Web Real Options

WEB CHAPTER III
Real Options
Tough Techniques for Tough Problems.
web-realoptions.tex: Ivo Welch, 2004. Condential: Access by Permission Only! last le change: Feb 23, 2006 (13:39h). compile date: Thursday 30th March, 2006 (14:02h).
This chapter oers a much more detailed discussion of real options compared to what you learned originally in Chapter ??. (You must read Chapter ?? before you read this web chapter!) Assessing the value of real options is as important as it is dicult. This web chapter should help you learn how to think about and solve these dicult NPV problems. It relies more heavily on statistical concepts than the rest of the book.
Side Note: Some academics refer exclusively to valuation by replication (explained in Section 33.D) as the real options approach. However, this chapter refers to real options as options embedded in real projects, which can be valued through a number of dierent techniques, valuation by replication being one of them.
Anecdote: An Early Real Option The earliest known option contract was also a real option. It was recorded by Aristotle in the story of Thales the Milesian, an ancient Greek philosopher. Believing that the upcoming olive harvest would be especially bountiful, Thales entered into agreements with the owners of all the olive oil presses in the region. In exchange for a small deposit months ahead of the harvest, Thales obtained the right to lease the presses at market prices during the harvest. As it turned out, Thales was correct about the harvest, demand for oil presses boomed, and he made a great deal of money. Source: Wisegeeks What Are Futures?
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le=web-realoptions.tex: LP
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Web Chapter III. Real Options.
31. Types of Real Options

Explicit and Implicit Financial Options.
The word option is a synonym for choicethe ability to do something or not do something in the future, at your discretion. Financial options are common. The most familiar are stock options, which are traded, e.g., on the Chicago Board Options Exchange (CBOE). The prices of these options can be looked up on Yahoo!Finance. Some options are traded over the counter: if you want to purchase a 10-year option on the Sony, chances are that you would have to ask someonetypically an investment bankto manufacture such an option for you. Other nancial options are embedded in contracts and securities. For example, your mortgage contract more than likely gives you the option to pay o the mortgage at your discretion, which you should do (and renance) if interest rates drop enough. Your car insurance liability may have a deductible, which de facto means that the insurance is only an option that gives you the right to exercise it if the damage exceeds the deductible. But this chapter is not so much interested in nancial options as it is in real options. What is the dierence? A real option diers from a nancial option in that the exercise of the real option requires a change in the physical, real project. Such real option projects can be factories, buildings, R&D activities, and so on. The most prominent real options are Timing Your ability to start or stop a project at a time of your discretion. Abandoning Your ability to abandon a project at a time of your discretion. Accelerating Your ability to speed up a project at a time of your discretion. Expansion Your ability to expand a project at a time of your discretion. Switching Your ability to switch to a dierent technology. Real options are dicult to value, but no one would argue that this means that you can ignore them. In fact, valuing real options is often more important than getting the discount rate right. You have no alternative but to give it your best shot.
Real Options: Your choice to alter operations in the future.
Anecdote: Real or Unreal? In their article on real options in the Harvard Business Review (March 2004), Copeland and Tufano cite a Bain&Company Management Tools and Techniques 2001 survey of 451 senior executives who had tried the real-options approach. One-third had given up on it the very same yearand I would guess that most of these managers had only adopted the simplest real option techniques, to begin with. Whose fault is this? Is it primarily the fault of the technique? No! It is primarily the fault of the problems. Projects with real options are usually very dicult to value, and the only alternative is the head-in-the-sand method. Neither does this ostrich method work better, nor is ignoring real option values often just a modest error in terms of the value. It might be rst-order!
le=web-realoptions.tex: RP Section 32. Valuing A Gas Turbine Plant.
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32. Valuing A Gas Turbine Plant

