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Agenda
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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Create probability distributions for model assumptions: Model the risk profile for the opportunity
Determine quantifiable options embedded in the opportunity, including options for deferral, abandonment, growth, flexibility, and timing; Create a decision tree
Develop estimates for the economic value determined by discounted cash flow and strategic value determined by real options; create budget for the Development stage
Reduced risk in valuation estimate; identification of market, (non-diversifiable) risk and project-specific (diversifiable) risk
Assess product development process efficiency; demonstrate value created by the NPD team during the subject phase, Determine optimal portfolio investments
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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Implicitly assumes only one investment decision Not applicable for comparing competing projects with different risks or scale Value of learning or managerial flexibility is not quantified Discount rate incorrectly includes market risk and unique risk
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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Risks
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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Idea Generation
Feasibility Assessment
Development
Piloting
Launch
Project-Specific Risk
100%
80%
50%
30%
High
High
Low
Negative
Negative
Positive
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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100 85%
Cumulative Percent of Cost
95%
80 60 40 20
70%
Life-Cycle Cost Determination Up to 85% of Product Costs are Committed During Design and Development
35% 22%
Cost-Reduction Opportunities
Source: DARPA Rapid Design Exploration and Optimization (RaDEO) Project
Idea
Validation
Design
Development
Mfg.
Support
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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Case Study
A food company has completed a business plan for a delicious, non-fat yogurt smoothie, aimed at busy professionals who often dont have time to eat, but are still health-conscious and desire tasty, healthy alternatives to vending-machine food. Market research indicates strong evidence of customer demand and willingness to pay for the product, and the next major investment needed before entering a regional market is $1 Million, to be used for the creation of a production process to manufacture the product in high volumes. The development of the production process is expected to take one year, and a regional rollout can be completed in two years, at a cost of $5 Million, if the process design and implementation is successful. If the regional rollout succeeds, a national market launch can be completed during the fourth year. The full market launch is expected to cost $66 Million over the next four years. The company would like to determine if the current $1 Million investment is prudent, given the size of the opportunity, the proposed staging of investments, and the project and market risks. The company would also like to quantify the value of managerial flexibility embedded in the opportunity.
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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Ideation
Analysis 2
Experiment 3
Business Plan 4
Should we invest $1,000,000 in the next stage of product development, resulting in the creation of a production process for a new beverage?
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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Market Share
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
8.0%
10.4%
13.5%
17.6%
22.8%
25.1%
27.6%
30.4%
33.5%
36.8%
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Market Share
8.0%
10.4%
13.5%
17.6%
22.8%
25.1%
27.6%
30.4%
33.5%
36.8%
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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5
50%, go
6
60%, go
Launch in the U.S. market Cost: ($60.00 M) PV Cost: (49.36 M) PV Cash Fl: $63.57 M NPV: $14.21 M
$2.68 M
50%, abandon
1 year
2 years
40%, abandon
abandon
1 year
20% X (($0.95 M)+($4.32 M)) = 20% X ($5.27 M) =
($1.05 M)
50% X ($0.95 M) =
($0.48 M)
The decision to invest would be easier if we knew the value of each stage The value of managerial flexibility is not yet quantified Success probabilities apply to unique risks only The case is marginally attractive
$1.15 M
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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A contract conveying the right, but not the obligation, to buy or sell designated securities or commodities at a specified price during a stipulated period.
Call option a contract to buy Put option a contract to sell A European option gives the owner of the option contract the right to buy the designated securities only on the expiration date for the option. An American option gives the owner of the option contract the right to buy the designated securities at any time before the expiration date.
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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There are several methods for estimating the value of a financial option (such as a stock option), but the most commonly used is the Black-Scholes1 equation, which expresses the value as a function of six variables:
1. 2. 3. 4. 5. 6.
