when it is brought to the market, i.e., there is an uncertain market price for a new product when it starts to be sold. The market risks thus require a higher discount rate as extra compensation, since they are unavoidable23. In a product innovation process, managers anticipate and integrate the process at each stage. Through analyzing, planning, performing the project, the active management flexibility changes the risks in the product innovation. The decision on the following stage is based on the results of the former stage. The future investment opportunities depend on today’s investment but will only be undertaken contingent on the first investment’s outcome. The following stage is an option There are many challenges in valuing product innovation: •

Product innovation process is influenced by numerical factors. Many of them are independent. How to identify and qualify these influence and relationships between these factors, which contribute to create value in product innovation process, are difficult.

•

Managerial flexibility penetrates in the entire product innovation process. These flexibilities are many “soft factors” which are most difficult to measure.

•

Concentration of management flexibility changes from stage to stage in order

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to achieve different goals on different stage. How to reflect the changes in valuing product innovation is the third challenge. •

As illustrated, a product innovation process is a long-term strategic decision in company. It often takes a few years from beginning the project to the first

20 21 22 23

20

Neely, J. E. 2001. Hybrid real options valuation of risky product development project, p.10 Neely, J. E. 2001. Hybrid real options valuation of risky product development project, p.10 Neely, J. E. 2001. Hybrid real options valuation of risky product development project, p.10 Neely, J. E. 2001. Hybrid real options valuation of risky product development project, p.10

Real Option Valuation of Product Innovation product test and market launch. In this time horizon the economic environment changes. As a result, management decisions are continuously changed to matching the demand. This raises the question how do we correctly decide the input parameters for measuring the value? 2.3. Selection of the Adequate Methodology 2.2.1. Net Present Value Net Present Value is one of the major decision criteria based on discounted cash flow analysis which is recommended as the standard tool for project evaluation. The NPV is defined as the sum of the discounted gross operating cash flows over a predefined period of time 24 . It represents an additional market value of the company due to performing the project. n NPV = ∑

GOCF t

t = 1 (1 + WACC )

t

+

GOCF (WACC − g ) * (1 + WACC ) n +1

Where t = the time of cash flow n = the total time of the project WACC = weighted average cost of capital g = the expected growth rate of the cash flow in perpetuity GOCF = gross operating cash flow

GOCF = normalized gross operating cash flows Regarding the capital structure, the weighted average cost of capital (WACC) (after tax) is used by many companies as a discount rate for financed projects. The logic of WACC is that company raises money from two main sources: equity and debt. The

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capital structure of a company comprises three main components: preferred equity25, common equity26 and debt (typically bonds and notes). The WACC takes into account

24 25

26

Selchert, M. 2003. CFROI of Customer Relationship, p.57 Preferred equity financing, that is senior to sponsor equity, for commercial real estate properties and portfolios with value creation opportunities. This product can resemble a mezzanine loan and be useful when secondary financing is prohibited or can be used for transactions which require an equity partner due The sum of the value of common stock at par, the surplus of capital received (over par) from the sale of common (i.e., capital surplus), and retained earnings (i.e., earned surplus). Retained

21

Real Option Valuation of Product Innovation the relative weights of each component of the capital structure and presents the expected cost of new capital for a company. The weighted average cost of capital is defined by:

WACC =

E D y + b (1 − t c ) C C

Where C = D + E D = total debt E = total equity C = total capital invested

c = weighted average cost of capital y = required or expected rate of return on equity t = corporate tax rate

Using the weighted average cost of capital formula, time value of money, project specific risk and financial risk are blended into a single risk adjusted discount rate. It can be interpreted as the minimum acceptable rate of return for the project. There are two input parameters in net present value method: one is the future cash flow, the other is the discount rate (WACC). The WACC assumed is constant. It is implicitly based on the assumption that uncertainty concerning future cash flows increases at a constant rate over time. If this assumption is inappropriate for the product innovation project, application of the net present value will result in a bias against the long-term product innovation as long as the model is not changed to reflect reality. The variables in the weighted average cost of capital refer to the company as a whole and thus are only suitable to investment projects that exactly replicate the company’s existing assets and capital structure. If the profile of product innovation project differs from the company’s average profile, WACC cannot reflect the project risk based on the concrete product innovation process.

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Inter-project flexibility and intra-project flexibility are typical characteristics of product innovation process. Traditional discounted cash flow analysis ignores management’s ability to adapt projects under changing conditions and to deploy assets to their best use 27 . It treats a project largely as a black box which automatically generates cash flows once it is launched with no possibility for further managerial

27

22

earnings in this context equals net profits earned in all years, less dividends paid in all years. to risk profile or deal structure Müller, J. 2000. Real Option Valuation in Service Industries, p.44

Real Option Valuation of Product Innovation interaction. The use of traditional net present value analysis will thus lead to an undervaluation of the project due to asymmetries in cash flows introduced by the ability to actively manage the project’s future.28 As Myers (1984) pointed out, the applicability of the discounted cash flow analysis is limited to the valuation of safe cash flows and investments that do not incorporate significant growth or flexibility options29. In summary, a correct application of the NPV will encounter five main obstacles30: 1. to estimate the opportunity cost of capital, 2. to estimate true incremental cash flows over time, 3. to estimate cross-sectional relationships between cash flows, 4. to estimate times series links between projects (inter-project flexibility) 5. to estimate the impact on project value when the decision is a dynamic process of periodical adjustment (intra-project flexibility) The first three points mainly represent a challenge to the thoroughness of the analysis but this is not a fundamental problem. Shortcomings in this area, especially in the estimation of the opportunity cost of capital, will lead to a bias against long-term projects. Applying discounted cash flow analysis to projects that exhibit the fourth or fifth characteristic is, however, misleading and even conceptually wrong31. 2.2.2. Other traditional approaches

Several approaches have been recommended on how to amend NPV analysis to overcome the problems discussed in above paragraph. These approaches are extensions of the NPV that help to cope with complexity and uncertainty. Decision Tree Analysis (DTA) is a means to clearly represent expected cash flow

consequences of decisions over the life of the project. With decision tree analysis, Copyright © 2009. Diplomica Verlag. All rights reserved.

projects involving sequential decisions will be explicitly modelled at first. Then, the present value of the optimal decision will be calculated by rolling back the tree. The probabilities at each event node either come from subjective assessments or from 28 29

30 31

Müller, J. 2000. Real Option Valuation in Service Industries, p.45 Myers (1984), page 135, Typical investment categories would be asset replacement, cost-reduction or expansion of existing capacity. Müller, J. 2000. Real Option Valuation in Service Industries, p.44 Müller, J. 2000. Real Option Valuation in Service Industries, p.45

23

Real Option Valuation of Product Innovation historical data from similar situations (see Figure 8). Decision tree analysis allows incorporation of the value added by active management over the life of the project32.

probability of each event node event tree if invested invest

su ccess

52,47

failure

0

0,4 20,99 0,6

0

decis ion

possible NPV of each node

don't invest

Figure 8: Decision Tree Analysis

But the difficulty in finding an appropriate discount rate limits its applicability. Due to the decision alternatives available in the tree, the systematic risk of the project cash flows changes from node to node. A constant discount rate that has been estimated within the WACC framework cannot reflect this character. Because of the use of a single risk-adjusted discount rate and no explicit consideration of the option features embedded in the tree, wrong pricing of investment opportunities is therefore likely to occur with decision tree analysis33. Sensitivity/ Scenario Analysis is to determine how the net present value of the

project will be influenced by changes in the underlying assumptions. It allows identification of the key variables, exposes incoherent assumptions and shows where additional information would be most valuable. If several assumptions are altered simultaneously to represent possible future states of the project and to understand the

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interaction between the variables, sensitivity analysis develops into scenario analysis34. A shortcoming of sensitivity/scenario analysis is that assumptions about best or worst cases are necessarily subjective and thus may blur inter-project comparability. 32 33 34

24

Müller, J. 2000. Real Option Valuation in Service Industrie, p.46 Müller, J. 2000. Real Option Valuation in Service Industrie, p.46 Müller, J. 2000. Real Option Valuation in Service Industries, p.47

Real Option Valuation of Product Innovation Moreover, cash flow asymmetries introduced by managerial flexibility are difficult to incorporate into the analysis and any risk that has not been explicitly specified and modelled is not considered. The fundamental problem with traditional valuation model lies in the valuation of investment opportunities whose claims are not symmetric or proportional 35 . As Trigeorgis pointed out, traditional valuation methods are unable to capture the value of operating options properly, because of their discretionary asymmetric nature and their dependence on future events that are uncertain at the time of the initial decision 36 . Due to the shortcomings of the traditional valuing methods in the quantitative analysis of strategic or flexible investment projects, strategic decisions in corporate practice such as product innovation have typically been based on intuition, good feeling or other subjective considerations. A new method of investment valuation that permits the evaluation of intangible or strategic assets to make

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corporate strategy measurable is therefore required.

35

36

Trigeorgis, L.1997. Real Options – Managerial Flexibility and Strategy in Resource Allocation, p.155 Trigeorgis, L.1997. Real Options – Managerial Flexibility and Strategy in Resource Allocation, p.154

25

Real Option Valuation of Product Innovation

3.

Introduction of Real Option Valuation

3.1. The Definition of an option

Option is a definition in capital budgeting. An option37 provides the buyer (holder) the right (but not the obligation) to exercise by buying or selling an asset at a set price (called an exercise price or a strike price) on (European style option) or before (American style option) a future date (the expiration date). An option is often classified as call option and put option. Exercise price38 is the amount of money invested to exercise the option if you are

“buying” the asset with a call option, or the amount of money received if you are “selling” it with a put option. Underlying asset39 for a financial option is a security such as a share of common

stock or a bond. For example, in a stock option to buy 100 shares of BlackBerry at EUR 140 at the end of year 2007, the BlackBerry share is the underlying asset. In a futures contract to buy EUR 10 million 10 year German Government Bonds, the underlying assets are the German Government bonds. Underlying risk40 is that you may lose the money you invested – your capital. It is a

measure of the variance 41 of possible outcomes. A risk is related to the expected losses which can be caused by a risky event and to the probability of this event. A financial risk is often presented as the unexpected variability or volatility42 of returns, and thus includes both potential worse than expected as well as better than expected returns.

37 38 39 Copyright © 2009. Diplomica Verlag. All rights reserved.

40 41

42

26

from http://en.wikipedia.org/wiki/Stock_option from http://en.wikipedia.org/wiki/Strike_price from http://en.wikipedia.org/wiki/Underlying from http://en.wikipedia.org/wiki/Risk The variance and the closely-related standard deviation are measures of how spread out a distribution: They are the measures of variability. The variance is computed as the average squared deviation of each number from its mean. A varies in option-pricing formulas showing the extent to which the return of the underlying asset will fluctuate between now and the option's expiration. Volatility refers to the amount of uncertainty or risk about the size of changes in a security's value. A higher volatility means that a security's value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. Whereas a lower volatility would mean that a security's value does not fluctuate dramatically, but changes in value at a steady pace over a period of time.

Real Option Valuation of Product Innovation A Call option gives the buyer the right to buy the underlying asset at an exercise price, at any time prior to the expiration date. At expiration date, the option is not exercised and expires worthless if the value of the underlying asset is less than the exercise price. If the value of the asset is greater than the exercise price, the option is exercised – the buyer of the option buys the stock at the exercise price. Figure 3.143 illustrates the cash payoff on a call option at expiration. The net payoff is negative (and equal to the price paid for the call) if the price of the underlying asset is less than the exercise price. If the price of the underlying asset exceeds the exercise price, the difference between the price of the underlying asset and the exercise price comprises the gross profit on the investment. The net profit on the investment is the difference between the gross profit and the price paid for the call initially. Net Payoff

Net Payoff

Exercise Price

Exercise

Price

Price of Underlying Asset

Figure 9: Payoff on call option

Price of Underlying Asset

Figure 10: Payoff on put option

Source: Damodaran Aswath: The Promise and Peril of Real Options, page 6, 7

A put option gives the buyer the right to sell the underlying asset at exercise price, at

any time prior to the expiration date of the option. At expiration date, if the price of the underlying asset is greater than the exercise price, the option will not be exercised and will expire worthless. If the price of the underlying asset is less than the exercise price, the buyer will exercise the option and sell the stock at the exercise price. As

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shown in figure 3.2, a put option has a negative net payoff if the price of the underlying asset exceeds the exercise price. If the value of the underlying asset is less than the exercise price, a gross payoff equals to the difference between the exercise price and the price of the underlying asset. The net payoff is the gross payoff minus the price paid for put option initially.