32.A. Our Knowledge The best way to understand real options is to work an example. Say it is the end of 1999, and you are considering purchasing a lease for a combined cycle gas-turbine electricity generation plant with 400MW capacity. Your input, natural gas, has a fairly constant price of $7 per thousand cubic feet, so your plants total cost of electricity production is $25/MWh. Table III.1 shows the electricity prices for 1999. What is the per-week value of leasing this plant?
The scenario inputs.
Table III.1. Average Weekly Wholesale Price of Electricity Per MWh at the California Power Exchange in 1999.
Jan 1 - Jan 2 $$12.89 May 2 - May 8 $$23.46 May 9 - May 15 $$22.68 May 16 - May 22 $$26.08 May 23 - May 29 $$26.63 May 30 - Jun 5 $$15.82 Jun 6 - Jun 12 $$16.49 Jun 13 - Jun 19 $$25.29 Jun 20 - Jun 26 $$26.30 Jun 27 - Jul 3 $$32.26 Jul 4 - Jul 10 $$23.13 Quarterly Average $24.02 Jul 11 - Jul 17 Jul 18 - Jul 24 Jul 25 - Jul 31 Aug 1 - Aug 7 Aug 8 - Aug 14 Aug 15 - Aug 21 Aug 22 - Aug 28 Aug 29 - Sep 4 Sep 12 - Sep 18 $$40.80 $$24.31 $$26.58 $$28.19 $$23.05 $$26.59 $$47.26 $$33.64 $$30.95 Sep 5 - Sep 11 $$28.61 Sep 19 - Sep 25 $$31.91 Sep 26 - Oct 2 $$49.71 Quarterly Average $31.90 Oct 3 - Oct 9 $$43.25 Oct 10 - Oct 16 $$52.59 Oct 17 - Oct 23 $$45.34 Oct 24 - Oct 30 $$44.10 Oct 31 - Nov 6 $$59.84 Nov 7 - Nov 13 $$40.15 Nov 14 - Nov 20 $$30.44 Nov 21 - Nov 27 $$30.40 Nov 28 - Dec 4 $$28.25 Dec 5 - Dec 11 $$30.03 Dec 12 - Dec 18 $$31.26 Dec 19 - Dec 25 $$28.31 Dec 26 - Dec 31 $$28.89 Quarterly Average $37.90
Jan 3 - Jan 9 $$23.14 Jan 10 - Jan 16 $$24.13 Jan 17 - Jan 23 $$20.78 Jan 24 - Jan 30 $$18.29 Jan 31 - Feb 6 $$18.89 Feb 7 - Feb 13 $$19.57 Feb 14 - Feb 20 $$18.78 Feb 21 - Feb 27 $$18.95 Feb 28 - Mar 6 $$17.70 Mar 7 - Mar 13 $$17.79 Mar 14 - Mar 20 $$19.76 Mar 21 - Mar 27 $$18.31 Mar 28 - Apr 3 $$20.15 Quarterly Average $19.71 Apr Apr Apr Apr 4 - Apr 10 11 - Apr 17 18 - Apr 24 25 - May 1 $$23.31 $$25.23 $$26.83 $$21.88
Mean Standard Deviation Range: Interquartile Range
$28.09 Median $10.11 $12.89$59.84 $20.78$30.95
$26.30
32.B. Recognizing The Real Option Historically, according to Table III.1, the average electricity price was around $28/MWh, and this is not far o from the current electricity price of $28.89 (standing at the end of 1999). So, a rough nave estimate would be that with 400MW capacity and $3.09 prot per hour and for the 8,765.8 hours per year, you would have earned a net prot of 400MW$3.09/MWh8, 765.8h $10.8 million in 1999. But this nave valuation would have been wildly incorrect. The reason is that you have a real option: you can shut down your gas turbines when the price of electricity is low. The value of your option depends on how quickly you can shut down and reopen your plantand how much doing so would cost. If you simplify the problem, assuming that you can only shut down once a week and without cost (conservative), but that you know what the average price during the entire week will be (aggressive), you can determine the prots you could have made in 1999. There were 30 weeks in 1999 during which the price of electricity exceeded $25. The average price in these weeks was $34.19. If you had operated only during these weeks, you would have earned $34.19 $25 $14.19/MWh, albeit only for 30 24 7 = 5, 040 hours. Your cash ow would have thus been $14.19/MWh5, 040h400MW $28.6 millionalmost three times what
The value in the most likely scenario.
The value is much higher if you recognize that you can shut down and reopen.
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the nave valuation had suggested. Ignoring the real option to shut down and reopen would not have been a forgivable valuation mistake! 32.C. Variance, Option Value, and Technological Choice
Variance increases the value of exibility.
An important insight is that if you own a real option, variance helps you: If the price had been $28.09/MWh constant, you would have earned $10.8 million and you would never have shut down or reopened the plant. But because the price was highly variable around $28.09/MWh, you would have earned $28.6 million. It is your ability to operate only when desired that has value. Intuitively, the bigger the upside, the better for you. The lower the downside makes no dierence: you are not operating anyway. Variability is on your side!
Important: Real options are more valuable if there is more variance.
This does not contradict our intuition from the investments section. There, we posited that you disliked risk (at least systematic risk), and would only take it on if you receive extra expected rate of return. You may still intrinsically dislike risk, and require a higher hurdle (discount) rate for investments with much embedded real option valuessuch cash ows are typically very risky. But, in the presence of a real option, the risk also increases your expected cash owsand often so tremendously that you end up much better o with risk than without risk. The present value, taking the higher discount rate into account, can be much greater.
Fixed cost technologies have fewer real options.
Real options generally arise from your exibility (here, whether to operate or not to operate). Dierent technologies have dierent real options and to dierent extents. For example, nuclear power plants have higher upfront xed costs, but lower marginal costs. A nuclear power plant may cost over $1 billion to construct, but it may be capable of producing electricity at costs as low as $5/MWh. Therefore, nuclear energy plants typically run continuously, regardless of electricity price. They have fewer embedded real options. This has another consequence: If you ignore real options, you will mistakenly end up with too many high xed-cost, low variable-cost technologies. You will believe nuclear power plants are much better than turbine gas plants, even if they are not. Indeed, many economic resources are nothing but real options. Much R&D, e.g., into a new cancer drug, will never pay o in and of itself. But, if the drug development were to succeed, the pharmaceutical company would create factories and earn billions of dollars. An investment of R&D can thus be considered the purchase of a real option. Similarly, undeveloped land has zero inows today, and still requires the payment of real estate taxes. Its only value is the real option to build on it if demand for land use were to increase in the future. And, your degree and next job may have more value, because you can walk away from them if other, better opportunities were to appear.
Many assets are primarily real options.
Solve Now!
Q III.1 Is it possible that you may prefer a scenario in which in the most likely scenario, you would do worse?
Q III.2 Compare two technologies. The rst can produce electricity at $28/MWh, but cannot close down and reopen. The second can produce electricity at $29/MWh, but can close down and reopen. In the most likely price scenario, which technology would have earned more? Which technology is worth more?
Q III.3 Do variable-cost technologies or xed-cost technologies usually contain more real option value?
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32.D. Real-World Complications By recognizing your ability to shut down the gas turbine plant, you are able to estimate a much more precise value than you would assuming a stupid always running plant value. However, many problems remain with the $28.6 million value estimate. Even if you cannot address each and every one, you want to at least recognize them. Your most important concern is that you need to estimate the electricity price process for 2000, not for 1999. This is a self-contained taskyou can do so, even before you ever consider the plant itself. 1. Your $28.6 million calculation was for prots if you had operated in 1999. Alas, it is more sensible to assume that 1999 would only be indicative of 2000 in terms of the electricity price process (e.g., mean and standard deviation). Moreover, you know that 1999 closed with a price of $28.89, not the average price of $28.09. Can you make use of this knowledge? In any case, you should assume that history will not repeat itself, but that it can teach you a lot about the future. This is exactly analogous to our earlier assumption in the investments part of our book, where we stipulated that historical return statistics (means and standard deviations) are indicative of future statistics, but that the exact future return realization could end up quite dierent from the past. 2. Even if you use 1999 data to estimate the statistical process for 2000, it could be that the historical process is not a good guide for your future. If your experience in electricity management makes you capable of better estimating the price of electricity in 2000, then you can come up with a better cash ow estimate. But to improve your estimate of the value of the plant, you must be able not only to forecast the mean electricity price, but also the standard deviation in the electricity price. (In retrospect, we know that the past turned out not to be indicative of the future. California experienced a famous energy crisis in 2000, partially due to price manipulation by the energy producers themselves!) 3. If you look at the historical prices, you will see that each weekly price is not exactly a random draw from a xed distribution. When the price the previous week was high, chances are that the price this week is also high. For example, at the end of the year, the price stood at $28.89. This implies that the next price is unlikely to be $50 or $18, but more likely something between $26 and $32. In contrast, when the price was $50 last week, you would expect it to be something, say, between $44 and $52. (Note that this is not necessarily symmetric around $50!)
Side Note: For intuition, think of this process (in which recent prices are indicative of the next price) as being similar to, but not the same as the random-walk process. The reason is that there need to be reasonable limits to how far the electricity can wander o before demand drops and supply increases. Statisticians call such processes autoregressive, and we will discuss this in much detail below. Note also that there could be some seasonality: electricity prices in summer could be higher, but you would need more years of historical data to judge whether this is the case. Thus, we ignore seasonality.
Problems in predicting cash ows.
Electricity price process prediction
The future is not exactly the past.
The future may not even be indicated by the past.
You need a good prediction for electricity prices, standing at $28.89.
You know that in order to value your plant, you must forecast some process for the electricity price in 2000. Your technique itself can range from the simple to the fancy. In the real-world, the better you are at electricity price process estimation, the better will be your value estimates. Typically, the best forecasts combine qualitative managerial knowledge of the industry and business with quantitative statistical modeling techniques. We shall explore two kinds of electricity forecasting processes in the next two sections: a simple qualitative version, in which you write down a reasonable and intuitive binomial tree (Section 33); and a quantitative statistical time-series estimation, in which you estimate a time-series model from the historical electricity price data (in Section 34).
Prediction of the Electricity Time-Series Process can be done in many different ways.
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Electricity Price Process Prediction You may need appropriate (shorter) time intervals.
Of course, your generation plant introduces its own set of diculties, too: 4. It is not clear that one week is an appropriate time interval for your analysis. In the backof-the-envelope valuation, we simply assumed that at the beginning of each week, you would know the xed average electricity price for this particular weekbut in real life, electricity prices may uctuate by the minute! 5. Even if electricity prices vary by the minute, it is not clear if your technology allows you to react instantly. Can you shut down your gas turbines the minute the price falls below $25/MWh, or does it take several hours? Can you restart them immediately? If you cannot act instantly, then you do not need to know the minute-by-minute electricity price process. If you can act instantly, you might have to perform your electricity price analysis over much shorter frequencies than weekly. If you can act only very slowly, maybe you should just forecast your electricity price process over, say, quarterly horizons. 6. In the example, your only choice is whether to operate or not to operate. What if you can produce energy at various prices in various plants? For example, you may have some newer turbines that can produce at $20/MWh and some older ones that can produce at $30/MWh. Now, you have to make multiple decisions: when to switch on/o the rst turbine, and when to switch on/o the second turbine. Indeed, in many situations, the production cost function may be smooth over some range: if you drive the machine and employees harder, you can produce more electricity, but at a higher per-unit generation cost. And, do not forget about the market, both the electricity and the nancial markets:
You need to know the limits of your technology.
You need to know whether you have the option to work harder.
You need to know whether all electricity is always sold.
7. Can electricity always be sold, or do you need to search for consumers? If you are a large enough power producer, your power generation could itself have a nontrivial eect on the electricity market price! 8. Electricity is not your only source of uncertainty. For example, the price of natural gas could also be uncertainand it could correlate with the price of electricity. This matters: if the price of your input, natural gas, always goes down when the electricity price goes down, you may always choose to operate. However, if the price of your input varies inversely with your output price (gas would be cheap when electricity is expensive), then you may be in an even more volatile situationwhere your real option is even more valuable. 9. What is the appropriate discount factor for discounting cash ows? How do your cash ows covary with the rate of return on the stock market? Of course, you know that for a 1-year project, the net present value is not particularly sensitive to reasonable errors in your discount rate estimate, so this is probably not an issue of rst-order importance here. But, what if you were to consider leasing the plant for many years? Then estimating the appropriate discount rate would again become an issue of great importance. (In some special situation, you may not even need to estimate the discount rate, but can derive a value purely by replication, as explained below.)
You need to know what other important factors are uncertain.
Discount Factor?
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32.E. Path (History) Dependence These are all dicult questionsbut your problem becomes exponentially more dicult if your best operating decision depends not only on the current electricity price, but also on what happened earlier or what can happen later. Dependence on history can happen if it is expensive to change the operating state. For example, assume that it costs $200,000 to shut down your plant, and another $500,000 to restart it. Whether you operate or not then depends not only on the current price of electricity, but also on the state that your operations are in. For example, recall that your electricity production cost is $25/MWh, and presume now that the current electricity price has just moved to $24.99. If the plant was already closed, the choice is easy: keep the plant closed. After all, reopening would cost money today, plus you would lose money on each MWh you would produce. If the plant was open, should you shut it down? Probably notthe shutdown and reopening costs are so high, you would probably be better o just accepting the 1 cent/MWh loss instead of incurring the shutdown costs now and possible reopening costs next period if the price were to go up again (of course, unless you would be at the end of your lease). But where is the cuto price below which you should shut down? What if the price were $24.85? Similarly, at what price should you reopen a closed plant? Should you reopen at $25.01? Again, the answer is probably no: the $500,000 cost of reopening today plus the reclosing costs if the price were to drop again next week would be prohibitive. This set of issues is called path dependence, because your choice depends not only on the current market situation (the electricity price), but also on the path you have takenthe state of your plant, which in turn depends on whether the electricity price has just dropped a lot (in which case your plant would likely be open) or whether it has just increased a lot (in which case your plant would likely be closed). In other words, history matters. Of course, when history matters, you also have to consider how your choice today becomes relevant history tomorrow. (In the real world, your problem can become even more complex, because your choice may also depend even more directly on the future: for example, it may be possible to store electricity. If so, you might still produce electricity if the current price were $22/MWh and hope for a higher price later on. Of course, at some price low enough, you may not want to produce any more electricity.) 32.F. Preview Now, one chapter cannot address all of these pointsbut it can explain the general techniques of how you should approach them. The rest of this chapter shows you two dierent techniques in how to deal with the most dicult problems: Section 33 focuses on how you can handle path-dependent decisions if you assume that the electricity price follows a binomial tree process. This method can often be executed on a sheet of paper with pencil and paper (and a calculator, of course) and lends itself to use by more qualitative and less quantitative managers. Section 34 models the price process for electricity (for subsequent handling of path dependent decisions) in a more general statistical time-series process context. This can require a lot of statistical and computer expertise, but it is more adaptable and exible than the binomial tree technique.
We pick and choose issues to illustrate solution techniques. The current state depends on where we came from. If you can restrict your view to just the current time, the optimization problem becomes relatively easy. If you have to pay to change state (factory open or closed), then your choice depends on your current state, which depends on your history.
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33. The Simpler Method: Binomial Trees and Path Dependence