The stock price The exercise price (or, strike price) The risk-free rate of return The volatility of the underlying security The time to expiration The dividend yield
Fischer Black and Myron Scholes of the MIT Sloan School of Management developed the original option valuation model using five variables. The dividend yield variable was added by Robert Merton in 1975. Fischer Black and Robert Merton won the Nobel Prize in Economics for their work on the option valuation model in 1997. Fischer Black, who died in 1995, was mentioned in the award citation.
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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Real Options
Stewart Myers of the Massachusetts Institute of Technology observed that the Black-Scholes model could be used to value investment opportunities in real markets-the markets for products and services. Today, this technique is commonly used in industries such as:
Oil and Gas Exploration Pharmaceuticals Chemicals Semiconductors
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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Outputs d 1: N(d 1): d 2: N(d 2): Value of the option: All data as of 24 March, 2003 0.220646468 0.587316105 0.076491614 0.530486076 $1.89
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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$6.00
$4.00
$20.00 $25.00
$3.00
$27.50 $30.00
$2.00
$1.00
$0.00 Nov-00
Jan-01
Feb-01
Apr-01
Jun-01
Jul-01
Sep-01
Nov-01
Dec-01
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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2
D
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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Value of the Option to Delay Launch, Generic New Product Development Example
payoff and call option v alue
$300,000 uncertainty = 100% uncertainty = 50% uncertainty = 30%
$100,000
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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1.0
higher values
Cumulative Volatility (
higher values
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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Model the Regional Launch Phase as a 2-year call option to invest $60 Million in the
National Launch Phase
Model the Production Process Development Phase as a 1-year call option to invest $5
Million in the Regional Launch Phase
NPV: $1.98 M
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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30%
PV, Costs: ($1.0 M) PV, Benefits:: $ 2.19 M
NPV: $1.19 M
Develop a Production Process
40%
PV, Costs: ($1.0 M) PV, Benefits:: $ 2.98 M
NPV: $1.98 M
Develop a Production Process
50%
PV, Costs: ($1.0 M) PV, Benefits:: $ 4.03 M
NPV: $3.03 M
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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Inputs Stock Price ($, millions): Volatility (%): Exercise Price ($, millions): Time To Expiry (years): Div idends ($): Risk-free Interest Rate (%): $63.57 The present v alue of the cash flows, or, the v alue of the underlying security 30% The standard dev iation in the present v alue of the project cash flows $60.00 The unrecov erable costs of launching the product in a national market 2.0 The period for which this inv estment opportunity is v alid; proposed delay period for decision $0 The estimated annual cost of preserv ing the option (technical expertise, product dev elopers) 5.00% Two year treasury security yield
Outputs d 1: N(d 1): d 2: N(d 2): Gross Value of the Option: Probability of success: Net Value of the Option: 0.584063363 0.720411205 0.159799294 0.563480421 $15.21 60% $9.12
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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Stock Price:
31.20%
Uncertainty
5.98%
Time To Expiry
4.87%
Exercise Price
21.76%
1.97%
% change in option value for a 10% change in value driver
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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Cumulative Volatility (
Probably never
NP V=
Probably soon
Maybe later
Source: Timothy Leuhrman, Strategy as a Portfolio of Real Options, Harvard Business Review, Sept.-Oct 1998
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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2.0 1
Cumulative Volatility (
Regional launch
National launch
Probably soon
NP V=
Maybe later
Source: Timothy Leuhrman, Strategy as a Portfolio of Real Options, Harvard Business Review, Sept.-Oct 1998
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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Xcel Energy uses Real Options to estimate the strategic value of initiatives in our new product portfolio, and to plan investments in product development resources, market research, pilots and market trials. By using real options with a structured new product development process, this technique is invaluable for estimating the appropriate investments in successive development phases, and to ensure that we risk only the amount of money justified by the sum of the economic value derived from discounted cash flow analysis and the strategic value derived from real options analysis.
