Valuing Real Assets

Dr. Kumar Bijoy

Financial consultant
kumarcfa@yahoo.com
09810452266
 Tracking Portfolios
• A stock issued by a parent company to create
a financial vehicle to track the performance of
a particular division or subsidiary.
• The DCF method in valuation process is
actually based on the platform of tracking
portfolio approach.
• This approach is good for riskless cash flows.
• Tracking error which exists in the case of risky
projects is the difference b/w the Cash Flows
of the tracking portfolios and the projects.
• Valuing the projects requires to generate the
tracking portfolios for which the PV of tracking
error is zero. This is possible only when the
tracking error consists entirely of unsystematic
or firm specific risks.

• When a tracking error with zero systematic

risk and zero expected value is generated by a
tracking portfolio for the future cash flows of a
project, the market value for the tracking
portfolio is the present value of the project’s
future cash flows.
• Identifying the tracking portfolio that is mean
variant efficient makes the valuation simpler.
• It doesn’t call for:
– Expected return of the market
– The risk free return
– Expected cash flows
• This is possible through many ways like:
– Perfect tracking (tracking error zero)
– Use of market portfolio or factor portfolio (in
presence of tracking error)
 Valuation approaches..
• Risk Adjusted Discount Rate Method (RADR)
 Real Options
• It is an extension of the financial options theory
• Underlyings are real assets like business or projects
• The financial options are detailed in their contract
whereas real options are embedded in strategic
investments
• It provides the way the managers have to plan and
manage strategic investments.
• Both the options give rights and not the obligations
• Financial options are generally issued by the
independent agents and not by the issuers of
the financial instruments (like shares) and
hence agents have no control over the price of
the instrument whereas in real options
management controls the price of the u/a
• A real option is the right, but not the obligation, to
undertake some business decision, after the project
has been implemented; generally the option to make/
withdraw/withhold a capital investment.
• “Options to modify the projects are known as Real
options” For example, by investing in a project, a
company may have the real option of expanding, /
abandoning (less drastically)/ postponing the project
in the future.
• This kind of option is not a derivative instrument, but
an actual tangible option (in the sense of "choice") that
a business may gain by undertaking certain decisions.
• A Real option is the ability or right to take a
certain course of action
• Real options represent those that exist in a
real physical business sense
• Real options often exist in capital expenditure
decisions.
 Real options Vs Financial options
Financial options Real options

Underlying asset is financial asset like The underlying asset is the project
share/ currency about which decision is to be taken

Traded in the market Not traded in the market

Maturity period generally in months Maturity period generally in years

Volatility can be calculated on the basis No historical data exists. Hence

of historical data volatility is estimated on the basis of
experience of the management experts.

Have been trade since 1973 (Chicago Recent development in the field of
Board of Options Exchange was the Corporate finance
first to start financial options)
 Types of Real Options
• Abandonment options:
• leaving the project before completion of economic life or even
before commissioning of project
• Investment timing options:
• Now or Never
• Defer for future date
• Growth options:
• Increase the capacity of existing product line
• Expand into new geographic market
• Add new product line: complementary product or successive
generations of the original product
• Flexibility options:
• alter operations depending on market or economic conditions
e.g. power plant operation
• There are two approaches regarding valuing the
real options :
– (i) NPV method and
– (ii) Option valuation methods
• (a) Binomial method / Risk neutral method
• (b) Black- Scholes method.
• The positive feature of NPV method is its
simplicity in calculation and understanding the
outcome. The limitation of the method is that it
does not consider Risk (SD).
• The Binomial method/ Risk neutral method
can be applied only when we are given two
possibilities regarding expected cash inflows
(without giving their probabilities).
• Black-Scholes method is considered as a good
method because of its consideration of SD.
• The value of the option, calculated by this
method, cannot be explained to the
management.
 Abandonment Option(NPV Method)
• Sumati Ltd is considering an investment of Rs.250m in
a new technology. The total amount has to be paid
initially though its installation will take one year. There
is only seven percent probability that the new
technology will work. If it works, it will generate a cash
flow of Rs.2,700m at the end of each of the second and
third year. If the technology does not work, the
investment will be a dead loss. Cost of capital is 10%.
Should the investment be made?
Now suppose that if the technology does not work, its
supplier will return Rs.180m in the beginning of the second
year. NPV? Value of abandonment option?
• NPV (without abandonment facility) :
-250m + 2700x(0.826+0.751)x 0.07 + 0 x 0.93 =
Rs.48.053m
• The investment is recommended as the NPV is Positive.
• NPV (with abandonment facility) :
-250m + 2700x(0.826+0.751)x 0.07 + 180 x 0.93 x 0.909
= Rs.200.2196m
• Value of abandonment option = 200.2196 – 48.053
= Rs.152.17m
• Lalita Ltd is considering a proposal of a Research and
Development project requiring an outlay of Rs.10m
initially and Rs.8m at the end of I year. The project will
generate cash inflow only after two years from today.
The cash inflows will depend upon the state of the
economy. There is 75% probability that there will be
boom in the economy in the first year and in this
situation there is only 78% chance that there will be
booming economy in the second year as well. If there
is no boom in the 1st year, there is only 30 % chance
that there will be boom in the second year.
• The cash inflows at the end of 2nd year will be:
– Boom in 1st year & boom in 2nd year: Rs. 99m
– Boom in 1st year but no boom in 2nd year: Rs. 58m
– No boom in 1st year but boom in 2nd year: Rs. 5m
– No boom in 1st yr & no boom in 2nd year: Rs. -48m
• Assuming the cost of capital to be 10%, find the NPV.
• Now suppose that the company has the option of
abandoning the project at the end of 1 year. The
st