This approach works for the particular process (binomial tree), and especially if only a few decisions can be made.
Our rst method is simple (well, simpler), focusing more on getting the main value drivers right, instead of getting the electricity forecast details perfect. It posits a particular process for the electricity pricea binomial tree (see below). It is typically used by managers for relatively low-frequency processes, such as quarterly choices. Because it tends to work well for decisions that have to be made only a few times, it might apply here if your electricity plant can only be shut down infrequently (say, quarterly), perhaps because it requires a long time or because changing state costs a lot of money. (Without a computer program, this method would be too tedious if you wanted to model daily decisions.) 33.A. Basic Processes and Decisions
Decisions are less frequent.
To t this description, assume that your plant is really less of a turbine gas plant and more of a nuclear power plant: you make only a once-a-quarter decision whether to operate or not operate it. Because a standard year has 8,765.81277 hours, if you operate in one quarter, you will run the plant for all (approx.) 2,191.5 hours of the quarter, and earn a prot of 400MW (Price $25) per hour. For example, if the electricity price were $30/MWh, then you would earn in one operating quarter
R( $30/MWh) = 400MW ($30/MWh $25/MWh) 2, 191.5h R( P ) = 400MW (P $25/MWh) 2, 191.5h
M
$4.383 (III.1)
(M$denotes million of dollars.) Your ultimate goal is to work out the value if you can lease the plant for this plus another four quarters.
Toughest part: estimate the price process.
Your rst step is the most dicult, and the most criticaland the one where this section takes its main shortcut: we assume a simple binomial tree process for how the price of electricity can evolve. In the real world, its construction can rely not only on historical data, but also on your managerial judgment. Your hope must be that this ve-quarter binomial tree posits an electricity process that captures the basic electricity price dynamics, rather than a process that is the very best in heavy-duty statistical artillery. As a good qualitatively-oriented manager, you should start with your intuition based on historical experience. The electricity price in 1999 started at $23.14/MWh. If you compute the average quarterly price in 1999, you nd that it was $19.71/MWh in Q1, $24.02/MWh in Q2, $31.90/MWh in Q3, and $37.90/MWh in Q4. This means that, given the starting price, the percent change to the rst quarter average price was 15%. The remaining changes were +22%, then +32%, and +18%. As an experienced and knowledgeable electrical plant manager with access to this and other information, let us assume that you believe the future electricity price to be well represented by a process that either increases by 20% in one quarter, or decreases by 15%, give or take, and with equal probability. Thus, Figure III.1 represents your tree for possible electricity prices. (Warning: All subsequent price, revenue, and present value calculations will carry full precision internally. Be prepared for small rounding errors if you replicate the calculations from the displayed prices and revenues.)
Our specic electricity process.
le=web-realoptions.tex: RP Section 33. The Simpler Method: Binomial Trees and Path Dependence.
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Figure III.1. Assumed Electricity Price Processfor Planning Purposes
Now
Q1
Q2
Q3
Q4
$59.906
1/2
$49.922
d 1/2
$41.602
d 1/2 d d
$42.434
d 1/2
$34.668
d 1/2 d d
$35.361
1/2 d d 1/2 d d
$30.057
d 1/2
$28.89
d 1/2 d d
$29.468
1/2 d d 1/2 d d
$25.048
d d 1/2 d d
$24.556
1/2 d d 1/2 d d
1/2
d 1/2
$20.873
d 1/2 d d
$21.290
d d 1/2 d d
$17.742
1/2
d d 1/2 d d
$15.081
Each path is equally likely, hence the probability of 1/2 on each arrow. An up-path is a 20% electricity price increase, a down-path is a 15% decrease. In the real world, you would round prices, but to make computations easier to check for you, prices have three digits after the decimal point. Side Note: If you believe that the price cannot wander o too far, e.g. from $50/MWh, then you can change the price on a node to something you consider to be more realistic. For example, you might change the $49.922 price to $45, and the $59.906 price to $52. Use your managerial intuition! All subsequent methods will work with a tree modied in this manner.
62 33.B. Costly vs. Free Operating Changes

