Session 23: The Options to Expand and Abandon

Name: Session 23: The Options to Expand and Abandon
Uploaded: 2014-08-25T00:00:00.000Z
Duration: 24 min 55 s
Description: Look at how the option to expand into new markets/products can add value to young growth companies and the option to abandon investment can create value for flexible companies.

Introduction to Options in Valuation

In this section, the speaker introduces the concept of using option pricing in valuation. They discuss two options: the option to expand and the option to abandon. These options are undervalued using conventional valuation approaches.

The Option to Expand

The option to expand is when a company has made an investment that currently doesn't look good but has potential to enter a much larger market or business.

Companies with options to expand and abandon are undervalued using conventional valuation approaches.

Companies sometimes take bad investments knowing they are bad investments because they have an option to expand or abandon.

The characteristics of the option to expand include knowing the cost of expansion, having a value of cash flows from expanding, and being able to walk away with the difference if cash flows exceed costs.

Example: Marriott's Investment in China

Marriott opens 10 hotels in China even though they estimate these hotels will lose money because it gives them an option to open 100 more hotels in China if these first 10 do well.

Example: M Bev's Investment in Guarana

M Bev considers taking guarana, a soft drink popular in Brazil, into the US market. They estimate it will cost $500 million but could make $400 million. This initial investment would have a net present value of minus $100 million.

Valuing Real Options

In this section, the speaker discusses the concept of real options and how they can be valued. He explains the option to expand and the option to abandon, providing examples of each.

The Option to Expand

The initial investment has a net present value of -100 million.

This gives you rights to a second investment with a net present value of -250 million.

The second investment can wait until you see what happens with the first investment.

Ignorance about the market works in your favor because it allows for more potential value in the future.

To value this option, estimate the variance based on publicly traded beverage companies in the US (34.25%).

Plug numbers into an option pricing model to get a value of 234 million for this option.

Consolidating both investments results in a net number of 134 million.

Companies often take bad investments if there is an option to expand down the road.

Questions for Using Option to Expand

Do I need to make that first investment to get to the second?

How much exclusivity will I have assuming that first investment pays off?

Assuming I expand, what are my competitive advantages?

The Option to Abandon

If early indications show that a long-term project is not working, it's nice if you're able to shut it down and walk away.

This is known as the option to abandon, which is structured like a put option in real options.

If the value of underlying asset drops below abandonment price, you abandon asset and collect abandonment price.

If asset stays above abandonment price, you never abandon project and pay whatever price paid for abandonment option initially.

Example: Lear Aircraft

Assuming Lear Aircraft wants to create small commercial airliner but lacks expertise. They enter into joint venture with Airbus where Lear puts in half a billion and Airbus puts in half a billion. If early indications show that the project is not working, it would be nice if they could shut down the project and walk away.

Option to Abandon

In this section, the speaker discusses the option to abandon and its value in providing downside protection.

The Right to Walk Away

Airbus has the right to walk away from the investment anytime over the next five years.

If Airbus exercises this right, they will receive $400 million less than their initial investment of $500 million.

This provides downside protection and limits potential losses.

The Value of Flexibility

Companies that build flexibility into their operating processes are more valuable than those without it.

The option to abandon is a simple way to value the flexibility that companies have built into their business models.

By entering into short-term contracts rather than long-term contracts and having flexible wage contracts rather than fixed wage contracts, companies can build escape hatches that provide more flexibility to deal with uncertainty.

Valuing the Option

The present value of cash flows for this investment is estimated at $480 million.

The option to abandon is valued at $73 million as a put option.

With the option to abandon valued at $73 million, Airbus' net value for this investment becomes positive at $53 million.

Overall, having an option to abandon provides downside protection and increases flexibility. Companies that build flexibility into their business models are more valuable than those without it.