43

Damodaran, A. The Promise and Peril of Real Options, p.6

27

Real Option Valuation of Product Innovation 3.2. Difference between Real Options and Financial Options

Both of real options and financial options are the right but not the obligation, to take an action. A real option is the right, but not the obligation, to undertake some business decision, at a predetermined cost called exercise price, for a predetermined period of time – the life of the option44. These are called "real options" because they pertain to physical or tangible assets, such as equipment, rather than financial instruments45. It is a choice that an investor has when investing in the real economy (i.e. in the production innovation of goods or services, rather than in financial contracts). In contrast to financial options, a real option is not tradable - e.g. the factory owner cannot sell the right to extend his factory to another party, only he can make this decision. It is not a derivative instrument, but an actual tangible option in the sense of “choice” that a business may gain by undertaking certain endeavors. For example, by investing in a project or property, a company may have the real option of expanding, deferring, or abandoning other projects in the future. Other examples of real options may be opportunities for research and development, mergers and acquisitions, etc. The underlying asset for a real option is a tangible asset, for example, a business unit or a project while the underlying asset for a financial option is a security such as a share of common stock or a bond. The value of underlying asset: Financial options are written on traded securities. It

makes much easier to estimate the parameters of financial options 46 . The security price is usually observable, and we can estimate the variance of its rate of return either from historical data or by calculating the forward-looking implied variance from other options on the same security. With real options, the underlying risky asset is usually not a traded asset. It is difficult to estimate the value of underlying asset from market. Copyright © 2009. Diplomica Verlag. All rights reserved.

Copeland and Antikarov proposed the marketed asset disclaimer assumption (MAD). Combining the ration of a “twin security” and the Mason and Merton assumption, the MAD states that the real asset value is perfectly correlated with itself and is the best

44 45 46

28

Copeland, T. and Antikarov, V. 2000. Real Options – A Practitioner’s Guide, p.5 http://en.wikipedia.org/wiki/Real_option Copeland, T. and Antikarov, V. 2000. Real Options – A Practitioner’s Guide, p.111

Real Option Valuation of Product Innovation unbiased estimate of the market value of the real asset were it traded. Therefore, the real asset value should be used as the underlying security47. The possibility of enhancing the value of the underlying asset is another important

difference between financial and real options. Most financial options are side bets. The company on whose shares they are contingent does not issue the financial options. The independent agents who write them and buy those that are written issue them. Consequently, the agent that issues a call option has no influence over the actions of the company and no control over the company’s share price. Real options are different. Management controls the underlying assets on which they are invested and implements their decisions with time series. For example, a company plans to start a new product innovation project. Management may have the right to abandon it and may choose to do so if its present value is low. However, if the company comes up with a new idea that raises the present value of the underlying project (without flexibility), the value of the right to abandon may fall, and the company may decide not to abandon. Usually, the act of enhancing the value of the underlying real asset also enhances the value of the valuation48. The possibility of changing the risk by management: With both financial and real

options, risk - the uncertainty of the underlying - is assumed to be exogenous49. This is a reasonable assumption for financial options. The uncertainty about the rate of return on a share of stock is, in fact, beyond the control or influence of individuals who trade options on the stock. The actions of a company that owns a real option may affect the actions of competitors, and consequently the nature of uncertainty that the

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company faces

47 48 49

Müller, J.2000. Real Option Valuation in Service Industries, p.60 Copeland, T. and Antikarov, V. 2000. Real Options – A Practitioner’s Guide, p.111 Copeland, T. and Antikarov, V. 2000. Real Options – A Practitioner’s Guide, p.111

29

Real Option Valuation of Product Innovation 3.3. Value Drivers of Real Options 3.3.1.

Value Drivers relating to the underlying asset and financial market

The Mckinsey consultants Leslie and Michaels (1997) have identified six levers on financial option value within the Black-Scholes equation (which will be discussed in chapter 3.5.3). They attempt to convert these levers into comparable term that can guide real option decisions50. The Black-Scholes equation presents as follows:

OV = S e-δt N(d1) - K e-rT * N(d2) where,

d1 =

ln( S / K ) + (r + σ 2 / 2)T σ T

d 2 = d1 − σ T OV = Option Value

σ = uncertainty (Standard deviation) (4)

S = stock price (1)

r = risk-free rate

K = exercise price (2)

δ = dividends

T = time to expire

(3)

(5) (6)

N(d) = cumulative normal distribution function

In this equation there are six variables that influence the value of the option. In the opinion of Leslie, several of these variables represent levers that are straightforward in real options situation as well. He used a hexagon (in Figure 11) to illustrate the similarities between the variables in a financial option and those in a real option. Financial option value levers time to expire

uncertainty of stock price movement

exercise price

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Real option value levers

stock price

risk-free interest rate

dividends

time to expire present value of fixed costs(-) risk-free interest rate

uncertainty of expected cash flows present value of expected cash flows(+) cash flows (dividends) lost due to competitors who have fully committed

Similarities between financial and real options Figure 11: The six levers of financial and real options Source: Leslie, 2000 50

30

Smith, R. “Applying Options Theories to Technology Management Decisions”, p.2

Real Option Valuation of Product Innovation Copeland illustrated the six value drivers relating to the underlying asset and financial market qualitative as follows:51 •

Present value of expected cash flows: An increase in the present value of the project will increase the net present value (without flexibility) and therefore the value of real option approach will increase

•

Present value of fixed costs (the exercise price): A higher investment cost will reduce net present value (without flexibility), and therefore reduce the value of real option approach.

•

The time to expiration: A longer time to expiration allows managers more about the uncertainty and therefore it will increase the value of real option.

•

Uncertainty of expected cash flows (the standard deviation of expected net present value): In an environment with managerial flexibility an increase in uncertainty will increase the value of real option.

•

The risk-free rate of interest over life of the real option: An increase in the riskfree rate will increase the value of real option, since it will increase the time value of money advantage in deferring the investment cost.

•

Cash flows (Dividends) lost due to competitors who have fully committed: Increasing cash flows lost to competitors will decrease the expected cash flows, therefore the value of real options will decrease.

3.3.2. Uncertainty

Uncertainty is often an important factor in economics. According to economist Frank Knight, it is different from risk, where there is a specific probability assigned to each outcome (as when flipping a fair coin). Uncertainty involves a situation that has unknown probabilities, while the estimated probabilities of possible outcomes need

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not add to unity. There is a difference between financial options and real options regarding the sources of uncertainty52. For example, suppose you held a financial option contract on a stock – you had an option to buy 100 shares of BlackBerry. The contract terms specify the observable underlying asset (BlackBerry stock). 51 52

Copeland, T. and Antikarov, A. 2000. Real Options – A Practitioner’s Guide, p.7 Amram, M. and Kulatilaka, N. 1999. Real Options – Managing Strategic Investment in an Uncertain World, p.92

31

Real Option Valuation of Product Innovation Real options are more complex. They often have multiple sources of uncertainty and a mix of private and market-priced risk. The sources of uncertainty that trigger the execution of options may not be observable. For example, a company would develop a new product. What sources of uncertainty would the company identify as driving the value of this investment decision, would be not observable. This product is a new one, there were no comparable product. Customer und the company were still not familiar with its technology and prospects. In comparison with NPV method, the real options approach has a very different way of thinking about risk and uncertainty. In the net present value viewpoint a higher level of uncertainty leads to a lower asset value. The real options approach shows that increased uncertainty can lead to a higher asset value if managers identify and use their options to flexibly respond to unfolding events 53 . Figure 12

54

illustrates this difference. In

opinion of option approach, the value of an option is inferred from the value of a portfolio of traded securities which mimics its fluctuations in value over time. If the value of the option and the portfolio are not equal, an opportunity to profit from trading would exist. There are two parties for real options approach. The first half is about recognizing that uncertainty provides managers with investment opportunities. The second half is about how options are valued. Real options and financial options are valued relative to the prices of traded assets, adding discipline and objectivity. That allows the real options approach to provide consistent valuations across internal and external applications, making possible an “ apples-to-apples” comparison on all strategic opportunities, including opportunities to use financial market transactions to better manage investments and risks. Initially, the concepts behind the options approach may appear complex, but using the options approach allows you to make

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great strides over competitors who are wedded to current practice.

53

54

32

Amram, M. and Kulatilaka, N. 1999 Real options Managing Strategic Investment in an Uncertain World, p.13 Amram, M. and Kulatilaka, N. 1999 Real options Managing Strategic Investment in an Uncertain World, p.15

Real Option Valuation of Product Innovation

Figure 12: Uncertainty increases value

3.3.3.

Managerial Flexibility

Managerial Flexibility arises from management’s ability to adapt and reformulate a set strategy as uncertainty resolves over time. Managerial Flexibility is valuable since it leads to asymmetry in the structure of expected future cash flows. Two different sources 55 of flexibility that are adding value to capital investment projects can be distinguished as operational flexibility (e.g. delay, abandon, switching, expand, contract, etc.) and strategic flexibility (e.g. growth option etc.). Operational flexibility is the flexibility within a single project. For example, managers can defer an investment project until more information about the future has been gathered. Strategic flexibility is the flexibility between a series of interdependent contingent investments. When there is high uncertainty and when managers have flexibility to respond to it, real options are important and have the greatest value56 (see Figure 13). But the value of real options relative to NPV is large when the NPV is close to zero, in the yellow Copyright © 2009. Diplomica Verlag. All rights reserved.

area. If the NPV is high, then most options that provide additional flexibility will have a very low probability of being exercised, and therefore have low relative value. Conversely, if the NPV is extremely negative, no amount of optionality can rescue the project. It is in making the tough decisions − those where the NPV is close to zero − that the additional value of flexibility makes a big difference. 55 56

Müller, J. 2000. Real Option Valuation in Service Industries, p.54 Copeland, T. and Antikarov, V. 2001. Real Options – A Practitioner’s Guide, p.14

33

Real Option Valuation of Product Innovation

Low When:

Uncertainty

Room for Managerial Flexibility

Ability to respond

High

Low

High

Likelihood of receiving new information

Moderate Flexibility Value

High High

Moderate

Moderate

Flexibility

Flexibility

Value

Value

Figure 13: When managerial flexibility is valuable

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1. High uncertainty about the future *Very likely to receive new information over time 2. High room for managerial flexibility *Allows management to respond appropriately to this new information

Flexibility Flexibility Value Value

In every scenario, flexibility value is greatest when the project’s value without flexibility is close to break-even.

34

Flexibility Value Greatest

3. NPV without flexibility near zero * if a project is neither obviously good nor obviously bad, flexibility to change course is more likely to be used and therefore is more valuable.

Under these conditions, the difference between ROA and other decision tools is substantial.

Real Option Valuation of Product Innovation 3.4. Typology of Real Options

In this chapter we will discuss the different types of real options and show how to value them by using the basic valuation idea. Figure 14 provides an overview of description and potential applications of the different operational flexibilities seen as real options. Operational flexibility

Delay Abandon

Expand/ Contract

Switching

Compound Options

Description Possibility to defer capital outlay for an irreversible investment project with uncertainty about important influencing factors dissolving over time; Particularly sensitive to competitive interaction.

Industries where institutional mechanisms such as licences or patents provide insulation from competitive action. (e.g. natural resource extraction, real estate development)

Possibility to abandon a project before the end of its planned useful life by selling it in secondary market and thus realizing the salvage value. Possibility to increase (decrease) production capacity of an initial investment against a follow-up capital outlay (future cost savings) once the capacity of the base investment is no longer sufficient (too large) Possibility to switch between different processes (products), i.e. inputs (outputs) based on relative cost; Incorporates also switching the production location for multinational companies due to changes in relative factor costs.

Capital intensive industries with fairly efficient secondary markets.

Mixture options

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Potential applications

of

any

of

simple

Cyclical industries such as natural resource extraction or consumer goods. Entry into new market with considerable uncertainty about future demand. Input: power generation, refineries, manufacturing processes, where input substitutes are available, multinational companies with geographically separate production facilities. Output: Industries where small batch size or tailor-made products are important; Industries that face a high volatility of demand and are subject to fads and trends (e.g. toys, apparel). Where there are two or more sources of uncertainty.