Benchmarks: No real option. Free exercise real option.
Your rst benchmark is the value of the plant if you always operate it. With the electricity price process in Figure III.1, and assuming that the discount rate is 2.5% per quarter, you would estimate your plants value V to be
V = R( $28.89 ) + + + +
1/2 R( $24.556 ) + 1/2 R( $34.668 )
1 + 2.5% (1 + 2.5%)2 (1 + 2.5%)3 (1 + 2.5%)4 = (+M$3.410)
1/4 R( $20.873 ) + 1/2 R( $29.468 ) + 1/4 R( $41.602 )
1/8 R( $17.742 ) + 3/8 R( $25.048 ) + 3/8 R( $35.361 ) + 1/8 R( $49.922 )
1/16 R( $15.081 ) + 4/16 R( $21.290 ) + 6/16 R( $30.057 ) + 4/16 R( $42.434 ) + 1/16 R( $59.906 )
+ + +
M
1/2 (M$0.389) + 1/2 (+M$8.475)
1 + 2.5% (1 + 2.5%)2 (1 + 2.5%)3
1/4 (M$3.618) + 1/2 (+M$3.916) + 1/4 (+M$14.553)
1/8 (M$6.362) + 3/8 (+M$0.042) + 3/8 (+M$9.083) + 1/8 (+M$21.847)

M
1/16 ( $8.695) + 4/16 ( $3.252) + 6/16 (+M$4.433) + 4/16 (+M$15.282) + 1/16 (+M$30.599)
(1 + 2.5%)4 M$22.266 . (III.2)
You already know that this ignores the real option to close the plant if the price of electricity goes down. Your second benchmark is the value if you can shut down and reopen at no cost. To
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compute this, simply replace 2,191.5h with 0h if the electricity price is below your generation cost of $25, and the plants value would be
V = R( $28.89 ) + + + +
1/2 $0 + 1/2 R( $34.668 )
1 + 2.5% (1 + 2.5%)2 (1 + 2.5%)3 (1 + 2.5%)4 = (III.3) (+M$3.410)
1/4 $0 + 1/2 R( $29.468 ) + 1/4 R( $41.602 )
1/8 $0 + 3/8 R( $25.048 ) + 3/8 R( $35.361 ) + 1/8 R( $49.922 )
1/16 $0 + 4/16 $0 + 6/16 R( $30.057 ) + 4/16 R( $42.434 ) + 1/16 R( $59.906 )
+ + + +
1/2 $0 + 1/2 (+M$8.475)
1 + 2.5% (1 + 2.5%)2 (1 + 2.5%)3

M
1/4 $0 + 1/2 (+M$3.916) + 1/4 (+M$14.553)
1/8 $0 + 3/8 (+M$0.042) + 3/8 (+M$9.083) + 1/8 (+M$21.847)
1/16 $0 + 4/16 $0 + 6/16 (+ $4.433) + 4/16 (+M$15.282) + 1/16 (+M$30.599)
(1 + 2.5%)4 M$25.284 .
We now introduce the complication which is the whole point of this section: shutting down and reopening are not free. Lets assume that laying o employees and mothballing the plant will cost you $200,000. Rehiring them and restarting the plant will cost you another $500,000. Without closing and opening costs, you really had only two decisionsopen the plant or shut the plant. With opening and closing costs, you now have four potential decisions to consider: Re-Close (C) Re-Open (O)
Action changes are costly.
If Open Keep Open (KO) d
If Closed d Keep Closed (KC)
Without the extra costs, the keep open and open up decisions were always the same, as were the keep closed and close down. They did not depend on whether you came into a period with a closed or open plantyou would just do whatever would be best. Note that you can also think of the value of the plant if always operating, and the value of the plant if perfectly exible as special cases of particular closing/reopening prices: If the closing cost were innite (or at least very, very high), you would always operate, and thus obtain a value of M$23.541. If both opening and closing costs were zero, you would do whatever is currently optimal and thus obtain a value of M$26.792. Therefore, you already know that the true value of your plant must lie between your two benchmarks. Even with these costs, many decisions are still immediately obvious. If the electricity price is far away from your cost of $25, e.g., if electricity is $30, you earn so much money in one quarter (400MW ($30/MWh $25/MWh) 2, 191.5h M$4.383) that even if you were to arrive in this quarter with a closed plant, you would still gladly incur a $500,000 restartup cost (and potential future reclosing cost of $200,000). Similarly, if the electricity price were $20, operating the plant would lose you so much money (400MW ($20/MWh $25/MWh) 2, 191.5h M$4.383) that you would always shut down even if you were to come into this quarter with an open plant.
For most nodes, switching costs are too small too matter one way or the other.
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Figure III.2. Obvious and Non-Obvious Decisions
Now
Q1
Q2
Q3
Q4
P=$59.906 Operate
(R = +M$30.599)
P=$49.922 Operate
(R = +M$21.847)
P=$41.602 Operate
(R = +M$14.553)
P=$42.434 Operate
(R = +M$15.282)
P=$34.668 Operate
(R = +M$8.475)
P=$35.361 Operate
(R = +M$9.083)
P=$28.89 Operate
(R = +M$3.410)
P=$29.468 Operate
(R = +M$3.916)
P=$30.057 Operate
(R = +M$4.433)
P=$24.556 What to do?