salvage value of Rs. 4m will be realized and no further

investment will be required. Value of the option?
 OPTION OF ABANDONING THE
PROJECT AT THE END OF 1ST YEAR.
A: Boom in I year and Boom in II year: 0.585
B: Boom in I year and No Boom in II year: 0.165
C: No boom in I year: 0.250

Value of abandonment option = 41.19761 – 31.84196 = Rs.9.35565m

• Keshav Ltd. is considering an investment of
Rs.4.50m in a project. The output of the project
can sold maximum for 2 years. Cash inflows of
the project are uncertain as exhibited in the
tables given below. Ignoring tax and assuming
cost of capital to be 10%, find the NPV. Will your
change if the company has the option of
abandoning the project at the end of 1 year. If the
option is exercised, the assets of the project will
be sold, at the end of 1st year, for Rs.2.25m.
 Answer
Calculation of NPV without abandonment option
 Calculation of NPV with abandonment option
• If net cash in flow in I year is Rs.1.50m:
– The company shall have two options (a) Discontinue and receive
Rs.2.25m at the end of I year (b) continue and expect 1.50m x
0.50 +3m x 0.15 i.e.1.20m cash in flow at he end of II year. It is
clear that the company should discontinue at the end of I year.
• If net cash in flow in I year is Rs.3.00m:
– The company shall have two options (a) Discontinue and receive
Rs.2.25m at the end of I year (b) continue and expect 1.50m x
0.25 +3m x 0.50 + 4.50m x 0.25 i.e. 3m cash in flow at he end of
II year. It is clear that the company should continue in II year.
• If net cash in flow in I year is Rs.4.50m:
– The company shall have two options (a) Discontinue and receive
Rs.2.25m at the end of I year (b) continue and expect 3m x 0.45
+4.50m x 0.50 + 5.25m x 0.05 i.e. 3.8625m cash in flow at he
end of II year. It is clear that the company should continue in II
year.
 FOLLOW ON INVESTMENT /
EXPANSION OPTION (NPV Method)
• Q. Vishakha Ltd has been considering the
establishment of a manufacturing unit with the
domestic market as the target customer. Life of
the project is 7 years. The finance department
reports the expected NPV to be ‘Minus Rs.3m’.
The Chairman refers the project to a Project
Consultancy Group (PCG). The PCG brings a new
fact to the notice of the management – it is
expected that at the end of 2nd year the
Government may allow the export of the output
of the manufacturing unit. Probability of this
happening is 0.78.
• In that case, Vishakha Ltd shall have the
option to increase the production and sale of
output of the plant. This will require new
investment. The NPV of this new investment
will be Rs.14m at the end of 2nd year. Value of
option assuming cost of capital to be 12%?
Answer:
• Value of option = 14m x 0.797 x 0.78 =
Rs.8.70m
 Q. Brijnandan Ltd. is considering a project
requiring the initial investment of Rs.5m. The
expected cash inflow from the operation is
Rs.0.85m annually for 15 years. The cost of capital is
18%. Find NPV. Some experts in the industry believe
that the government is considering change in the
industrial policy. If this happens, the shall have an
option of making further investment of Rs.1m at
the end of 4th year. The new investment will result
in incremental cash inflow of Rs.0.85m for years 5
to 15. Determine the value of the option.
Answer:
• NPV = -5m + 0.85 x 5.092 = -0.6718
• Value of additional investment = NPV of follow
on investment = -1m x 0.516 + 0.85m x 2.402
= 1.5257m
• Value of Options = 1.5257m + -0.6718
= 0.8539
Q. Udhavji Ltd is considering a project requiring
initial cash investment of Rs.12m. The project is
expected to generate annual cash inflow for 2 years,
the details given below:
Annual cash flow Probability
Rs.12m 0.24
Rs.8m 0.45
Rs.1m 0.31
Cost of capital is 16%.NPV?
• Suppose the experience gained by implementing the project
will provide the company an option to start a new venture
at the end of 2nd year. The required investment would be
Rs.8m. The new venture is expected to generate annual
cash inflow of years 3 and 4, the details given below :
Annual cash flow Probability
Rs.10m 0.20
Rs.9m 0.45
Rs.2m 0.35
• The amount of required investment is certain and hence, it
should be discounted on the basis of risk free rate of return
which is 7%. Value of the option?
 Answer
NPV = -12m +(12m x 0.24 +8m x 0.45 + 1m x
0.31)x(1.605)= -1.10205m
Value of option = NPV of follow on investment =
-8m x 0.873+(10m x 0.20 +9m x 0.45 + 2m x
0.35)x(1.193)= 1.06875m
• Opportunistic India Ltd is considering a project for
an Innovative set up device that will enable cable
users to view satellite channels according to their
own wish. The total initial investment is Rs 5cr but
the future cash inflow of the project depend on
demand of the conditional access system (CAS)
that is to be provided by the government which is
not very certain. The Cash inflows are given in the
table. A basic analysis reveals that the project is
riskier thus company wants a return of 14% in
the environment of 6% risk-free return.
Market Probability 20x0 20x1 20x2 20x3
Condition