Figure 1457: Qualitative Description of real options with potential industry applications

The basic valuation idea of real option is built around the idea of a standard replicating portfolio. It assumes that a portfolio of traded investments can be

57

Müller, J. 2000. Real Option Valuation in Service Industries, p.57

35

Real Option Valuation of Product Innovation constructed which would exactly replicate the returns of the option in any state of nature. This portfolio, consisting of buying m units of the twin security and borrowing against them B units of the risk-free bonds, has the same future cash flows as the option being valued. Since the option and this equivalent portfolio would provide the same future returns, to avoid risk-free arbitrage profit opportunities they must sell for the same current price. Thus, we can value the option by determining the cost of constructing its equivalent replicating portfolio. The general formulation 58 of the replication portfolio is as following: Current value of underlying asset * Option Delta – Borrowing needed to replicate the option _________________________________________ = Value of the call option Suppose that stock prices can either move up to uVt-1 or down to dVt-1 in any time period as shown, u2V0 uV0 p

p(1-p)

V0

udV0 1-p

p(1-p)

dVo (1-p)

2

d2V0

the replication portfolio for a call with strike price K will involve borrowing $B and acquiring Δ (option delta) of the underlying asset, where: Δ = Number of units of the underlying asset bought = (Cu – Cd)/(uV0 – dV0)

where, V0 = Stock price at time t = 0 Cu = Value of the call if the stock price is uV0 Cd = Value of the call if the stock price is dV0

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u = Up movement

58

36

d = 1/u = Down movement

Damodaran, A. The Promise and Peril of Real Options, p.11

Real Option Valuation of Product Innovation 3.4.1.

The Option to Delay

The most common real option is probably the option to delay the investment project until more information about the future has been gathered. It is a call option found in most projects where one has the right to delay the start of a project. Its exercise price is the money invested in getting the project started. Assume that you are interested in acquiring the exclusive rights to market a new product that will make it easier for people to access their email on the road. If you do acquire the rights to the product, you estimate that it will cost you $300 million upfront to set up the infrastructure needed to provide the service. Based upon your current project, you believe that the service will generate only $100 million in aftertax cash flows each year. In addition you expect to operate without serious competition for the next 3 years. The risk-free discounted rate is assumed as 10%.59 Net present value of this project = - 300 + 100 PV (of annuity, 10%, 3 years) = - 300+ 253

=

-47 million $

This project has a negative present value.

You recognize that the biggest source of uncertainty on this project is the number of people who will be interested on this product. While the current market tests indicate that you will capture a relatively small number of business travelers as your customer, the test also indicates a possibility that the potential market could get much larger over time. Next, you decided to think of the project as having a deferral option, allowing you to postpone you investment decision until there are plenty of people who are interested in the new product, in order to make you relatively certain that the return could recover your initial investment costs before the serious competition

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comes.

59

This example is adopted from Damodaran, A. The Promise and Persil of Real Options, and is simplified by Kang,Yuanyun

37

Real Option Valuation of Product Innovation The valuing of this deferral option is shown in Figure 15. ____________________________________________________________________ Exercise price = initial investment needed to introduce the product = Vo= 253 u= 1,1 d= 0,9090909 m= units of the twin security rf = 15% for bonds B= units of risk-free bond

300

The value of underlying :

B

Payout without D delay 2 u Vo= 306 =306-300 6

E

uVo= 278 Vo= 253

udVo= 253 =253-300 -47

A

Payout with delay 6 =MAX((306-300),0)

0

=MAX((253-300),0)

dVo= 230

C

2

d Vo= 209 =209-300 0 =MAX((209-300),0) F -91 The deferral option allows the decision maker to avoid negative payouts. Because the value of node E, F are zero, the value of node C is zero, too.

Replicating portfolio for node B is: m * 306 + B (1+ rf ) = 6 m * 253 + B (1+ rf ) = 0

m= 0,1153774 B= -25,496066

The value of node B = m * 278 + B (1+ 0,15) = 2,8

Replicating portfolio for node A is: m * 278 + B (1+ rf ) = 2,8 m * 230 + B (1+ rf ) = 0

m= 0,0577443 B= 2,7890476

The value of node A = m * 253 + B (1+ 0,15) = 17,8 The difference between the value with delay and the net present value without delay is the value of the option of delay = 64,8

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_____________________________________________________________________ Figure 15: Valuing an option to delay

38

Real Option Valuation of Product Innovation 3.4.2. The Option to Abandon

If one has the right, but not the obligation, to rid oneself of a risky asset at a fixed (predetermined) price, it is called an abandonment option Abandonment options are important in research and development, in exploration and development of natural resources, in new product development and in merger and acquisition projects60. Exercise price = initial investment needed to introduce the product = Vo= 100 u= 1,062 d= 0,942 rf = 5% for bonds m= units of the twin security k= 15% cost of capitals B= units of risk-free bond

80

The value of underlying :

Payout without Abandonment

Payout with Abandonment

113

= MAX(113,90) 113

udVo= 100

= MAX(100,90) 100

d2Vo=

= MAX(89,90) 90

D 2

u Vo=

B uVo= 106 Vo= 100

E

A dVo= 94

C

89

F

Abandon Replicating portfolio for node B is: m * 113 + B (1+ rf ) = m * 100 + B (1+ rf ) =

113 100

m= 1 B= 0

The value of node B = m * 106 + B (1+ 0,05) = 106,2

Replicating portfolio for node C is: m * 100 + B (1+ rf ) = m * 89 + B (1+ rf ) =

100 90

The value of node C = m * 94 + B (1+ 0,05) =

m= 0,8843 B= 11,02 94,9

Replicating portfolio for node A is:

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m * 106 + B (1+ rf ) = m * 94 + B (1+ rf ) =

106,2 94,9

m= 0,9439 B= 5,6754

The value of node A = m * 100 + B * (1+ 0,05) =100,3 The difference between the value with abandonment and the present value without abandonment is the value of the option of abandonment = 0,3

Figure 16: Valuing an option to abandon

60

Copeland, T. and Antikarov, V. 2001. Real Options – A Practitioner’s Guide, p.126

39

Real Option Valuation of Product Innovation For example, a company is considering to take a 10-year project that requires an initial investment of $ 80 million in a real estate partnership, where the present value of expected cash flows is $ 100 million. While the net present value of $20 million is small, the company has the options to abandon this project anytime in the next 10 years if the expected cash flows proceed poorly, by selling its share of the ownership to the other partners for $90 million. Figure 16 will illustrate the valuing of this abandonment option with assumption that risk-free rate rf is 5% per year, the cost of capital k is 15%, the up movement is u, and the down movement is d. 3.4.3.

The Option to Expand

In viewpoint of the option of expand, a project may start small (pilot) instead of investing all at the start. If the project turns out better than expected, it is often desirable to expand it. The extra investment is the exercise price of an expansion option – a call option. The value tree for the underlying upward shifts reflects the benefits of the expansion. Assume that the Home Depot is considering to open a small store in China. The store will cost $90 million. The present value of expected cash flows from the store is $100 million. Because the Home Depot still does not still know much about the market for home improvement products in China and hence there is considerable uncertainty about this estimate. The Home Depot believes that the market potential would be very great due to giant population there. He acquires to expand into a much larger store at any time over the next 5 years. The cost of expansion will be $20 million, and it will be taken only if the expected cash flow exceeds $100 million, and for a benefit that increases the value of operations by 10 percent. In this example we keep the other parameters (u, d, rf, k) as the same as in Figure16. Figure 17 will show the valuing of

Copyright © 2009. Diplomica Verlag. All rights reserved.

Expand.

40

Real Option Valuation of Product Innovation Exercise price = initial investment needed to introduce the product = Vo= 100 u= 1,062 d= 0,942 m= units of the twin security rf = 5% for bonds k = 15% cost of capitals B= units of risk-free bond R = 20% expected increasing rate of value for expand

80

The value of underlying :

Payout with Expand = MAX(113,(1,2*113-10)) Expand 115

Payout without D Expand 2 u Vo= 113

B

Vo= 100

A

uVo= 106 dVo= 94

C

The value of node B =

115 100

m * 100 + B (1+ rf ) = m * 89 + B (1+ rf ) =

100 89

m * 94 + B (1+ 0,05) =

Replicating portfolio for node A is: m * 106 + B (1+ rf ) = m * 94 + B (1+ rf ) =

The value of node A =

= MAX(100,(1,2*100-10)) 100 = MAX(89,(1,2*89-10)) 89

m= 1,2 B= -19,0476

m * 106 + B (1+ 0,05) = 107,4

Replicating portfolio for node C is:

The value of node C =

2

d Vo= 89

F

Replicating portfolio for node B is: m * 113 + B (1+ rf ) = m * 100 + B (1+ rf ) =

E

udVo= 100

107,4 94,2

m= 1 B= 0 94,2 m= 1,103 B= -9,23817

m * 100 + B * (1+ 0,05) = 100,6

The difference between the value with Expand and the present value without Expand is the value of the option of Expand = 0,6

The value of underlying with Expand : B

Vo= 100,6

A

= MAX(106,(1,2*106-20)) uVo= 107,4 = MAX(94,(1,2*94-20)) dVo= 94,2

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C

D = MAX(113,(1,2*113-20)) 2 u Vo= 115 E = MAX(100,(1,2*100-20)) udVo= 100 = MAX(89,(1,2*89-20)) 2 d Vo= 89

F

Figure 16: Valuing an option to expand

41

Real Option Valuation of Product Innovation 3.4.4. The Option to Contract

If market conditions turn weaker than originally expected, management can operate below capacity or even reduce the scale of operations, thereby saving part of the planned investment outlays. This right to sell some capacity, thereby shrinking the scale of operations, is an American put call that we call the option of contract.61 The option to contract, like the option to expand, may be particularly valuable in the case of new-product introductions in uncertain markets. The option to contract may also be important, for example, in choosing among technologies or plants with different ratios of construction cost to maintenance cost, where it may be preferable to build a plant with lower initial construction costs and higher maintenance expenditures in order to acquire the flexibility to contract operations by cutting down on maintenance if market conditions turn unfavourable62. To illustrate the valuation of a contract option, we keep the same underlying risky asset as in the option of expand. (see Figure 17) but introduce an option to contract the scale of operations (and therefore its value) by 50% by selling assets (computer, office

Copyright © 2009. Diplomica Verlag. All rights reserved.

equipment, some licences of technique) worth $50 million after-taxes.

61 62

42

Copeland, T. and Antikarov, V.2000. Real Options – A Practitioner’s Guide, p.135 Trigeorgis, L. 1997. Real Options – Managerial Flexibility and Strategy in Resource Allocaiton, p.12

Real Option Valuation of Product Innovation Exercise price = initial investment needed to introduce the product = Vo= 100 u= 1,062 d= 0,942 p= 0,5 rf = 5% for bonds m= units of the twin security k = 15% cost of capitals B= units of risk-free bond

The value of underlying :

Payout without D Expand u2Vo= 113

B uVo=

106

Vo= 100

A

dVo=

C

94

The value of node B =

113 100

m * 106 + B (1+ 0,05) =

Replicating portfolio for node C is: m * 100 + B (1+ rf ) = m * 89 + B (1+ rf ) =

The value of node C =

100 94

m * 94 + B (1+ 0,05) =

Replicating portfolio for node A is: m * 106 + B (1+ rf ) = m * 94 + B (1+ rf ) =

The value of node A =

106,2 97,1

Payout with Contract = MAX(113,(0,5*113+50)) 113

udVo= 100

= MAX(100,(0,5*100+50)) 100

d2Vo= 89

= MAX(89,(0,5*89+50)) 94 Contract

F

Replicating portfolio for node B is: m * 113 + B (1+ rf ) = m * 100 + B (1+ rf ) =

E

80 Percentage of Selling

m= 1 B= 0 106,2 m= 0,5 B= 47,61905 97,1 m= 0,757498 B= 24,52363

m * 100 + B * (1+ 0,05) = 101,5

The difference between the value with Contract and the present value without Contract is the value of the option of Contract = 1,5

The value of underlying with Contract : B = MAX(106,(0,5*106+50)) uVo= 106,2 Vo= 101,5

A

= MAX(94,(0,5*94+50)) dVo= 97,1

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C

D = MAX(113,(10,5*113+50)) u2Vo= 113 E = MAX(100,(0,5*100-20)) udVo= 100 = MAX(89,,(10,5*89+50)) d2Vo= 94