(R M$0.389)
P=$25.048 What to do?

(R +M$0.042)
P=$20.873 Dont Op.

(R = M$3.618m $0)
P=$21.290 Dont Op.

(R = M$3.252m $0)
P=$17.742 Dont Op.

(R = M$6.362m $0)
P=$15.081 Dont Op.

(R = M$8.695m $0)
R is the single-period revenue of the plant if open and operating. Opening and closing costs are ignored. The boxed nodes are where your decision is not obvious, and requires more thought. Revenues are in million dollars (M$).
65
Here are some boundaries as to where we have obvious decisions and where not.
Can you determine some price ranges where you do not need to bother with much thinking? Yes! Pick the total reopening and shutting down costs of $700,000. If by operating, you were to earn more than $700,000, you would clearly always start up, even if you were coming in closed. Similarly, if by shutting down, you were to avoid a loss of more than $700,000, you would always shut down, even if you were operating. You can determine the price at which this happens by solving
R( P ) = 400MW (P $25/MWh) 2, 191.5h = $700, 000 P $25.80 , (III.4) R( P ) = 400MW (P $25/MWh) 2, 191.5h = $700, 000 P $24.20 .
So, you do not have to do any thinking if the electricity price is above $25.80 or below $24.20. You will always open (or shut) the plant. It is only for electricity prices in between $24.20 and $25.80 that you shall have to turn on your brain. Your knowledge so far is illustrated in Figure III.2. For later convenience, I have also already added the value of R( P ) if you were to operate at each node. Although your logic has been impeccable, this is not a systematic way to approach this problem it will not help you determine what you should do if the price is between $24.20 and $25.80. For example, what should you do if the price were $24.556 in Q1 and you came in with an open plant? Or, if the price were $25.048 in Q3, and you came in with a closed plant? You will therefore have to learn how to work out your problems in a more systematic way. 33.C. Solution Techniques for Dynamic Problems
We have not solved out problem!
The Tree Setup So how can you work these kinds of problems more systematically? How can you handle tree nodes where decisions are not obvious? You need an algorithm that tells you how to approach the problem systematically. There are two main rules you need to follow. 1. Work backwards. 2. Keep track of both best choices (decisions) and the current state when working the decision tree. It will soon become clear exactly what these two rules mean. Figure III.2 provides your basic tree. (Figure III.2 only carries the operating revenues, ignoring any possible reopening costs.) At each node, you have two choiceswhat you would do if you come in with an open plant, and what you would do if you come in with a closed plant. If you arrive with an open plant, your choices are to keep open or to close down. If you arrive with a closed plant, your choices are to keep closed or to open up. The revenues of your plant and thus the plant value depends on your action, and must also be carried in the diagram. Plus, if you determine that you want to shut down the plant at one particular node, you have to remember that you will arrive in the next quarter with a closed down plant, which will itself have value implications. Let us now work out the details of the valuation. You already know the correct answer for many of the nodes (from Formula III.4 on Page 65), which could make your life easier. But we want to develop a method to work problems of this kind systematically, rather than piecemeal. So, please bear with my more tedious method for now.
OK, we will take the extra slow route now. The two cardinal rules: work backwards, and consider decisions contingent on state.
66 Quarter 4
The decisions in the nal period are worked out rst.
Your rst rule is to always work backwards, so you start with the nodes at the right end of the tree for Quarter 4. The big advantage of starting at the end is that nothing comes thereafterso you do not have to worry about what impact your Q4 decision may have the following quarter. Now, you need to ll in what the value would be, depending on the current plant state, for each node. Thus, you need to determine the best action (with consequent value) contingent on a plant that is arriving while open and that is arriving while closed. You already know the correct decisions. For example, if the price is $59.906, you should operate, regardless of prior state. So here is the complete list: P = $59.906, arrive open: The price is so high, you want to be open. Recall that the quarterly revenue function is
R( P ) = 400MW (P $25/MWh) 2, 191.5h =
M
$30.599 .
(III.5)
The plant net revenue is just the electricity produced, V = R( P ) = +M$30.599. P = $59.906, arrive closed: The revenues would be M$30.599 minus the reopening costs for a net of M$30.099, but this is irrelevant. If you think about this node, reection will tell you that you can never come to this node with a closed plant. That is, in order to reach this node, you would have to have experienced three up movesin which case the price would have been $49.922, and your plant would already be open.
P = $42.434, arrive open: You always operate, so the plant net revenue is +M$15.282. P = $42.434, arrive closed: Again, this cannot happen. Therefore, you can ignore this possibility.
P = $30.057, arrive open: The net revenue is +M$4.433. P = $30.057, arrive closed: This can happen, because the price may have just risen from $25.048! The revenue is +M$4.433 minus the reopening costs of $500,000 for a net of +M$3.933.
P = $21.290, arrive open: You would not want to operate, so the net revenue is $0, minus closing costs of $200,000 for a net of -M$0.2. P = $21.290, arrive closed: The value is $0.
P = $15.081, arrive open: Never happens. If it did, you would pay $200,000 to shut down, for a net of -M$0.2. P = $15.081, arrive closed: The value is $0. Now, write these best actions and resulting values in Q4 into your tree to arrive at Figure III.3.
67
Figure III.3. Tree With Quarter Q4 Worked Out
Now
Q1
Q2
Q3
Q4
P=$59.906 (R = +M$30.599) if closed: Reopen, V= +M$30.099 if open: Keep Opn, V= +M$30.599

P=$49.922 (R = +M$21.847) if closed: Reopen, V= M$43.728 if open: Keep Opn, V= M$44.228

d d

d d


d d

d d
d d

P=$24.556 (R = M$0.389) if closed: Keep Cld, V= M$7.074 if open: Reclose, V= M$6.874
d d

P=$25.048 (R = +M$0.042) if closed: Keep Cld, V= M$1.919 if open: Keep Opn, V= M$2.107
d d

d d
P=$21.290 (R = M$3.252) if closed: Keep Cld, V= $0 if open: Reclose, V= M$0.020
d d