Bullish 0.25 -5 3.3 3.3 3.3

Moderate 0.50 -5 2.5 2.5 2.5
Bearish 0.25 -5 0.5 0.5 0.5
Answer:
Cash Flow = {(3.3 x 0.25) + (2.5 x 0.50) + (0.5 x
0.25)} = 2.2cr
• NPV = -Rs5cr + 2.2cr x PVIFA (14%, 3 years)
= 10,80,000
So, based on DCF method company should go in
for the project. At the cash flow of Rs 2.15cr or
lower project should have been rejected.
• It can also delay the project for one year
without any impact on the initial investment
and future cash flows. However, each cash
flows will be delayed by one year. If company
waits for one year then it will be able to know
which of the demand conditions, and in return
which of the set of cash flows will exist. Thus
on delaying the project it will go in for
investments only if the demand is sufficient
enough to provide positive NPV.
 Decision Tree Analysis …
One year deferment
Market Probability 20x0 20x1 20x2 20x3 20x4
Condition

Bullish 0.25 ---- -5 3.3 3.3 3.3

Moderate 0.50 ---- -5 2.5 2.5 2.5
Bearish 0.25 ---- 0 0 0 0
 Using Black-Scholes Model…
One year deferment
Market Prob 20x0 20x1 20x2 20x3 20x4 PV Prob x
Condition PV

Bullish 0.25 ---- -5 3.3 3.3 3.3 6.721* 1.680

Moderate 0.50 ---- -5 2.5 2.5 2.5 5.091 2.546
Bearish 0.25 ---- -5 0.5 0.5 0.5 1.018 0.255
Total 4.480

*{3.3 x PVFIA14%, 3years}xPVIF14%,1yr = {(3.3x2.3216)} x 0.8772= 6.72047

 Using Black-Scholes Model…
One year deferment
Market Prob 20x0 20x1 20x2 20x3 20x4 PV at Prob x
Condition the end PV
of 1st yr
Bullish 0.25 ---- -5 3.3 3.3 3.3 7.661* 1.915
Moderate 0.50 ---- -5 2.5 2.5 2.5 5.804 2.902
Bearish 0.25 ---- -5 0.5 0.5 0.5 1.161 0.290
Total 5.108

*{3.3 x PVFIA14%, 3years}x = {(3.3x2.3216)} = 7.661

Variance (σ2) = (x- 𝑥)ҧ 2P = (7.661 − 5.108)2 x 0.25 + (5.804 − 5.108)2 x 0.50 + (1.161
− 5.108)2 x 0.25= 5.76 ; σ = 2.401
 Using Black-Scholes Model…
One year deferment
• Current Project’s Value is PV of expected future
cash flows (S) = Rs 4.48
• Initial investment is Exercise Price (X) = Rs 5.0
• Variance of the Project’s Return = ln(CV2 + 1)/t
• CV = Coefficient of Variation
• T = Time of expiry of the project
• CV = σ/𝑥ҧ = 2.401/5.108
• Variance (σ2)= ln(0.472 + 1)/1 = 0.19958829 =
0.20
• SD (σ) = √0.20 = 0.4472
• C = SN(d1) – X N(d2)e-rt
• d1= {ln (s/x) + (r+ σ2/2)t}/ σ√t
• d2 = d1 - σ√t
• d1= {ln (4.48/5) + (0.06+ 0.2/2)1}/ 0.4472√1
= (-0.109815 + 0.16)/0.4472
= 0.112
d2= -0.335
N(d1) = N(0.112) = 0.5446
N(d2) = N(-0.335) = 0.3688
C = 4.48 x 0.5446 – (5 x 0.3688)e-0.06x1
= 2.4398 – 1.7366 = 0.7032