F

Figure 18: Valuing an option to contract

43

Real Option Valuation of Product Innovation 3.4.5. The Option to Switching

Switching options are the right to close an operation that is currently opened and the right to open it later for a different fixed cost to a common type of option. By closing an operation you have to pay fixed shutdown costs, for example, the severance payment of workers, the costs for maintaining the equipment while an operation is closed. It is a put call. By reopening it you have to pay other fixed costs, for example, the rent for building, and calculate the expected present value of periodic cash flows as a common type of options. So, actually a switching option is a portfolio of a put option (shutdown) and a call option (reopen). The option to exit and then re-enter an industry, the option to switch between two modes of operation, and the option to start up and shut down a facility are all switching options.63 Switching options are among the more complicated option problems because they are path dependent64. Assume that a company is considering to build a new factory. For the new factory they can either use technology A or technology B. The initial investment for both technologies would be $50 million. The switching costs are $8 million from A to B, and $2 million from B to A. Suppose that the new factory with technology A or B will generate the following cash flows in each year with three decision points: Technology A

Technology B

u= 1,8 d= 0,6

u= 1,5 d= 0,8

t=0

1

2

324

t=0

180 100

1

191

128 108

60

85

102 68

36 Copyright © 2009. Diplomica Verlag. All rights reserved.

2

54

The expected rate of return for two technologies is 20%, the probabilities for up-state und down-state are each 0,5. The risk-free interest rate is 8%. The net present value of cash flows from the technology A can be obtained as follows: NPV(A) = 100 + (0,5*180 + 0,5*60)/1,20 + (0,25*324 + 0,5*108 + 0,25*36)/1,202 63 64

44

Copeland, T. and Antikarov, V. 2001. Real Options – A Practitioner’s Guide, p.179 Copeland, T. and Antikarov, V. 2001. Real Options – A Practitioner’s Guide, p.180

Real Option Valuation of Product Innovation = 100 + 100 + 100 –50 = 250 Similarly, the net present value from using technology B is: NPV (B) = 85 + 85 + 85 – 50 = 205 Without flexibility, we choose technology A at beginning of the project because of its higher net present value. Consider now a flexible operating system, C, that can switch between alternative technologies, A and B. The switching with costs not only affects the current decision and cash payoff but also alters the exercise costs and switching decisions (options) in future periods. Basically, exercise of a prior option (i.e., switching operating modes in an earlier period) creates a series of nested new options (to switch in the future), analogous to a compound option 65 . So, the separate switching options from technology A to B or from B to A are dependent. That causes the breakdown of option-value additivity (the combined flexibility value is smaller than the sum of value from their separate switching options). Suppose that we would switch from A to B at time 1, in the case of up-state the value of switching option is –60 (=(128-8)–180), in the case of down-state the value of switching option is 0 (=(68-8)-60), so, the option to switch from A to B at time 1 becomes worthless (C0 (A→B) = 0). Suppose that we would switch from A to B at time 2, the value of the flexibility to switch operation from A to B ( F (A→B) ) is as shown in Figure 4.10 F (A→B) = C0 (A→B) + C1 (A→B) + C1 (A→B) = 0 + 0 + 3,1=3,1 The value of cash flow from operating technology A: C (A) = PV (A) + F (A→B) = 303,1 With the same logic, we have the value of the switching option from B to A: Copyright © 2009. Diplomica Verlag. All rights reserved.

C (B) = PV (B) + F (B→A) = 306,3

65

Trigeorgis, L. 1997. Real Options – Managerial Flexibility and Strategy in Resource Allocation, p.177

45

Real Option Valuation of Product Innovation

t=0

1

2

Value creation if switching from A to B

Vu2

=MAX[191-324-8, 0] =0

Vud

=MAX[102-108-8, 0] =0

Vd2

=MAX[54-36-8, 0] =10 Switching from A to B

F

Cu G C0 =0 (A-B)

E

Cd

Using risk-neutral probabilities, we can calculate the value at each node. The risk-neutral probability p' =( (1+rf)-d)/(u-d)= 0,4 1-p' = 0,6 Obviously, the value at node F is zero through backward calculation from time 2. At node E : CE = (0,4*0+0,6*10)/1,08 = 5,6

At node G : CG = (0,4*0+0,6*5,7)/1,08 = 3,1

Figure 19: Value creation of switching from mode A to B

Because of asymmetric switching costs, the value of the project with switching flexibility cannot simply be viewed as being equivalent to the value from one of the mode plus the sum of simple options to switch to the other technology. At each decision node, we have two basic choices: Continue operating in the current mode for one more period to receive the current cash payoff plus any expected future benefits. Or switch immediately by paying the switching cost in exchange for receiving the current cash flow and its expected future benefits from another mode. The switching will be optimal only if the value from switching immediately exceeds

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the value from delaying potential switching66. 3.4.6. Compound Option

Compound option is an option whose value is contingent on the value of other options. There are simultaneous compound option and sequential compound option. In simultaneous compound option, the life of the first option is longer (or equal to) the

66

46

Trigeorgis, L. 1997. Real Options – Managerial Flexibility and Strategy in Resource Allocation, p.180

Real Option Valuation of Product Innovation life of the second option. During the life of the second option, both options are alive simultaneously. In sequential compound option, the second option is created only when the first option is exercised. In a sense, the first option chronologically is the right to buy the second option67. Compound option is very important and common set of problems. In their famous seminar paper (1973), Black and Scholes recognized that the equity of a leveraged company (a company that has debt in its capital structure) is an option in the value of the firm (a call option) whose exercise price is the face value of the firm’s debt (D) and whose maturity is the maturity of the debt. A call option written on the equity of the firm as the underlying risky security is therefore an option on an option68. He used a closed form to get the original solution (found in Geske 1977). Now, we will use the replicating portfolio to solve this problem. In order to ensure the rightness, we adopt the original data from Copeland’s book “Real Options” on page 164. Suppose that a company’s current value is $ 1,000 million and that its value could go up by 12.75 percent or down by 11.31 percent – a standard deviation of 12 percent per annum. The risk-free interest rate is 8 percent. The equity of this company is subordinate to debt that has a face value of $800 maturing in 3 years and that pays no coupons. What is the value of an American call option written on the equity if its exercise price is $400 and it matures in 3 years? There are two options in this problem. The equity value is an option on the company value and the call option written is an option on the equity value. So, the solution should proceed in two steps. First, we value the equity as an American call on the value of the company with its exercise price equal to the face value of debt (see Copyright © 2009. Diplomica Verlag. All rights reserved.

Figure 20)

67 68

Copeland, T. and Antikarov, V. 2001 Real Options – A Practitioner’s Guide, p.178 Copeland, T. and Antikarov, V. 2001. Real Options – A Practitioner’s Guide, p.163

47

Real Option Valuation of Product Innovation V0 = 1.000 up-movement = 12,75% down-movement= 11,31% risk-free rate= 8%

exercise price 1= exercise price 2=

800,00 € 400,00 €

1.

Valuing the equity as an American call on the value of the firm with its exercise price:

1.1

Company value event tree 0

1

H uV0 = 1.127,50 V0 1.000,00 J

dV0 = 886,90 I

Decision 3 at the maturity

2

A 1.433,34 =Max[1.433,34-800,0] 633,34

E 2 u V0 = 1.271,26

1.127,50 =Max[1.127,50-800,0] B 327,50 udV0 = 1.000,00 F

886,90 = Max[886,90-800,0] C 86,90

2

d V0 = 786,59 G 1.2

calculating the equity value tree of nodes E, F, G with the replicationg portfolio approach.

Node E F G

End-of-Period Payoff Up State Down State 633,34 € 327,50 € 86,90 €

327,50 € 86,90 € 0,00 €

for Node E the replicating portfolio is: 1433,34m + 1,08B = 633,34 = 327,5) -(1127,50m+ 1,08B m= 1 B= -740,74 for Node G the replicating portfolio is: 886,90m + 1,08B = 86,90 = 0) -(697,63m + 1,08B 1.3

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Replicating Portfolio Parameters m B 1,00 1,00 0,46

-740,74 -740,74 -296,58

Option Value 530,52 259,26 64,57

for Node F the replicating portfolio is: 1127,50m + 1,08B = 327,50 -(886,90m + 1,08B = 86,90) m= 1 B= -740,74

m = 0,46 B = -296,578

Moving on to the remaining nodes for H and I, we use the replicating approach again:

Node H I

48

697,63 =Max[697,63-800,0] D 0,00

End-of-Period Payoff Up State Down State 530,52 € 259,26 €

259,26 € 64,57 €

Replicating Portfolio Parameters m B 1,00 0,91

-685,87 -604,65

Option Value 441,63 204,45

Real Option Valuation of Product Innovation

for Node H the replicating portfolio is: 1271,26m + 1,08B = 530,52 -(1000m + 1,08B = 259,26) m= 1

1.4

for Node I the replicating portfolio is: 1000m + 1,08B = 259,26 -(786,59m + 1,08B = 64,57)

B= -685,8704

m= 0,91

for Node J the replicating portfolio is: 1127,50m + 1,08B = 441,63 -(886,90m + 1,08B = 204,45)

B= -604,65

The value of node J is the value of the firm's equity: m Vo + B = 365,56 €

m= 0,99 2.

B= -620,23

Even tree underlying the compound option (equity values)

E 530,52 H 441,63 365,56 J

A 633,34

Decision at the maturity =Max[1.433,34-800-400,0] 233,34 €

327,50 B

=Max[1.127,50-800-400,0] 0,00 €

86,90 C

=Max[886,90-800-400,0] 0,00 €

0,00 D

=Max[0-400,0] 0,00 €

259,26 F

204,45 I

64,57 G

Because the value at node B, C, D is zero, the value at Node F, G is then zero, too. The similar for node I, its value is zero zero. we only need to calculate the value at Node E and H, J with replicating portfolio approach. For Node E: 633,34m + -(327,50m +

1,08B 1,08B

= 233,34 = 0)

m= 0,76 B= -231,36 Option Value at node E= 173,40

Copyright © 2009. Diplomica Verlag. All rights reserved.

For Node J: 441,63m + -(204,45m +

1,08B 1,08B

= 128,78 = 0)

For Node H: 530,52m + 1,08B = 173,30 -(259,26m + 1,08B = 0) m = 0,64 Option Value at node H = 128,78

B= -153,36

m = 0,54 Option Value at node J = 95,70

B= -102,79

Figure 20: Valuing a compound option

Thus, the value of the American call option written on equity is $95,70 million. 3.5. Methodology of Real Option Valuation

The methodology and tools for the valuation of real options are based on the literature on the valuation of financial options. In their seminal paper, Black and Scholes (1973) 49

Real Option Valuation of Product Innovation suggested a model for the valuation of European options on non-divided paying stocks, which was later modified by Merton and is referred to as Black-Scholes Model. An alternative approach to pricing financial options was presented by Cox, Ross and Rubinstein (1979). Their binomial approach allows for a simpler way to model options with complex payoff features. These two models can be called “standard” in financial option pricing theory. Both methods use the same arguments to derive the option value but involve different mathematics to find the solution69. 3.5.1. Black-Scholes Model

Black-Scholes model is a closed form solution for pricing a European call on nondivided paying stocks. It uses the continuous-time geometric Brownian motion as underlying stochastic process 70 . The continuous application of the replicating portfolio argument leads to their partial differential equation. The Black-Scholes formula for a European call on non-dividend paying stocks is:

C = S N (d1) – K( e – r T) N (d2) where d1 =

ln( S / K ) + (r + σ 2 / 2)T σ T

d 2 = d1 − σ T

C = Value of call S = Current value of the underlying asset K = Exercise price of the option T = Life of expiration of the option r = Risk-free interest rate corresponding to the life of the option

Copyright © 2009. Diplomica Verlag. All rights reserved.

σ2 = Variance in the value of the underlying asset N (d1), N (d2) = cumulative normal distribution function The Black-Scholes model is based on five core assumptions:

69 70

50

Müller, J. 2000. Real Option Valuation in Service Industries, p.58 a process that can be described by a probility process distribution. The two most common types of stochastic processes are the time series, which has a time interval domain, and the random field which has a domain over a region of space

Real Option Valuation of Product Innovation 1. No dividend payments occur over the life of the option 2. The option can only be exercised at expiration and no early exercise effects exist. 3. The interest rate remains constant over the life of the option. 4. Frictionless security markets, meaning: (1) Unrestricted borrowing and lending at the same risk-free rate. (2) No short-selling restrictions or costs. (3) No transaction costs or taxes. (4) Securities are perfectly divisible. 5. The stock price changes smoothly and the process is fixed with future values being log-normally distributed as a geometric Brownian motion71. 3.5.2. Binomial Tree Model

The binomial option pricing model was popularized by Cox, Ross, Rubinstein (1979). It is based on the replicating portfolio argument described in section 3.4, except that the stock-price movements follow a more strictly multiplicative binomial tree72. The fundamental idea is that a certain time period, for instance, the time to expiration for an option, can be divided into equally spaced, finite intervals Δt. The strict key assumption here is that over each finite time interval, there are only two states the underlying asset price can attain – up movement (u) or down movement (d). The size of the up and down movements (u and d) is a constant proportion of the stock price. This implies a constant variance of the stock price movements73. The underlying stock price follows a stationary multiplicative binomial process over successive periods described in following graphic:

(

)

Copyright © 2009. Diplomica Verlag. All rights reserved.