d d
V means value, which includes both current revenue and discounted expected future revenues, assuming optimal future behavior, as well as opening and closing costs. One period revenue, if operating, is R( P ) = 400MW (P $25/MWh) 2, 191.5h. Present values (V ) include subsequent events, and are quoted in millions of dollars (M$). If you arrive with an open plant, Keep Opn means your best action is to keep the plant open, Reclose means your best action is to shut down the plant. If you arrive with a closed plant, Keep Cld means your best action is to keep the plant closed, Reopen means your best action is to open up the plant.
68 Quarter 3
The values at the three nodes where you know whether to operate or not are easy to compute.
Now continue to work backwards. In Q3, your best courses of actions are obvious if the price is $49.922(operate), $35.361(operate), or $17.742(do not operate). You can quickly work out the value in the tree if you are standing at any of these nodes. Start with the node where the price is $49.922. You would earn current revenues R( P = $49.922 ) = +M$21.847 in Q3. In addition, looking at Figure III.3, you see that you will then either earn R( $42.434 ) = +M$15.282 or R( $59.906 ) = +M$30.599 in Q4, to which you have to apply your discount rate of 2.5%. Therefore,
P = $49.922 and arrive open: V = +M$21.847 + value today +
1/2 +M$15.282 + 1/2 +M$21.847
1 + 2.5% disc exp value next quarter
$44.228 .
(III.6)
This V is the present value not just of the current-period (Q3) revenues at this node, but the total value of the plant including all future net revenues. Although it cannot happen, if you came in with a closed plant, you would immediately open it up and earn
P = $49.922 and arrive closed: V =
M
$44.228 M$0.5 =
$43.728 .
(III.7)
You can easily work the same calculation for the other two obvious prices, $35.361 and $17.742. The present value at these nodes are
P = $35.361 and arrive open: P = $17.742 and arrive closed: V = V = +M$9.083 $0 + +
1/2 +M$4.433 + 1/2 +M$15.282
1 + 2.5%
1/2 $0 + 1/2 $0
= = .
$18.700 $0
value today +
(III.8)
Each of these two nodes has two other possible states, which are just the preceding values minus the opening and closing cost, respectively.
P = $35.361 and arrive closed: P = $17.742 and arrive open: V =
M
$18.700
$0.500 = $0
$18.200 (III.9)
V = M$0.200 +
= M$0.200 .
Even the one tough node is easy, if you arrive with the plant open.
What you should do if you arrive at P = $25.048 in Q3 and you are closed? The answer is easy if you arrive open: the plant is earning money on the margin, so you may as well just keep the plant open. An open plant earns
R( P ) = 400MW ($25.048/MWh $25.00/MWh) 2, 191.5h = $41, 752 (III.10)
in electricity-sold, so your plant value will be

P = $25.048 and arrive open : V = +M$0.042 +
1/2 +M$4.433 + 1/2 (M$0.2)
$2.107 .
(III.11)
value today +
This is because next quarter, if the price goes up to $30.057, you continue operating and earn +M$4.433; if the price goes down to $21.290, you close down, suering a closing cost of $200,000.
69
And here is the tough decision: what to do if you arrive closed? You need to compare values.
The real interesting choice, however, occurs if you arrive at the node where P = $25.048 in Q3 and you are closed. What should you do? You have to make one of two choices: Keep Plant Closed If you were keep the plant closed, you would earn nothing in Q3. In addition, you would arrive in Q4 with a closed plant. This means that you would keep the plant closed in Q4 if the electricity price were to drop to $21.290, but you would open it and earn M$4.42 minus the $500,000 reopening costs next quarter if the electricity price were to increase to $30.057. Therefore, the plants present value if you keep it closed today would be
P = $25.048 and arrive closed and you keep plant closed : V = $0 +
1/2 $0 + 1/2 (+M$4.433 M$0.5)
= .
$1.919
(III.12)
value today +
(Note that the M$0.5 reopening costs would occur the quarter thereafter, not here in Q3.) Open up Plant If instead you were to open up the plant, you would earn an immediate $43,680 minus the reopening costs of M$0.5 in Q3. If next quarter the price of electricity were to fall again, then you would need to shut down the plant down again. Of course, if the price were to go up, you could then just leave the plant open. In sum,
P = $25.048 and arrive closed and you open up the plant : V = M$0.5 + M$0.042 + value today + [1/2 (M$0.2) + 1/2 (+M$4.433)] = 1 + 2.5% disc exp value next quarter .
M
$1.607 .
(III.13)
Because M$1.919 is more than M$1.607, the better choice is to keep the plant closed. So, the optimal strategy if the price is $25.048 is If P = $25.048 in Q3, If P = $25.048 in Q3, If you arrive open, keep open If you arrive closed, keep closed V = M$2.107 V = M$1.919 .
Enter this information into your tree to arrive at Figure III.7. You should actually do such comparisonsis the value higher if my action is to keep the plant in its present state or if my action is to switch the plant to the opposite state? You need to work through the comparisons at every node of the tree, and then choose the action with the higher value. However, in our other nodes, the right choice was so obvious that we did not have to go through the painful computations.
Digging Deeper: It is here, at the price of $25.048, that your tree has become path-dependent: your best action depends on whether the price has just increased (coming from $20.873, in which case you would be closed and not operate) or decreased (coming from $29.468, in which case you would be operating and continue to operate). Without path dependence (here caused by opening and closing costs), you could just work out the tree at each node independently of any other node in the treea much easier task.
70
Figure III.4. Tree With Quarters Q3 and Q4 Worked Out
Now
Q1
Q2
Q3
Q4


d d

d d


d d

d d
d d

d d

d d

d d
d d

d d
71
Quarter 2 Again, you work backwards. Quarter Q2 is relatively easier, because all decisions are clear. One of the exercises below asks you to check these values in Figure ?? yourself. Quarter 1 Again, you continue working backwards. In Q1, if the price is $34.668, then the plant value is easy to compute, because the correct decision is obviousoperate. If you arrive open, the value is M$8.475, plus the expected discounted value of M$44.250 and M$14.114,
V =
M
Now you get something to do, too!
An obvious decision$34.668is too high a price to not operate.
$8.475
1/2 M$45.249 + 1/2 M$14.006
= .
$37.409 . (III.14)
value today +
If you could arrived closed (which never happens), you would immediately reopen the plant and earn M$36.909. Enter these V s into Figure ??. But Q1 has another, more interesting decision. If the price is $24.556, what should you do? Of course, if you come in closed, you can just leave it closed, because you are not earning money from producing electricity on the margin. (The plants present value of the future then is really all you have, which is
P = $24.556 and arrive closed and you keep it closed : V = $0 +
1/2 M$13.566 + 1/2 M$0.936
Q1 has another interesting choice.
(III.15) =
M
1 + 2.5%
$7.074 .
However, if you come in open, should you close the plant? This is again a more dicult decision, and requires a full calculation: Close Down Plant: If you close the plant, you have to pay $200,000 in shutdown costs, you will come into the next quarter with a closed plant, which means that its value will be either M$13.566 or M$0.936 next quarter. Thus,
P = $24.556 and arrive open and you close down the plant : V = M$0.2 +
1/2 M$13.566 + 1/2 M$0.936
= .
$6.874
(III.16)
value today +
Keep Plant Open: If you keep the plant open, you lose ($25 $24.556) = $0.444 per MWh produced, for an immediate operating loss of M$0.389. In addition, you know that you will come into the next quarter with an open plant, and that the value of this plant will be either M$14.066 or M$0.736. Therefore
P = $24.556 and arrive open and you keep the plant open : V = M$0.389 +
1/2 M$14.066 + 1/2 M$0.736
= .
$6.832
(III.17)
value today +
Therefore, it appears that if the price is $24.556and you arrive open, you are better o if you close the plant. (Of course, in this example, the value dierence to keeping the plant mistakenly open is small. So, you cannot badly go wrong here.) In sum, your best choices are If P = $24.556, If P = $24.556, If you arrive open, close the plant If you arrive closed, keep the plant closed V = M$6.874 V = M$7.074
72
Figure III.5. Tree With Quarters Q2 to Q4 Worked Out
Now
Q1
Q2
Q3
Q4


