REAL OPTIONS ANALYSIS

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Annals of the „Constantin Brâncuşi” University of Târgu Jiu, Economy Series, Issue 5/2014

„ACADEMICA BRÂNCUŞI” PUBLISHER, ISSN 2344 – 3685/ISSN-L 1844 - 7007

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ASSESSMENT METHOD OF INVESTMENT PROJECTS

IN GREEN ENERGY

MAFTEI DANIEL

POSTDOCTORAL RESERCHER, INSTITUTE OF NATIONAL ECONOMY, ROMANIAN

ACADEMY, BUCHAREST, ROMANIA

Email: danielmafthei@yahoo.com

Abstract: This article highlights the importance of real options as a evaluation method of investment in green energy.

Article consider several theoretical and practical approaches, the analysis based on real options by many authors who have theorized and used this method. Each approach provides a operationalisation through a steps series of specific evaluation. This paper highlights the different views: academics, financiers, managers and facilitates the access to an accurate evaluation decisions of projects.

Keywords: Real Options Analysis, Real Options Approaches, Investment decisions.

J.E.L. Classification: G11, H54, R42, Q13, P28.

1. Introduction in Real Options Concept

Introducing the term Real Options (RO) is due to Stewart Myers, who announced in 1977. The term refers to the option pricing theory application and assessment of non-financial or real investment. The post was not one of great interest initially, but was developed in the 80s and 90s, when a series of articles were published and accompanied by various applications. Since the mid 90s, the interest in the concepts of value and valuation techniques have increased substantially.

Real options began to attract attention in industry as an important tool for assessing and mapping strategies. Since with oil and gas industry and expanding with a number of other industries, management consultants and various analysts began to apply real options to corporate investment in major problems.

The switching from an analytical approach to a practical approach has many obstacles, especially since scholars do not agree on the basics. From here they were born a variety of contradictory approaches that have been suggested to implement real options. This leaves potential practitioners in problematic situations. In principle, the concept seems a valuable one, with outstanding results from its application. However, in practice, nobody risk to implement an inadequate approach because it would be lost.

2. Real Options Approaches[2]

2.1 The classical approach

The "classical" term refers to a Myers[13] defined approach in 1977. The largest exposure to this approach is the work of Amram and Kulatilaka[1] authors. The book contains broad concepts, without detailed analysis. To these authors we add Brennan and Schwartz[4], Trigeorgis and Mason[16], Trigeorgis[17], Copeland, Koller and Murrin[7]. The real options approaches are based on value account. In the classical approach, this value is clearly the financial market or internal evaluation of strategic business opportunities that are aligned with the assessments of the financial markets[1]. The calculated value is an estimate of the shareholder wealth created by an investment.

When evaluating an investment in a business point of view, this concept should be formulated in terms of strategy or decision. Although not stated, the calculated value can be regarded as a decision threshold; depending on growth situation, or not, the wealth shareholder will make a decision. From this perspective, the classical approach applies to decisions about firm investment.

Amram and Kulatilaka discusses different types of investments[1], including uncertainty with a relatively small impact. They noted that real options analysis is not necessary in these cases. Instead, it requires optimization models for application investment with considerable uncertainty. In short, the classical approach requires[1]:

1. Portfolio identification and pricing and volatility calculation 2. Investment sizing relative to replication portfolio

3. Application of standard financial instruments.

These steps of classic approach have resulted following assumptions issued by various authors. Amram and Kulatilaka[1] wrote the first book of scale based on real options and portfolio replication. Assumptions made for the two plays an important role in articles written[4] by Brennan and Schwartz, 1985. The article written[16] by Trigeorgis

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and Mason in 1987 is often cited when it comes to applying real options evaluation and production facilities. The standard in the industry, however, is determined by the book[7] written by Copeland Koller and Murrin. In the second edition of this book the authors state clearly that real options method is built around a replication portfolio.