T! n T −n P n T , p' = p ' (1 − p ' ) bio (T − n)! n!

71

72

73

is a continuous-time stochastic process in which the logarithm of the randomly varying quantity follows a Brownian motion. Trigeorgis, L. 1997. Real Options – Managerial Flexibility and Strategy in Resource Allocation, p.84 Müller, J. 2000. Real Option Valuation in Service Industries, p.62

51

Real Option Valuation of Product Innovation

t=0

1

2

3

4 V0u4

V0u3 V0u2 V0u

p4

p3

V0u3d p3(1-p)

p2

p

p2(1-p)

V0

p(1-p)

V0u2d2 p2(1-p)2

1-p

V0d

(1-p) 2

V0d2

p(1-p)2

V0ud3 p(1-p)3

(1-p) 3

V0d3

(1-p) 4

V0d4

Figure 21: Description of a stationary multiplicative binomial process Where, the stock price V0 at the beginning of a given period may increase with probability p to V0u or decrease with complementary probability (1-p) to V0d at the end of the period. Now, we extend this analysis to a multi-period setting. Assume that the number of the period Δt will be denoted by m, the number of up-movements during these periods is represented by n. For multiplicative binomial process, the stock price at the nth node at time m is calculated as Vm,n = V0 u n d m-n For example, we start at the far left, "V0" denotes the stock price today, which is assumed as $100. The up-movement rate (u) is assumed as 1.2, the down-movement rate (d) is 1/u. At the first node “V0u”, the stock price equals: 100 ×1.2 = 120. Further

Copyright © 2009. Diplomica Verlag. All rights reserved.

we can calculate the stock price at each node in next 3 years (shown in Figure 22):

52

Real Option Valuation of Product Innovation

u= 1,2 d=1/u= 0,8333

Su3= 104,41 Su2= 102,92 Su2d= 101,45

Su= 101,45 S= 100

Sud= 100 Sud2= 98,57

Sd= 98,57 Sd2= 97,16

Sd3= 95,77

Figure 22: Event tree of stock price

The probability distribution approaches (assumed) a lognormal distribution as the number of becomes infinite. The binomial probability for each payoff is: Where T is the total number of periods, and n is the number of upward movement in the value of underlying risky asset and p’ is the risk-neutral probability ( p’ = [(1+rf)d]/(u-d) ). Note that the value of a call option does not depend on investor’s subjective estimates of the probabilities of the up and down states, because the market – aggregated probabilities of each state is contained in the value of the underlying risky asset74. Assumed that the stock would expire at the end of the nodes, the value of stock price is the stock price at the end of the node minus exercise price. Having found the value of stock price at the end of the nodes, we are able to calculate the option value by means of backwards induction, that is, working from the far right of the tree, back to Copyright © 2009. Diplomica Verlag. All rights reserved.

the origin. Because the value of an option would not be negative, the discrete payouts at the branches of the tree are bounded by zero at the bottom and approach infinity as the number of periods grow. Assume that the exercise price for the stock in Figure 22 is $101, the value of the option is illustrated as in Figure 23:

74

Copeland, T. and Antikarov, V. 2001. Real Options – A Practitioner’s Guide, p.198

53

Real Option Valuation of Product Innovation

MAX[Vt-X,0] u= 1,2 d=1/u= 0,83 p'= 0,727 1-p' = 0,273

rf = 0.1 T= 4

Su4=

Su2= 144,00 Su= 120 S= 100

Probability (T!/n!(T-n)!)p'np'T-n

Sud= 100 Sd= 83,33

Su3= 172,80

Su2d= 120

Sud2= 83,33

2

Sd = 69,44

Sd3= 57,87

207,36 106,36 0,27976231

Su3d= 144,00

43,00 0,41964347

Su2d2= 100

0,00 0,23604945

69,44

0,00 0,05901236

48,23

0,00 0,00553241

Sud3=

Sd4=

1,0000 The Value of this option =(106,36* 0,2797623+43 * 0,4196435)/(1,1)^4 = 32,65

Figure 23: Valuing an option using binomial tree

A simple computer algorithm is able to solve the option values with a large number of nodes. For European call and put options, the binomial model is given as: ⎡T

n T −n ⎤ T! n T −n u d − p ' ( 1 p ' ) − X (1+ r 0 T ⎥ f (1 + rf ) ⎦ ⎢⎣ n=1 (T − n)!n!

c0 = V ⎢∑

⎤ T! p'n (1 − p' )T −n ⎥ ⎥⎦ ⎣n=a (T − n)!n!

)−T ⎢∑ ⎡T

In order to simplify the calculation for a long period, we can use the excel spreadsheet. It helps us to draw out the binomial tree more transparent and simple. With the same input-parameters as in Figure 22 and in Figure 23, the excel spread

Copyright © 2009. Diplomica Verlag. All rights reserved.

sheet shows as follows:

54

Real Option Valuation of Product Innovation u= 1,2 d=1/u= 0,83

rf = 0.1 T= 4

p'= 0,73 1-p' = 0,27

Underlying in periods 0 1 2 3 4 100,00 120,00 144,00 172,80 207,36 83,33 100,00 120,00 144,00 69,44 83,33 100,00 57,87 69,44 48,23

Exercise price at end of year 4 101 101 101 101 101

4 106,36 43,00 0,00 0,00 0,00

Value in periods 3 2 1 80,98 60,59 44,72 28,43 18,80 12,43 0,00 0,00 0,00

0 32,65

Figure 24: Spreadsheet for a long period binomial tree

On the left-hand of the spreadsheet is the underlying event tree. It is the same as in table 3.8. On the right-hand of the spreadsheet is the value of underlying. Starting with the end nodes of year 4, the payoffs are defined as the maximum of the value of the underlying or zero, MAX(207,36-101;0) and so on. Then we calculate backward to year 3. for example, 80,98 =(106,36*p’+43*(1-p’))/(1+rf), the same for 28,43=(43,00*p’+0,00*(1-p’))/(1+rf) and the other nodes. With the spreadsheet we have the same value of the stock in t =0 as shown in Figure 23. Both are 32,65. 3.5.3. Selection of the adequate methodology

Black-Scholes model provides a closed-form solution for the equilibrium price of a call option. The seven assumptions embedded in the Black-Scholes model limit its use in real options analysis. These seven assumptions are75: 1. The option may be exercised only at maturity--- it is a European option. 2. There is only one source of uncertainty---rainbow options are ruled out (e.g., the interest rate is assumed to be constant). 3. The option is contingent on a single underlying risky asset; therefore, compound options are ruled out. Copyright © 2009. Diplomica Verlag. All rights reserved.

4. The current market price and the stochastic process followed by the underlying are known (observable). 5. The underlying asset pays no dividends. 6. The variance of return on the underlying is constant through time. 7. The exercise price is known and constant.

75

Copeland, T. and Antikarov, V.: Real Options – A Practitioner’s Guide, page.106

55

Real Option Valuation of Product Innovation In reality, most investment decisions are compound options because they progress in phases, and there are usually several correlated sources of uncertainty76. .

Proof by Cox, Ross, Rubinstein, binomial tree model has more advantages. First, it can span a large range of real option applications, including those with some complexity. Second, the approach is more comfortable for many users because, although it is consistent with the option valuation breakthrough, it retains the appearance of discounted cash flow analysis. Third, uncertainty and the consequences of contingent decisions are laid out in a natural way; the binomial model generates good visual images.

From the equation of binomial tree, we recognize that the more sub-periods are specified, the more accurate the valuation of the option will be. In fact, with Δt approaching zero, and period approaching infinity, this binomial model of stock price movements converge to the geometric Brownian motion77 . The Black-Scholes can therefore be viewed as limiting case of the binomial model for Δt

0 and constant

d and u78. In the binomial tree formula, the value of underlying does not depend on the probability of an up or down movement in the price. Individual risk attitudes are irrelevant. The stock price is the only source of uncertainty79. Since the binomial model is very intuitive, requires only elementary mathematics and allows for the explicit modelling of discrete events over the life of the option, it is best suited to model complex options such as encountered in most real options

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circumstances80.

76 77

78

79 80

56

Copeland, T. and Antikarov, V.2001. Real Options – A Practitioner’s Guide, p.106 In a comparison of different numerical approaches, Trigeorgis (1996), pp329-336 shows that the results of the Black-Scholes and the binomial model are equivalent. d and u are only the symptoms. The risk-free rate and the volatility of the underlying asset are actually assumed to be constant over the life of the derivative. Müller, J. 2000. Real Option Valuation in Services Industries, p.63 Müller, J. 2000. Real Option Valuation in Service Industries, p.63

Real Option Valuation of Product Innovation

4.

Applying Real Option Valuation to the illustration BlackBerry

4.1.

Introduction of the Product Innovation BlackBerry

BlackBerry is a wireless platform of Canada Company Research In Motion (RIM). This platform provides users with a wireless extension of their work and personal email accounts, including Microsoft “Outlook”, Lotus Notes, “Novell”, MSN Hotmail; POP3/ISP email and others. It includes sales of BlackBerry wireless devices, software and service.

BlackBerry wireless devices are the primarily cash flow stream of Research In Motion. It provides users with the ability to send and receive wireless messages and data. RIM’s BlackBerry wireless devices also incorporate a mobile phone, a personal information manager (PIM) including contract, calender, tasks and memo functionality, which can synchronize with the user’s desktop PIM system, and webbrowsing capability.

For the shortening lifecycle and strong competition in this industry, we assume that RIM will develop a new model Smartphone, named BlackBerry 9900. Comparing with the newest model existing BlackBerry 8800, BlackBerry 9900 has additional functions as MP3, and navigation and transmitting voice email. As illustrated in Chapter 2.1.3, the innovation process of BlackBerry 9900 will consist of four phases: generation of new ideas → research → development → product launch. The initial Investment for generation of new ideas would be $5 million. Based on the experience of developing the other Smartphone in the past years, the first phase would have only a 40% chance to proceed into the research phase. The research phase would cost $ 10 million and would have a 50% chance to proceed into the development phase. The

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development phase would need $ 20 million and have 70% chance to realize this new product. To go to market, a final investment of $ 30 million is required to build a new product line and market campaign. The expected cash-in-flow starts at the end of the construction of the new product line (in 4 years). According market information, the sales in first year would be expected 200,000 units. It is estimated to grow at an annual constant rate of 13,98%. The price would be expected $400 per unit were it available now und estimated to decrease at an annual constant rate of 10,54%. 57

Real Option Valuation of Product Innovation In this example, we will only concentrate on how to value the product innovation using the four-step process. How to estimate the parameters as volatility, the weighted average costs of capital of the project; would not be explicitly illustrated. The fictive data are assumed as given:

Risk-free interest rate 15%

6%

Weighted average costs of capital

The annual growth rate of sales 13,98% 10,54%

The annual growth rate of price -

Price per unit at t = 0

Sales at t=0

p0 = 400

S0 = 200,000

4.2. Valuing Process of the chosen example

Figure 25 shows the four-step process that we will use to value the product innovation of BlackBerry 9900. Step 1 is the standard net present value analysis of the project using traditional techniques. With expected price, sales, cost and initial investment, we will forecast the entity-free cash flows over the life time of the project. Then, we will calculate the net present value under the assumption of no flexibility by discounting free cash flows. Step 2 is to build an even tree, which is based on the set of separate uncertainties that drive the volatility of the project. As illustrated in chapter 2, product innovation is influenced by numerical internal and external factors. The phased investment decision on product innovation often has both economic and technological uncertainty. Technological uncertainty is large at the start of the project, but is diminished as the

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company invests to learn more. Economic uncertainty (e.g. the price of a new product), grows more diffuse through time. Thus, there are two independent sources of uncertainty – economic uncertainty increasing through time and technological uncertainty decreasing. These two uncertainties must be estimated separately81. After estimating the uncertainties, an event tree will be built to model the uncertainty that

81

58

Copeland, T. and Antikarov, V. 2001. Real Options – A practitioner’s Guide, p.221

Real Option Valuation of Product Innovation drives the value of the underlying risky asset through time, and the set of values that the underlying risky asset may take through time. Step 3 in the process is putting the decisions that management may make into the nodes of the event tree to turn it into decision tree. The decision tree shows the payoffs from optimal decision, conditional on the state of nature. Therefore, its payoffs are those that would result from the option or options that we are trying to value82. The final step 4 is the valuation of the payoffs in the decision tree using the method of replicating portfolios as illustrated in chapter 3. Step 1 Computer Base Case Present Value without Flexibility

Step 2 Model the Uncertainty

Step 3

Step 4

Identify and Incorporate

Calculation Real

Managerial Flexibilities Creating

Using event tree

a decision tree

Option Value (ROA)

Actions: • Use the expected

• Identify major

• Analyze the event tree

• Value the total project

values of price,

uncertainty in

to identify and incorporate

using replication portfolio

quantity, cost,

each stage

managerial flexibility

methodology.

investments,

• Understand how

• Starting at the last period,

terminal value,

those uncertainties

compute the value of each

and WACC to

affect the PV

option at each node

compute FCFs

• Estimate

• Identify the optimal exercise paths for the real options.