d d

d d


d d

d d
d d

d d

d d

d d
d d

d d
73
After much calculations, you have therefore learned that your action here is not a historydependent decisions: the plant should not operate, no matter whether you arrive with an open or a closed plant (and no matter whether the price just increased or decreased). Today You are almost done. What should you do at the outset? If your plant is open, you keep it open and earn
V = +M$3.410 +
1/2 M$36.909 + 1/2 M$7.074
The nal value computation! you are done!!!!
= .
$24.512 . (III.18)
value today +
If your plant needed to be opened up rst, you would pay another $500,000. Figure ?? is your nal tree. You could do further analysis. For example, you could determine what the expected cost of opening and closing is. Looking at the tree, there are 24 = 16 possible price paths. The following price paths require changing the state of the plant:
Price Path UDDD DUUU DUUD DUDU DUDD DDUU DDUD DDDU DDDD Action close in Q4 close in Q1, open in Q2 close in Q1, open in Q2 close in Q1, open in Q2 close in Q1, open in Q2, close in Q4 close in Q1, open in Q4 close in Q1 close in Q1 close in Q1 PV of Changing $181,190 $671,029 $671,029 $671,029 $852,219 $648,097 $195,122 $195,122 $195,122
Additional Analysis: Expected Changing Costs.
Therefore, the expected plant state changing costs are $267,497. This is fairly smallbecause you will likely have to execute only a small number of plant changes. Now, compare your three value estimates:
Policy Always Operate Plant (innite closing costs) Only quarterly changes permitted, changing costs Only quarterly changes permitted, zero changing costs Plant Value
M$22.266 M$25.012 M$25.284
In this case, the changing costs were modest, and the value estimate of the real option with changing costs was not far from the solution without any changing costs. Reections Heuristics as Substitutes In one respect, this particular problem is pretty straightforward: it is an algorithm. You always work backwards, and keep track of the value of the plant in its possible states. It is just an exercise, perhaps tedious and computing-intensive, but something that you can solve with a pen, a calculator, and a piece of paperor by writing a computer program. In another respect, problems of this kind can very quickly become very complex. For example, how credible is the price process? How can you handle a situation in which you have more than two choices, opening and closing? What do you do if there are 100 choices? (The answer is that at each node, you have to determine not just the best action given one of two states, but the best action given one of 100 states. This is feasible if you write a computer program, but not if you have to do it by hand.) And, what do you do if there is more than just the uncertainty about the electricity price, but also uncertainty about other important inputs and outputs?
Easy but tedious in principle. Tough in practice.
74
Figure III.6. Tree With All Future Quarters Worked Out
Now
Q1
Q2
Q3
Q4