2.2 Subjective approach

The classical approach explicitly makes use of arguments that are not based on arbitration, but a portfolio of replication, clearly identified to provide input in standard calculations of price for financial options. Other authors have proposed an approach closely based on non-arbitrage arguments and the use of standard tools for financing options price, but does not include explicit identification of a portfolio of replication. However, the subjective approach is entirely based on subjective estimates of inputs. The best examples of this approach are found in the book on real options[9] by Howell et. All. and three articles written by Luehrman[10] in Harvard Business Review.

Regarding the applicability of this approach we can start with the original assessment article of Luehrman[11] which shows that the evaluation is key to the allocation of resources and their allocation is essential to the performance of a particular company or project. While firm performance is not explicitly defined, it is understood that this refers to the performance of the market, which has direct implications for shareholders. Real options approach provides a benchmark by which resources can be allocated to maximize shareholder value.

In this article Luehrman discusses a variety of investment and assessments. His approach suggests that a class of investments, ones called "opportunities" to be dealt with using real options. They should be used where the initial investment does not provide a cash flow, but instead provides the opportunity to make additional future investments.

Although the key assumptions behind the subjective approach is effectively identical to the classical approach, architecture theory is different. It involves:

1. Subjective estimation of price and volatility of the underlying asset. 2. Application of standard financial instruments and option pricing.

Specifically, this approach implies a replication portfolio and therefore not applying any arbitrage argument. Howell et. Al. pay little attention to their assumptions and adequacy. In contrast to the classical approach described in the previous section, Howell and Luehrman[9] approach is based on subjective evaluations value calculation, unlike the data dealt in the market.

2.3 MAD approach

The classical approach is firmly connected to the standard option pricing. Subjective approach differs from standard option pricing. MAD approach differs completely from the standard option pricing and justifies this step explicitly.

Specifically, the MAD approach does not rely on the existence of a traded replicating portfolio and option pricing. Instead, proponents of this approach argue that the same assumptions that are used to justify the application of the net present value (or discounted cash flow) corporate investment "fixed" can be used to justify the application's value (or real options) for flexible corporate investment.

Moreover, they argue that the same power input for valuation calculations, called subjective evaluation, is required. Copeland and Antikarov in book "Real Options"[6] offers the most complete description of this approach and provides even its name: MAD (Marketed Asset Disclaimer). A similar view is also supported by Trigeorgis[17] and even the classics Brealey and Myers[3] in Principles of Corporate Finance ".

According to Copeland and Antikarov[6], MAD phases include:

1. Building a spreadsheet model of cash flow and cash flow of the underlying asset using estimated subjective inputs.

2. Estimation of subjective uncertainty associated with the inputs in this model, and performing a Monte Carlo simulation model.

3. Using the resulting distribution to construct a risk-neutral binomial network and estimating yhe value using this network.

The applicability of this approach is explained by a number of authors who have addressed the issue in detail. Copeland and Antikarov[6], and Amram and see Kulatilaka[1] see the shareholder values as fundamental real options. Also, they point out that all investors in the firm will agree with the decision rule which establishes the keeping investments to the point of marginal return greater than the marginal cost of capital.

Clearly, these authors believe that their approach on real options applies to all, or almost every major corporate investment decisions that maximize the value of the point. Trigeorgis[18] has a similar view. The company goal is to maximize the market value, and, therefore, its shareholders wealth. Real options analysis extends the concept of NPV (Net Present Value) to include these factors and provide a more accurate estimate of value for almost all corporate investments. Analiza opțiunilor reale extinde conceptul de NPV (Net Present Value) pentru a include acești factori și

oferă o estimare mai exactă a valorii pentru aproape toate investițiile corporative.

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„ACADEMICA BRÂNCUŞI” PUBLISHER, ISSN 2344 – 3685/ISSN-L 1844 - 7007 2.4 Classical Revised Approach

By contrast with the classical approach, the classical revised approach explicitly provide that the assumptions underlying the real options are restrictive. It suggest that the based financing of real options approach can be applied if the initial assumptions apply. Science-based management approaches, such as dynamic programming and decision analysis applies if the hypothesis is not confirmed. Real options should be used where investments are dominated by risks related to the market, prices or public risks. The programmation/ dynamic decision analysis should be used where

investments are dominated by specific corporate or private risks. În first case, the direction of the calculated real option

is exactly the same as in the classical case. The calculated value is an incremental value of shareholder, and may be used as a target.