• At each node compare the

• compute the NPV

untertainty

value of the real option

without flexibility

using either

with the investment required,

at t =0

historical date

• Select the alternative that

or management

has the maximum value

estimate

at each node.

.

• Obtain PV Copyright © 2009. Diplomica Verlag. All rights reserved.

event tree

Figure 25: BlackBerry 9900 solution process

82

Copeland, T. and Antikarov, V. : Real Options – A practitioner’s Guide, p221

59

Real Option Valuation of Product Innovation 4.2.1. First Step: Valuing without Flexibility ⎯ Traditional DCF Method

By discounting the free cash flow over the life time of project, we obtain the present value of the project without flexibility for today. As illustrated in chapter 4.1, there are two stages of this valuation. The first stage is from initial investment to producing the first unit of BlackBerry 9900. This process is an internal company process. The discount rate is the risk-free interest rate. The second stage is product and market launch that is dependent on the market. The discount rate at this stage is weighted average costs of capital. The risk-free interest rate is the return on a security providing certain cash flows over time with a zero probability of default. Current yields on government securities most closely reflect these requirements in practice83. For valuation purposes, the yield on a 5-year Government of Canada Benchmark Bond (5,25%) will be used to a benchmark to determine the risk-free rate. We assume the risk-free interest in this example is 6%. On the first stage, the company has only cash outflows. The cumulative investment for the four phases is expected to be $65 million.

product launch 30

development

65 million 20

reserach

10

generation of new ideas

5

Copyright © 2009. Diplomica Verlag. All rights reserved.

Figure 27: Cumulative investment

The first cash-in-flow starts after the product/market launch. Figure 28 shows the spreadsheet of expected cash flows over the life time of the project after product launch. We estimate that the functional relationships between revenue and cost are

83

60

Müller, J. 2000. Real Option Valuation in Service Industries, p.137

Real Option Valuation of Product Innovation equal to the abrade average of historic data in past 3 years. The expected sales would be 100,000 units in first year, and then increase at 20% annually. The expected price would be $400 per unit, and then decrease at 20% annually. To capture the continuing value of the project, we expect that the project would get the average growth rate at 4% and the return rate at 8%.

Revenue cost of sale Gross margin Expenses: R&D S&A Amortisation Sub-total Litigation Net income

2006 (%) 100 44,8 55,2

2005(%) 100 47,1 52,9

2004(%) 100 54,4 45,6

7,6 15,1 2,7 25,4 9,8 18,5

7,5 14,1 4,8 26,4 26,1 15,7

10,5 18,2 7,3 36 5,9 8,7

abrade average(%) 100 47,2 52,8 8,1 15,3 4,2 27,5 14,6 15,9

Data from RIM 2006 Annual Report

Copyright © 2009. Diplomica Verlag. All rights reserved.

Figure 26: Calculation of functional relationships between revenue and costs

61

Real Option Valuation of Product Innovation

Item

Year 1

Quantity (T-units) (growth rate 15%) Continuous annual growth rate Price per unit (growth rate -10%) Continuous annual growth rate Cost per unit Revenues Cost of goods sold Gross income Gross margin % R&D S&A expenses EBITDA Depreciation EBIT EBIT growth Taxes (40%) Net income Depreciation Initial investment Free cash flow Change in FCF Continuing value Discount rate (15%)

Year 2

Year 3

Year 4

Year 5

continuing Value

Year 6

200

230

265

350

350

402

13,98% 400

360

324

292

262

236

169,8 82.800 39.054 43.746 0,53 6.665 12.655 24.426 3.450 20.976 0,03 8.390 12.586 3.450

152,8 85.698 40.421 45.277 0,53 6.899 13.097 25.281 3.571 21.710 0,03 8.684 13.026 3.571

137,5 102.005 48.113 53.893 0,53 8.211 15.590 30.092 4.250 25.841 0,19 10.337 15.505 4.250

123,8 91.801 43.300 48.502 0,53 7.390 14.030 27.081 3.825 23.256 -0,10 9.303 13.954 3.825

111,4 95.014 44.815 50.199 0,53 7.649 14.521 28.029 3.959 24.070 0,03 9.628 14.442 3.959

15.493

16.036 3%

16.597 3%

19.755 19%

17.779 -10%

18.401 3%

478.428

0,8696

0,7561

0,6575

0,5718

0,4972

0,4323

0,3759

13.472

12.125

10.913

11.295

8.839

7.955

179.859

-10,54% 188,7 80.000 37.733 42.267 0,53 6.440 12.227 23.600 3.333 20.267 8.107 12.160 3.333

PV= 244.459

We assume that the PV would be about 240 million.

Figure 28: Spreadsheet of expected cash flows after product launch

The present value after product launch from spreadsheet is 244,459 TUSD, we assume that the present value of this project after product launch would be 240 million. The Scenario of the product innovation process and net present value without flexibility are shown as follows:

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0,7 0,4

-10

0,6

0

-5

0,5

-20

0,5

0

new product with PV=

0,3

Net Present Value of total project without flexibility = -5-10/1,06-20/1,06^2-30/1,06^3+0,4*0,5*0,7*240/1,06^4 = -30,81

Figure 29: Scenarios of product innovation process

62

0

240

Real Option Valuation of Product Innovation 4.2.2. Second Step: Model the Uncertainty ---- Using Event Tree

In product innovation process there are two major sources of uncertainty – technological and product/market uncertainty. They evolve simultaneously through time in the project. Technological uncertainty is assumed to be independent of market conditions and has a time dependency. It would be diffuse now but reduce through time by doing research84. Technology can either be transferred successful or failure. The probability of the results is a 1-0 distribution. If the technological transfer in former phase is a failure, we have to abandon the project. If the technology is transferred successfully in former phase, the project would be proceed to a further phase. Product/market uncertainty is correlated with the market. It is based on expected price and expected quantity that are known today and become more diffuse through time85. According to our calculation for the present value of BlackBerry 9900 after product/market launch, we assume that BlackBerry 9900 will be worth $240 million. Obviously, this estimate is affected by product/marketing uncertainty. Product/market uncertainty includes price uncertainty, sales units uncertainty, variable cost uncertainty, competitor’s move, and so forth. Using statistic method, we can combine some uncertainties into one, for example, in his book “Real Options”, Tom Copeland explicitly illustrated how to use Monte Carlo Simulation to combine price uncertainty, uncertainty on quantity of output, and variable cost uncertainty into one uncertainty on the rate of return. If it seems reasonable to assume that the future will be like the past, then we may decide to use historical data to estimate the confidence bands around the variables that drive the uncertainty in our discounted cash flow model of a project86. Research In Motion is founded in 1980, and has been innovating many new products in the past. It is reasonable to estimate uncertainties which are from internal company with historical data. On the other hand, BlackBerry 9900 is a new one in the Copyright © 2009. Diplomica Verlag. All rights reserved.

market, it is impossible to estimate uncertainties from market by using historical data. To quantify the uncertainties, we use subjective estimate provided by management. In our example, based on historical data, we assume the functional relationships between revenue and costs after product/market launch. After analysis of RIM’s historical data, 84 85 86

Copeland, T. and Antikarov, V. 2001. Real Options – A Practitioner’s Guide, p.271 Copeland, T. and Antikarov, V. 2001. Real Options – A Practitioner’s Guide, p.271 Copeland,T. and Antikarov, V. 2001. Real Options – A Practitioner’s Guide, p.257

63

Real Option Valuation of Product Innovation we estimate subjectively that the cash flows brought by BlackBerry 9900 after product/market launch may fluctuate up or down by 50 percent in a year. In particular, we have to spend an additional $30 million on the new product line that will produce finished products. With an abandonment at any time, the product line would be worthless. Having combined management estimates of uncertainty about price and quantity into a single uncertainty of the value of the project, we build a value-based event tree. It should reflect the actual resolution of the uncertainty over time so that we can get optimal execution of the available real options and correct ROA valuation. As shown in section 3.5, the event tree in binomial tree is symmetric. The assumption behind this methodology is that the integrated uncertainty regarding the project gets resolved continuously overtime. This assumption reflects the reality for the evolution of the market value of whole company or a project6. At the first stage in our example, the technological uncertainty does not get resolved smoothly over time as in a Brownian motion process 87 . It is resolved when the information becomes available. When a significant part of the uncertainty is resolved at certain points of time, the value occurring would be changed. So, the actual event tree for the project may be asymmetric. As a result we cannot simply estimate the volatility of the project and use it in a standard binomial model to generate the event tree. The right way to do it is to keep the major uncertainties separate and to model their interaction and effect on the project’s value explicitly88. Figure 30 shows the event tree separately for each of the two types of uncertainty: On the left-hand side is technological uncertainty. The phase on generation of new ideas is expected to end with 40 percent of success and 60 percent of failure. Given success in the research phase with probability 50 percent, there is a 70 percent probability that Copyright © 2009. Diplomica Verlag. All rights reserved.

the technology will successful transferred and BlackBerry 9900 will be produced. Because technological uncertainty is independent of the market, we can discount the expected values at the risk-free rate.

6 87 88

64

Copeland T. and Antikarov, V. 2001. Real Options – A Practitioner’s Guide, p.270 Copeland T. and Antikarov, V. 2001. Real Options – A Practitioner’s Guide, p.270 Copeland T. and Antikarov, V. : Real Options – A Practitioner’s Guide, p.270

Real Option Valuation of Product Innovation On the right-hand side is product/market uncertainty. The expected value can go up or down by 50 percent each year. Product/market uncertainty is correlated with the market. We must choose the weighted average costs of capital to discount the expected cash flows. Then, we will value the uncertain outcomes that are resolved from product/market uncertainty by using the replicating portfolio approach.

Technological Uncertaity

Product/market Uncertainty u= 1,5 d=1/u= 0,667 810 2

u V0 = 540 uV0 = 360

360

BlackBerry udV0 =

0,7 V0 = 240

success

240

0,5

160

success

dV0 =

0,3

0,4

failure

Investment 5 million

160

0,5

d2V0 = 107

71

failure 0,6 failure

new idea generation research invest 5 mio. invest 10 mio.

development invest 20 mio.

manufacturing and marketing invest 30 mio.

Figure 30: Event tree for technological uncertainty and product/market uncertainty

4.2.3. Third Step: Identity and Incorporate Managerial Flexibility ⎯ Creating a Decision Tree

The third step is to identify the real options that management can exercise their effect Copyright © 2009. Diplomica Verlag. All rights reserved.

on the remaining present value, the exercise prices, and the timing. We can identify three options in this case.

If the uncertainty about technology and market information is too high, we can delay the start of the project until we have more knowledge and information about it. The first managerial flexibility is an option to delay. 65

Real Option Valuation of Product Innovation Research and development can be either successful or a failure. The second managerial flexibility is abandonment in each phase if research or development is a failure. Through abandonment we can save the life costs of project. The initial investment in this phase is the exercise price of abandonment.