Doug Jaeger Vice President of Sales and Marketing Xcel Energy Corporation
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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Market Share
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
8.0%
10.4%
13.5%
17.6%
22.8%
25.1%
27.6%
30.4%
33.5%
36.8%
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Simulation Results
Market Share Frequency Distribution
140 120 100
Frequency
80 60 40 20 0 13%
18%
24%
29%
35%
40%
45%
51%
56%
62%
67%
72%
Market Share
Median: 23.35% Standard Deviation: 4.88% Uncertainty, for Black-Scholes Equation: 4.88%/23.35% =
100 80 60 40 20 0 11% 14% 17% 20% 23% 26% 29% 32% 35%
21%
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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50
40
30
20
10
Oct-01
Nov-01
Dec-01
Jan-02
Feb-02
Mar-02
Apr-02
May-02
Jun-02
Jul-02
Aug-02
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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Benefits for using Real Options and Monte Carlo Simulation for NPD Valuation
Valuable tool for estimating the value of each stage Portfolio optimization Separation of unique risk and market risk Tool for prioritizing activities in each stage Quantify R&D and Market Research expenditures Justify numerous small experiments to produce valuable information Maximize value by building flexibility into plans Resource allocation tool-quickly estimate the value of deferring or accelerating projects Become proficient at recognizing opportunities with high market risk and controllable unique risk
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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Reading List
Books Martha Amram and Nalin Kulatika, Real Options: Managing Strategic Investment in an Uncertain World (Boston Mass.: Harvard Business School Publishing, 1998) Avinash K. Dixit and Robert S. Pinkyck, Investment Under Uncertainty (Princeton, N.J.: Princeton University Press, 1994) Lenos Trigeorigis, Real Options, Managerial Flexibility and Strategy in Resource Allocation (Cambridge, Mass.: MIT Press, 1996) F. Peter Boer, The Real Options Solution: Finding Total Value in a High-Risk World (New York, N.Y. John Wiley & Sons, Inc., 2002) Paul Wilmott, Paul Willmot on Quantitative Finance (West Sussex, England, John Wiley & Sons, Inc., 2000) Richard A. Brealey and Stewart Myers, Principles of Corporate Finance fifth edition (New York: McGraw-Hill, 1996) Journal and Magazine Articles Fischer Black and Myron Scholes The Pricing of Options and Corporate Liabilities Journal of Political Economy, May 9 1972 Timothy A. Luehrman, Whats It Worth A General Managers Guide to Valuation, Harvard Business Review May-June 1997 Timothy A. Luehrman, Investment Opportunities as Real Options: Getting Started on the Numbers, Harvard Business Review July-August 1998 Timothy A. Luehrman, Strategy as a Portfolio of Real Options Harvard Business Review September-October 1998 Timothy A. Leuhrman, Capital Projects as Real Options: An Introduction Harvard Business School Case Study 9-295-074 March 22, 1995 Avinash K. Dixit and Robert S. Pindyck, The Options Approach to Capital Investment Harvard Business Review May-June 1995 Keith J. Leslie and Max P. Michaels, The Real Power of Real Options The McKinsey Quarterly 1997 Number 3 Michael E. Edleson, Real Options: Valuing Managerial Flexibility Harvard Business School Case Study 9-294-109 June 4, 1999 Aswath Damodaran, The Promise and Peril of Real Options Stern School of Business web site, adamodar@stern.nyu.edu Michael J. Mauboussin Get Real: Using Real Options in Security Analysis Credit Suisse First Boston, 1999 F. Peter Boer Financial Management of R&D 2002 paper downloaded from www.tigerscientific.com F. Peter Boer Valuation of Techology Using Real Options paper downloaded from www.tigerscientific.com F. Peter Boer Traps, Pitfalls and Snares in the Valuation of Technology paper downloaded from www.tigerscientific.com Peter Coy Exploiting Uncertainty Business Week June 7, 1999 Thomas E. Copeland and Philip T. Keenan Making Real Options Real The McKinsey Quarterly 1998 Number 3 Thomas E. Copeland and Philip T. Keenan How Much is Flexibility Worth? The McKinsey Quarterly 1998 Number 2
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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Q&A
Real Options and Monte Carlo Modeling For New Product Development 25 March 2003
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