In the second case, meaning of calculated value is more complicated. Investments in this case are dominated by particular risks and subjective assessments are used to assess these risks. If the value is calculated using the time management and risk preferences, the calculated value is simply the investment certainty, equivalent based on utility function of leadership. On the other hand, assuming that the time and risk preference are treated properly, the calculated value is an estimate of the incremental value for shareholders using estimates of management inputs. In practice, the choice of discount rate can introduce inaccuracy in the calculation.

In short, the mechanics of this classic revised approach involves a series of steps: 1. Determination of public or private investment risk

2. If there are public risks, apply a classical approach. 3. If there are privatebrisks, apply decision analysis

 Building a decision tree representing investment alternatives

 Assigning probabilities and risk values depending on the subjective appreciation

 Applying a spreadsheet of cash flow at each end of the decision tree and calculate the NPV (net present value)

 Return on decision tree to determine the optimal strategy and the associated value.

This view is intense developed by Dixit and Pindyck[8] and more recently supported by Amram and Kulatilaka in 2000. Differences are not significant compared to the classical approach; only new arguments and completing its review bring the "revised" name.

2.5 Integrated approach

The approaches described above come from practitioners in finance. Integrated approach, on the other hand, has result of the views of management practitioners who wish to include consideration of capital market and shareholder value in the assessment of corporate strategy.

Like many of the approaches mentioned above, the integrated approach recognizes that there are two types of risks associated with most investments: publics, or market, and private or corporate. However, an integrated approach recognizes that the most realistic problems have both risk and was designed to address this situation.

This approach was first described by Smith and Nau[15] and Smith and McCardle[14]. Other authors, such as Constantinides[5] and Luenberger[12] have similar views, but less developed and substantiated. Approach, adapted by the authors mentioned above, includes:

1. Building a decision tree representing investment alternatives 2. Identify each risk, whether public or private

3. For public risks, identifying and assigning replication portfolio and risk-neutral probabilities 4. For corporate risks, assigning subjective probabilities

5. Applying a spreadsheet of cash flow, at each end of the decision tree and calculate NPV using the risk-free rate.

6. Return of the decision tree to determine the optimal strategy and the associated value.

Given the origin of the science of management, rather than finance, the integrated approach is based on a philosophy somewhat different from other approaches. This approach recognizes that companies have a variety of stakeholders, owners and managers. It is assumed that the owners and managers of companies are considering an investment one set of beliefs and preferences. Approach sets then a goal to invest and make the right decisions to finance and maximizing owners and managers revenues.

3. Conclusions

Real options approach described above vary considerably. However, to a large extent, they all have a similar objective. Specifically, they are intended primarily to help management and investment selection to maximize the wealth of shareholders of the company. Each one offers a number or "fair value option" that provides price to buy or

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sell the investment under evaluation. If the investment is bought for less than this price, shareholder wealth increased as for the case that the investment is sold for more than that price.

In MAD and Revised Classical approaches applied to private investment, the value represents management's subjective estimate, the equilibrium value of investments and associeted option, when they are traded. For the integrated approach the value represents a combination of market value of the investment component and a subjective estimation management balanced market value.

There are also differences in the types of investments which each approach is appropriate. Classical and subjective approaches are based on the replication portfolio argument, therefore, they are applicable to those investments where there is a appropriate replicating portfolio adecvat. Although the approaches share a common goal, they differ significantly in the assumptions of application for each approach. Key assumptions are born in two key areas: the nature of capital markets and the data source.

ACKNOWLEDGEMENT

This paper has been financially supported within the project entitled “Horizon 2020 - Doctoral and Postdoctoral Studies: Promoting the National Interest through Excellence, Competitiveness and Responsibility in the Field of Romanian Fundamental and Applied Scientific Research”, contract number POSDRU/159/1.5/S/140106. This project is co-financed by European Social Fund through Sectoral Operational Programme for Human Resources Development 2007- 2013. Investing in people!

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