If we have completed research and development successfully, we will decide whether to invest $30 million in the new product line. This is a good investment only if the product turns out to be great, otherwise we abandon. Thus, the third managerial flexibility is expansion, namely introducing BlackBerry 9900 into market. When the product launch is implemented, the expected cash flow will be $240 million from that time. As assumed, the expected cash flow under product/market uncertainty can go up or down by 50 percent each year. The underlying outcomes are contingent on whether the project turns out to be favorable or unfavorable. With a 70 percent probability for a successful product launch, the underlying asset value at the beginning of product launch is (as shown in Figure 32): V0 = 240 × 0.7 + 0 × 0.3 = 168 (million $)

If we work the tree backward, and take advantage of the fact that we have the option to invest $5 million at the end of the first time period and $10, $20 million at the end of second and third time period, we can avoid these investments if the results of the basic research or the development are unfavorable. As shown in following Figure 31, if we have arrived node B with favorable results from the first phase, the net present value of going ahead is:

Copyright © 2009. Diplomica Verlag. All rights reserved.

NPV (at node B) = -10 + 0,5 × (-20 + 0,7 × (240 / 1,06 – 30) + 0,3 × 0) / 1,06 = 52,47 If we arrive at the node C, with unfavorable results from the first phase, we will decide not to exercise our option to invest the $10 million. Moving back to node A, we find that the present value of the project, based on optimal decisions at node B, is NPV (at node A) = -5 + 0,4 × 52,47 / 1,06 + 0,6 × 0 = 14,80

66

Real Option Valuation of Product Innovation Therefore, the value of flexibility under technological uncertainty is NPV with flexibility = 14,80 NPV without flexibility = - 30,81 ________________________________________ Value of flexibility = 45,61 (million $)

Assumptions: Risk-free interest rate = 6% Project cash flows independent No other uncertainties cost of capital 15%

A invest $5 mio.? yes, NPV= 14,80

0,4

B invest $10 mio.? yes, NPV= 52,47

0,5

invest $20 mio.? yes, PV= 119,71

0,7

new product

--- invest $30 mio.?

no product

--- invest $30 mio.?

yes, NPV =(240/1,06)-30 196,42

0,3 NPV=0

0,5 NPV=0

0,6 NPV=0 C

Results: NPV without flexibility= ROA = Flexibility value =

-30,81 million 14,80 million 45,61 million

Figure 31: Value of flexibility under technological uncertainty

Copyright © 2009. Diplomica Verlag. All rights reserved.

Because product/market uncertainty is correlated with the market (even though it is independent of technological uncertainty), we will need to value the uncertain outcomes that are resolved from product/market uncertainty by using a replicating portfolio approach89.

89

Copeland, T. and Antikarov, V. 2001. Real Options – A Practitioner’s Guide, p.275

67

Real Option Valuation of Product Innovation

567

u= 1,5 d= 0,67

uV0 =

u2V0 =

378

252

252 udV0 =

V0 = 168

168 dV0 =

112

ud2V0 =

112

d2V0 =

75

50

Figure 32: Value event tree after product launch

There is an important point about the expansion opportunity. Since the additional investment will be made at the time of the expansion, they are not committed to the expansion right now. The decision to expand (and thus the timing of expansion as well) will depend on how well the existing sales are doing at that time. If the sales are large enough to cover the investment needed, BlackBerry9900 can be introduced profitably. Therefore, there is an important added dimension – that of flexibility of deciding whether and when to introduce BlackBerry 9900 to market.

Copyright © 2009. Diplomica Verlag. All rights reserved.

The decision tree in Figure 33 illustrates the optimal decision in total project.

68

Real Option Valuation of Product Innovation

decision decision event tree

expand

no product

abandon

0,7

net present value invest 119,71

invest 14,80

240 new product

0,4

0,5

196,42 success

invest $20 mio.?

invest 52,47 $10 mio.? success

0,3

don't invest

abandon

0,5 failure

abandon

don't invest

abandon

0,6

failure

don't invest

abandon

abandon

Figure 33: Decision tree in total project

4.2.4.

Fourth Step: Conduct Real Options Analysis

The project with flexibility is valued in Figure 34. Since the two major uncertainties are independent and exist simultaneously, we model the uncertainty by alternating product/market uncertainty with technological uncertainty90. As in binomial tree, we start the valuing from the end of the tree and analyze the optimal execution of the

Copyright © 2009. Diplomica Verlag. All rights reserved.

options at each final node.

90

Copeland, T. and Antikarov, V. 2001. Real Options – A Practitioner’s Guide, p.276

69

Real Option Valuation of Product Innovation

(Sce.1) (Sce.2)

= =

Scenario 1 = Scenario 2 =

if new product generated if no product generated

S 360 (Sce.1) 0,4 0 (Sce.2) 0,6 37

Q success 93

failure Abandon

M 540 (Sce.1) 0 (Sce.2) 164

0,5

I success 327

0,5 failure Abandon

N 240 (Sce.1) 0 (Sce.2) 62

0,5

J success 123

0,5 failure Abandon

U Invest 5 million ? 16

T 160 (Sce.1) 0,4 0 (Sce.2) 0,6 10

R success 25

failure Abandon

O 240 (Sce.1) 0 (Sce.2) 62

0,5

K success 123

0,5 failure Abandon

P 107 (Sce.1) 0 (Sce.2) 16

0,5

L success 33

0,5 failure Abandon

A 810 0 NPV= B 360 0 NPV= C 360 0 NPV= D 160 0 NPV= E 360 0 NPV= F 160 0 NPV= G 160 0 NPV= H 71 0 NPV=

(Sce.1) (Sce.2) 530

0,7 0,3

Invest PV= None

810

(Sce.1) (Sce.2) 224

0,7 0,3

Invest PV= None

360

(Sce.1) (Sce.2) 224

0,7 0,3

Invest PV= None

360

(Sce.1) (Sce.2) 88

0,7 0,3

Invest PV= None

160

(Sce.1) (Sce.2) 224

0,7 0,3

Invest PV= None

360

(Sce.1) (Sce.2) 88

0,7 0,3

Invest PV= None

160

(Sce.1) (Sce.2) 88

0,7 0,3

Invest PV= None

160

(Sce.1) (Sce.2) 28

0,7 0,3

Invest PV= None

71

Figure 34: Valuing the product innovation project with flexibility

The final technological uncertainty is resolved at nodes from A to H at the end of

Copyright © 2009. Diplomica Verlag. All rights reserved.

third year. At this point in time, we must decide either to invest another $30 million to go into production, or to abandon the project. The net present value of the project at each node can take advantage of the fact that the technological uncertainty is independent of the market. Therefore, the net present value is the expected value discounted at half of a year’s risk-free rate, less the cost of investment (the exercise price on the real option)91. For example, the computation of the NPV at node A is 91

70

Copeland, T. and Antikarov, V. 2001. Real Options – A Practitioner’s Guide, p.276

Real Option Valuation of Product Innovation based on the resolution of product/market uncertainty. At node A, good news in the production/market has driven the value of the project up three times so that if the development phase proves to be a technological success, it value will be $810 (240 × 1,53) million. We would invest $30 million only if the technology results a new product. The net present value at node A therefore calculated by discounting the expected cash flows, given the optimal investment decision, at the risk-free rate 6%/2: NPV (at node A) = [0,7 *(810 –30) + 0,3 * 0] / 1,03 = 530 (million $) Similar logic produces the NPV at nodes from B to H.

Working our way back through the tree, we next focus on nodes I, J, K, L. Because product/market uncertainty is correlated with the market, we must use a replicating portfolio approach. Choosing node I to illustrate, the end-of-period payoffs are $530 million in the up state, and $224 million at the down state. The beginning-of-period value of the underlying is the expected technological outcome from research phase $378 million. The end-of-period value of the underlying in the up state is $567 million, in the down state is $252 million. (See Figure 32) Using these data, we can form replicating portfolios for the up and down states as follows: 567 × m + (1+rf) × B = 530

m = 0,971

252 × m + (1+rf) × B = 224

B = - 19,795

Value at node I = 0,971 × 378 - 19,795 = 347 (million $) NPV (at node I) = PV (at node I) – initial Investment (at node I) = 347–20 = 327 (million $) With the same logic we compute the value at nodes J; K; L. in Figure 35. By repeating the procedure of discounting expected values due to technological uncertainty at the risk-free rate, then alternating to use the replicating portfolio Copyright © 2009. Diplomica Verlag. All rights reserved.

approach, we move backward along the branches of the decision tree, identifying all the nodes where the execution of expansion or the abandonment is optimal. At the beginning of the tree we get the ROA value of the project with flexibility. Because we assumed the project’s uncertainty with a high level (50%), the flexibility has added a significant value. By enhancing the project’s upside in case of success, and bounding the down side in case of failure, the options have moved their net

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Real Option Valuation of Product Innovation present value from negative $30,81 million to positive $16 million ROA value with flexibility. Expand Go Go Go Go

Abandon Abandon

Abandon Abandon

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Figure 36: Optimal decisions resulting from the real options analysis

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Real Option Valuation of Product Innovation

replicating portfolios for I 567 * m +(1+rf) * B = 530 224 252 * m +(1+rf) * B = Value at node I = 378 *0,971 - 19,795 =

m= 0,971 B= -19,795 347

Value at node I $347 million is so greater than investment needen, we would invest $30 million to proceed into production. replicating portfolios for J 224 252 * m +(1+rf) * B = 112 * m +(1+rf) * B = 88 Value at node J = 168 *0,971 - 19,795 =

m= 0,971 B= -19,795 143

Value at node J $143 million is greater than investment needed, we would decide to proceed the process. replicating portfolios for K 224 252 * m +(1+rf) * B = 88 112 * m +(1+rf) * B = Value at node K = 168 *0,971 - 19,795 =

m= 0,971 B= -19,795 143

Value at node K is $ 143 million, we would decide to invest $30 million to go into production. replicating portfolios for L 112 * m +(1+rf) * B = 88 50 * m +(1+rf) * B = 28 Value at node I = 75*0,971 - 19,795 =

m= 0,971 B= -19,795 53

The same logic as at node K, we would decide to invest $30 million to proceed into production. replicating portfolios for Q 164 378 * m +(1+rf) * B = 62 168 * m +(1+rf) * B = Value at node I = 252*0,485 - 19,318 =

m= 0,485 B= -19,318 103

Value at node Q is $ 103 million, we would invest $20 million to succeed the development phase. replicating portfolios for R 168 * m +(1+rf) * B = 62 75 * m +(1+rf) * B = 16 Value at node I = 112*0,440 - 19,318 =

m= 0,485 B= -19,318 35

Value at node R is $ 35 million, we would invest $20 million to succeed the development phase.

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replicating portfolios for U 37 252 * m +(1+rf) * B = 10 112 * m +(1+rf) * B = Value at node I = 18*0,194 - 11,386 =

m= 0,194 B= -11,386 21

Value at node U is $ 21 million, it is great than intial investment $5 million, we would decide to start this product innovation project.

Figure 4.9 Replicating portfolios for nodes I; J; K; L; Q; R; U

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Real Option Valuation of Product Innovation 5.

Conclusion

5.1. Thesis Summary

Incessant and ubiquitous changes in business environment make product innovation necessary. Chapter 1 explained the importance of product innovation in adapting to an uncertain and changing world marketplace and possible valuation methods for it. In reviewing the characters of product innovation in chapter 2, we saw that traditional valuation approaches that either ignore real options and strategic considerations altogether or attempt to value real investment opportunities with asymmetrical claims by using a constant risk-adjusted discount rate can lead to significant undervaluing for product innovation, since product innovation process is a asymmetric, contingent process which does not generally have the same discount rate. Chapter 3 provided an overview of different types of managerial flexibility seen as real options. Reviewing option pricing and binomial tree model, we illustrated the powerful capability of real option approach to quantifying flexibility with concrete

examples using a standard replicating portfolio assumption. Real option approach can overcome the two main shortcomings of the traditional approaches to capital budgeting. First, it is able to quantify time series links between projects by correctly valuing contingent cash flows92. Second, with the real options approach it is possible to explicitly recognize and quantify the value of flexibility embedded in investment project (intra-project). It therefore adds structure and transparency to the decision process for investment decision and replaces gut feeling with a structured analysis that is inter subjectively verifiable93. The real options approach can therefore help to focus attention on the relevant variables and information needed to assess and develop value creation potential provide significant insight for management into the value levers of

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the project. Chapter 4 presented a general conceptual framework for decision making in real option approach. The generalized four-step approach makes the practical application

92

93

74

Kester (1984), p.160, The typical example of an interproject real option is the growth option, where the access to future growth opportunities is contingent upon prior investments by the company. Müller, J. 2000. Real Option Valuation in Service Industries, p.102

Real Option Valuation of Product Innovation of real option valuation more feasible and traceable. This approach helps by providing a clear and explicit structure on how to conduct the valuation for a wide range of projects. In ROV, advanced mathematics is not required, which will reduce the common black box problem in valuation. The four - step approach also underlines the complementary relation between the DCF and the real options approach. Consequently, firms can continue using their familiar investment decision approaches and supplement them with the real option methodology when required. For projects with high uncertainty coupled with high leeway for managerial flexibility, real option valuation is in fact the only capital budgeting tool that can provide correct vale estimates. Even if the value of an investment project cannot be quantified exactly due to inadequacy in parameter estimation, real option valuation can at least give a theoretically substantiated estimate on the strategic value ignored by traditional capital budgeting techniques. It consequently allows management for the first time to make strategic decisions well founded in financial economics. 5.2. Limitation of Real Option Valuation

The real options approach is not always needed. If the investment is either incredibly valuable or a total dog, a real options analysis won’t change the valuing result. The necessary and sufficient condition for a real option can spell out into four separate pieces94: •

Project under uncertainty: If the future is certain, flexibility has no value, since

it is possible to ex ante design an optimal strategy. Under uncertainty, net present value would be the correct valuation tool. •

New information affecting the project value: If there is uncertainty, it is

necessary to decrease the level of uncertainty in order to make better informed

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decisions. Without new information coming in, revision of the strategy will always remain the same leap in the dark. This is a bet rather than an option situation. •

Ability to change initial strategy: If there is uncertainty and information that

helps to lessen the uncertainty is coming in, this information is not valuable unless management can act upon it appropriately. 94

Müller, J. 2000. Real Option Valuation in Service Industries, p.52

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Real Option Valuation of Product Innovation •

Irreversible investment: It is assumed that by becoming committed to a certain

strategy, management also commits itself to an investment plan. If these investments are fully reversible at any point in time, there is no value added by having flexibility. With new information coming in, it would always be possible to adapt the strategy and thus the investment plan at zero cost. Like any model that tries to replicate the effects of reality, its applicability hinges on assumptions and its validity is confined within boundaries. In a financial context, the price of an option will closely reflect its economic value. This results from the existence of a twin security that allows for arbitrage if price and vale diverge too much95. In the market for real assets, twin securities do not usually exist so that the arbitrage cannot actually be performed. This is the most frequent criticism against the use of option pricing theory for the valuation of real investments. Another major shortcoming is that the mathematical complexities in its predominant form of presentation (continuous time models with partial differential equations). This shortcoming reduces real option valuation to a black box for most corporate decision makers. Despite binomial tree model provides a more intuitive analytical framework, it might also be a hard challenge to accustom management to the option view of investment projects, especially since some of the implications run counter to conventional wisdom. One of the potential reasons, why the application of option pricing theory to financial assets has been so successful is the fact that, except for volatility, all input variables are readily available. This will typically not be the case with real option valuation96. The estimation of the underlying volatility and modeling of competitive interaction are likely to be major challenges. The skills needed are very difficult. For example, Copyright © 2009. Diplomica Verlag. All rights reserved.

how to estimate the volatility of a project from a real world? How do we actually build spreadsheet models that reflect the complexity of the decision at hand without overcomplicating or oversimplifying the problem? Parameter estimation becomes more difficult for projects, where market data is not readily available. When estimates 95

96

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Due to transaction costs, there will be a band around the theoretically correct value of an option in which the price can freely fluctuate without triggering arbitrage (Figlewski (1989), p.13) Muller, J. 2000. Real Option Valuation in Service Industries, p.53

Real Option Valuation of Product Innovation have to rely on insufficient or inadequate data sets, the credibility of the option analysis will be undermined. The full value of an option can only be captured with optimal exercise97. In contrast to financial options, the decision to exercise in a real options framework needs to take into account factors such as organizational inertia, contractual arrangements and strategic considerations in addition to the difference between the spot and the exercise price98. This means that the nurturing of real options and their optimal exercise in a complex organization can only be achieved if managerial incentives and monitoring

systems are adapted, which might entail the need for reorganization99. 5.3. Possible Complementation of Real Option Valuation 5.3.1.

Combining ROV and DCF

In the real project, the uncertainty does not equally distribute around a mean as in financial products100. van Putten suggests that a pure Black-Scholes method to real option valuation is not a good idea. It should be combined with DCF approach. Even then, there are situations in which the ROV needs to be adjusted to more appropriately address the real world. In his Harvard Business Review article, van Putten lays out a process (shown in Figure 35) for applying ROV to non-financial decisions and adjusting it to more accurately reflect real decisions.

In most cases, the primary driver that decreases uncertainty is the flow of time101. As shown in “Flee Zone” in Figure 35, when an option is far out in time, ROV will provide higher values to investments and number will decrease as uncertainty decreases. DCF, on the other hand, will generate small numbers in this situation because it is driven by the time-value of money. Therefore, van Putten suggests that at

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this extreme edge the results of an ROV calculation should be balanced against a more conservative DCF. If DCF value is significantly negative, managers should

97

98 99 100 101

Trigeorgis, L. 1991. Real Options – Managerial Flexibility and Strategy in Resource Allocation, p.153 Müller, J. 2000. Real Option Valuation in Service Industries, p.104 Müller, J. 2000. Real Option Valuation in Service Industries, p.104 Smith, R. 2004. “Applying Options Theories to Technology Management Decisions”, p.4 Smith, R. 2004. “Applying Options Theories to Technology Management Decisions”, p.4

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Real Option Valuation of Product Innovation discount the ROV results and decide not to make the investment in spite of the positive real option value.

In “Option Zone”, managers can rely on a mathematically combined ROV and DCF as the option date gets closer to the exercise date. As time decreases, the impact of DCF is increasing and the results of combining both methods become more directly useful.

Figure 37: van Putten’s Method for Combining BSM and DCF Source: van Putten 2004

When the time becomes very near the exercise date (in “Deep-in-the-money Zone”),

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uncertainty has almost completely disappeared. ROV contributes very little to the value. In this case, managers are making decisions almost completely based on DCF. Finally, the results of the option investment may be a residual technology, intellectual property, etc. This residual has value and should be included in the calculation of the

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Real Option Valuation of Product Innovation option value, if an estimate of its value can be made102, for example, by agreeing to license or selling the residual results to a partner if the host company decides not to proceed with the project. Managers should strive to bring this “Abandonment value” into existence. Applying the above assumptions, van Putten suggests that a real option should be calculated as: TPV = NPV + AOV + ABV Where,

5.3.2.

TPV = total project value

AOV = adjusted option value

NPV = net present value

ABV = abandonment value

Other Possible Complementation

Real options analysis is different from cautious business decision-making. The key is in the analytical mindset that forces a manager to quantify information that was previously evaluated in a very intuitive way 103 . The complexity to estimate input parameters brings other difficulties to managers. It would be a future complementation to develop generic options-based user-friendly software packages with simulation capabilities that can handle multiple real options as a practical aid to corporate planners104. Real option applications are now gradually receiving increased attention among major U.S. and international corporations and in the literature105. In order to popularize real option application, more field, survey, or empirical studies should be made to test the conformity of theoretical real option valuation and its implications with management’s intuition and experience, as well as with actual market data when

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available106.

102 103 104

105

106

Smith, R. 2004. “Applying Options Theories to Technology Management Decisions”, p.6 Smith, R. 2004. “Applying Options Theories to Technology Management Decisions”, p.6 Trigeorgis, L. 1997. Real Options – Managerial Flexibility and Strategy in Resource Allocation, p.375 Trigeorgis, L. 1997. Real Options – Managerial Flexibility and Strategy in Resource Allocation, p.341 Trigeorgis, L. 1997. Real Options – Managerial Flexibility and Strategy in Resource Allocation, p.375

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Real Option Valuation of Product Innovation Real option valuation approach is also a way of thinking. Analyzing more actual case applications, and tackling real-life implementation issues and problems in more

practical detail by expert could provide practical guides for managers to get more

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valuing techniques, so that real option approach would really become a valuing tool.

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Real Option Valuation of Product Innovation 6.

Appendix

6.1. References Amram, Martha and Kulatilaka, Nalin (1999) Real options – Managing Strategic

Investment in an uncertain World Copeland, Tom and Vladimir Antikarov (2001) Real Options – A Practitioner’s

Guide, New York Damodaran, Aswath The Promise and Peril of Real Options Disselkamp, Marcus (2005) Innovationsmanagement Holt, Knut (1998) Product Innovation Management Hommel,Ulrich and Scholich, Martin Realoptionen in der Unternehmenspraxis Hungenberg, Harald (2001) Strategisches Management in Unternehmen Lackner, David I. (1996) Strategic Technology Investment Decisions in Research &

Development Kaiser, Ulrich Product Innovation and Product Innovation Marketing: Theory and

Micro-econometric Evidence (Discussion Paper No. 01-31) Kaplan, Robert S. (1996) The balanced scorecard: translating strategy into action Meffert, Heribert (2000) Marketing – Grundlagen marktorientierter

Unternehmensführung Meyer, Jens Wilhelm, (2000) Produktinnovationserfolg und Target Costing Müller, Claudia (2002) Produktinnovation durch Projektmanagement Müller, Jürgen (2000) Real Option Valuation in Service Industries Neely, James E. and Richard de Neufville (2001) Hybrid Real Options Valuation of

Risky Product Development Projects Selchert, Martin (2005) CFROI of Customer Relationship Management Smith, Roger (2004) Applying Options Theories to Technology Management

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Decisions Trigeorgis, Lenos (1997) Real Options – Managerial Flexibility and Strategy in

Resource Allocation 6.2. Website www.bloomberg.com www.damodaran.com

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Real Option Valuation of Product Innovation http://www.mckinseyquarterly.com/article_page.aspx?ar=1754&L2=21&L3= 114&pagenum=1 http://en.wikipedia.org/wiki/Uncertainty www.blackberry.com www.rim.com

6.3. Table of Figures Figure 1: Calculation of net present value (Excel sheet) Figure 2: Calculation of real option valuation (Excel sheet) Figure 3: The Customer Utility Proposition Figure 4: Classifying of product innovation orientated by output and process Figure 5: Product innovation process Figure 6: Possible factors which influence innovation activities Figure 7: Expectation and chance of successful innovation Figure 8: Decision Tree Analysis Figure 9: Payoff on call option Figure 10: Payoff on put option Figure 11: The six levers of financial and real options Figure 12: Uncertainty increases value Figure 13: When managerial flexibility is valuable Figure 14: Qualitative Description of real options with potential industry applications Figure 15: Valuing an option to delay (Excel sheet) Figure 16: Valuing an option to abandon (Excel sheet) Figure 17: Valuing an option to expand (Excel sheet) Figure 18: Valuing an option to contract (Excel sheet) Figure 19: Value creation of switching from A to B (Excel sheet)

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Figure 20: Valuing a compound option (Excel sheet) Figure 21: Description of a stationary multiplicative binomial process Figure 22: Event tree of stock price (Excel sheet) Figure 23: Valuing an option using binomial tree (Excel sheet) Figure 24: Spreadsheet for a long period binomial tree (Excel sheet) Figure 25: BlackBerry 9900 solution process Figure 26: Calculation of functional relationships between revenue and costs 82

Real Option Valuation of Product Innovation (Excel sheet) Figure 27: Cumulative investment Figure 28: Spreadsheet of expected cash flows after product launch (Excel sheet) Figure 29: Scenarios of product innovation process (Excel sheet) Figure 30: Event tree for technological and product/market uncertainty (Excel sheet) Figure 31: Value of flexibility under technological uncertainty (Excel sheet) Figure 32: Value event tree after product launch (Excel sheet) Figure 33: Decision tree in total project (Excel sheet) Figure 34: Valuing the product innovation project with flexibility (Excel sheet) Figure 35: Replicating portfolios for nodes I;J;K;L;Q;R;U (Excel sheet) Figure 36: Optimal decisions resulting from the real options analysis

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Figure 37: van Putten’s Method for Combining BSM and DCF

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Real Option Valuation of Product Innovation

Autorenprofil Yuanyun Kang is a consultant at Deloitte & Touche since June 2008 focused on SAP ERP Finance & Controlling. Before joining Deloitte, she worked in auditing and taxation. She studied Business Administration specializing in auditing and taxation in Germany as well as industrial finance in China. Yuanyun Kang has many years of experience in accounting and auditing in China and became a Chinese Certified

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Public Accountant in 2000.

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