d d

d d


d d

d d
d d

d d

d d

d d
d d

d d
75
Figure III.7. The Full Tree Worked Out The Plant Value
Now
Q1
Q2
Q3
Q4


d d

d d


d d

d d
d d

d d

d d

d d
d d

d d
76
Instead of working systematically backwards to determine the optimal choice, you could just try out a heuristic strategy.
In some situations, you have no choice but to resort to simulations and heuristicsthat is, imperfect operating rules. In our example, a heuristic may have stated close an open plant if the price drops below $24.75, and reopen a closed plant if the price goes above $25.25. (Your heuristics might also depend on whether it is early or late in the plant leases life). Almost surely, the heuristic will occasionally recommend mistaken actionsit will sometimes tell you to operate when the perfect exact decision rule would tell you not to, and vice-versa. But the advantage of most good heuristics is that they turn a path-dependent tree into a plain pathindependent tree, where you no longer have to determine optimal decisions working through the entire tree. Instead, you can just work out the value at each node by itself. If you have written a program to just compute the expected value of the tree based on individual nodes, you can determine good policies through searchyou can try out dierent heuristics (critical shutdown and reopening prices) to see how the factory value changes. Of course, the better your heuristics are, the higher will be the value you attach to the factory. Q III.4 In Figure ??, work out the values in Q2.
Solve Now!
Q III.5 Conrm the new values in Figure ?? that were not computed in the text.
Q III.6 Rework the tree if the closing cost is M$1 and the opening cost is M$2.
Q III.7 Rework the tree if the closing cost is M$4 and the opening cost is M$8. (Do this only if you had trouble with the previous exercise.)
Q III.8 Rework the tree if the closing cost is M$16 and the opening cost is M$32. Do this only if you had trouble with the previous exercise.)
Q III.9 Compare the two benchmarks, the solution in the text, and the solutions in the three preceding exercises. What would you expect?
33.D. Nerd Section: Valuation by Replication
Important: This section is not necessary to an understanding of how to value real options. If you want to understand this section, you must rst thoroughly understand how to value options and contingent claims in binomial trees. This was explained in the Options and Derivatives chapter. The techniques in this section can be helpful in some very specic situationswhen the underlying uncertainty is already traded in nancial markets. In such cases, it often provides more accurate valuations. Most corporate projects do not qualify, because few underlying uncertainties/commodities are traded.
Replication methods de facto obtain useful project information from market prices.
Valuation by replication sees a project as providing payos that are contingent upon an underlying commodity, if the forward prices (values) are known today. For example, as you shall work out below, it might see your plant as a fancy set of derivatives on electricity forward contracts. If you know the electricity forward prices, you can value your plant using option pricing techniques relative to the known electricity forward contract prices. The sole advantage of this technique is that you do not need to estimate your projects own discount rate and the probability of an up versus a down move. Instead, you get these handed to you by the technique itself. The market prices for electricity forwards implicitly determine the discount rate and up/down probabilities.
77
Assume a risk-free rate of 0% per quarter for contrast to our own discount rate of 2.5% per quarter.
To make this clear, assume that when you check the 3-month Treasury bond, you nd that the risk-free interest rate is 0%. This is lower than the 2.5% that your project commanded in the previous sectionswhich you now ocially forget, so that this section has a sense of purpose. Similarly, if you wish, you can now assume that you erroneously believe that the probability of an up-move is 10%, rather than the correct 50%, which we have also ocially forgotten. This wont matter, because this method does not use the up/down probabilities at all. Assume that you are standing at the Q3 node where the current electricity price is $49.922/MWh. Further, assume that in Q3 you can buy a forward contract on electricity that prices each unit of electricity in Q4 at $49.9218/MWh. (In other words, you can contract upfront to receive each unit of Q4 electricity at this xed price, rather than take the chance that the price may go up or down.) Note that the forward price need not be the same as the prevailing electricity price in Q3!
Digging Deeper: Think about it: Oranges in spring are not the same commodity as oranges in summer. In fact, in spring, the immediate orange delivery price is usually much higher than the orange forward price for summer delivery. To value by replication, it is important that the good next period is storable. Forward contracts are pieces of paper, so they are easy to store. In Q3, the Q4 electricity forward contract is the same good as electricity in Q4. However, electricity in Q3 is not the same commodity as electricity in Q4because electricity storage is prohibitively expensive. Of course, if the good itself is easily storable (e.g., like gold), it might be as almost good as the storable forward contract. This is because if the commodity were freely storable, arbitrage determines the forward price from todays commodity price. If there is no forward contract available, and if the good is not storable or very expensive to store, valuation by replication is not workable.
You need a forward electricity price, not the current price.
Do you need to know your project discount rate of 2.5% to determine the value of your plant at the uppermost node (P = $49.922) in Q3? No, you do not! If you have forward contracts, each will be worth $59.906in the up-state, and $42.434in the down state. If you buy b treasury bonds, each will be worth b (1 + rF ) next quarter. Thus, if you purchase forward contracts and buy b risk-free bonds such that
$59.906 + b (1 + rF ) = +M$30.599 $42.434 + b (1 + rF ) = +M$15.282 ,
Replicate payoffs by making sure forwards+bonds have the same value in the up-state and down-state as provided by the plant.
(III.20)
then your forward+bond holdings will exactly replicate the payos of your plant. The solution of these two equations are = 0.876 million forward contracts, worth M$$43.589, and b = M$21.381. Conrm by substituting back: you will have +M$30.599 if the value of the 0.876 million forward contracts were to go up from $49.9218/contract to $59.906/contract; and you will have +M$15.282 if the value of the forward contracts were to go down from $50.540/contract to $42.434/contract. Therefore, the value of your plant must be
VQ3,P =$49.922 = $49.9218 + b =
M
$43.762 M$21.915 M$22.381 .
(III.21)
Add to this the current Q3 revenues of M$21.847, and you determine that V = M$44.228the same value you obtained earlier, but without having to provide either the 2.5% discount rate or the actual probability of up/down moves. You instead needed to know the electricity forward price in Q3 for Q4. Knowing one piece of informationeither the forward price vs. the correct probabilities and discount ratesis a perfect substitute for knowing the other. This method is perfectly general. Your plant is just a set of options on electricity forwards. In fact, replication is merely a method of computing the value of a tree node from its two children tree nodes in a dierent way from taking the probability-weighted discounted value. It has little to do with whether the project is currently closed or open, or whether the plant will be closed or open (depending on state) in the next period. It also has nothing to do per s with determining the decision of whether to keep the plant open or not (which depend on these values but not on how these values are obtained).
Replication is a technique for valuing a parent node.
78
Another value computation example.
For example, if you are standing in Q3 and the current electricity price is $25.048, what is the value of a closed plant? Substitute into
$30.057 + b (1 + rF ) = $21.290 + b (1 + rF ) =
M
$3.933 (III.22) $0.00
to obtain = 0.449 and b = M$9.551. If the forward price of electricity is $25.533, then the value of the plant is
VQ3,P =$25.048 = ??$25.56?? + b =
M
$11.43 M$9.52 M$1.91 .
(III.23)
Again, knowing the electricity forward price is a substitute for knowing the discount rate.
Important: Knowing the value of the forward contract on the underlying commodity upon which the real option depends is a perfect substitute for knowing the projects own discount rate and probability of up/down moves in the tree.
Unfortunately, most of the time, you do not know the value of the underlying forward contract.
There are many publicly traded futures and forward contractssuch as oil, pig bellies, oranges, copper, etc.whose publicly known prices can be used to help determine the value of projects that primarily depend upon these commodities. Still, this is the exception rather than the rule. Most corporate projects have revenues that are contingent on quantities for which you do not know the value of the underlying forwardin which case you shall have to return to your original method of estimating up/down probabilities and a reasonable project discount rate.
Digging Deeper: The project discount rate depends on how the project cash ows covary with the overall market. Thus, your tree should write down at each point what the overall market value will be. Of course, this returns us to the world of the CAPM, with all its diculties of estimating a good beta (which you now need to do from the tree), and more so on estimating a good market premium. Fortunately, you can often accept modest mistakes in discount rate estimates.
Even Black-Scholes can sometimes be used!
Finally, if the real option itself has no path-dependenceand very few real projects have none then you are back to a world in which the solution to the binomial tree can be much simpler. Under some additional assumptions, you can even do a value by replication approach using the famous Black-Scholes formula from the Options and Derivatives chapter.
Side Note: When managers claim that they have tried real-options methods, they often mean that they have tried to use the B-S formulaand often their approach is one in which the hammer is looking for the nail. That is, these particular managers are often recent egghead graduates who have a technique and are looking for a problem to use it on, whether it is a good one or not. This is rarely a good idea: your choice of technique should be driven by your problem, not the other way around.
Digging Deeper: Value estimates obtained from the B-S formula or any other option pricing technique (such as your binomial tree) are usually very sensitive to your underlying volatility estimate. The volatility inputwhich determines the up/down ratios in the binomial treeessentially comes from your estimate of the underlying (electricity price) process. Estimating volatility correctly is hard, and if you make mistakes, your value estimate can be far o. But what about the non-replication approach, where you need the discount rate for your project and the probability of up/down moves? Is it more robust? Your simplication of a constant discount rate of 2.5% at each node was almost surely incorrectat some nodes you face less risk than at other nodes. For example, if the price is $17.742/MWh in Q4, you know you will not operate and get the same constant cash ow, no matter what, so the risk-free interest rate would have been enough. Similarly, if the price is $25.048/MWh, the discount rate will be less than if the price is $49.922/MWh. Estimating the proper discount rate and proper probabilities of up and down moves is hard, and if you make mistakes, your value estimate can be far o. You are caught between a rock and a hard place. Valuation is dicult!
le=web-realoptions.tex: RP Section 34. The Sophisticated Method: Time-Series Processes and Monte-Carlo Simulation.
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34. The Sophisticated Method: Time-Series Processes and Monte-Carlo Simulation

You now know how to solve real option problems with pencil and paper if you can write down a good electricity process in a binomial tree. Can you do better than the binomial process if you use heavy statistical artillery to model historical electricity prices, and then use the model to predict the future electricity price? Probably. This is the rst goal of this sectionwe want to develop more general techniques to estimate future electricity prices, upon which your real option valuation ultimately depends. To t into this one chapter, we now assume that electricity price changes are only weekly. We will rely on three computing intensive tools, which must be applied in sequence: 1. Time-Series Data Modeling (to understand the historical electricity price process). 2. Monte-Carlo Simulation (to model the future electricity price process). 3. Optimization (to choose the best policy), more specically Monte Carlo based optimization. O-the-shelf spreadsheets are not especially well suited to any of these tasks, but they are exible enough to be contorted to work each one. (The example spreadsheet used for this problem is on the books website at http://welch.econ.brown.edu/book.) Morevoer, there are a number of vendors selling spreadsheet add-ons to make these three processes simpler. Even better tools leave the realm of spreadsheets and/or require programmingthe best would be a statistical program for time-series data modeling, a program for Monte Carlo simulation, and a programming library for optimization within the Monte Carlo simulations. 34.A. Statistical Data Modelling: Understanding The Historical Electricity Process Statistical modeling is not the domain of nance, but the domain of statistics. This domain is so large that there are literally thousands of books and professors, showing how it can be done. This chapter can only give you a taste of what can be done. Of course, if you are truly better than your competition in modeling time series, then you can predict the future betterand thus probably get very wealthy very quickly. An ability to forecast better would be a huge skill.
We can only do a tour of statistics. You can allow non-binomial processes.
The 3 main tools.
Figure III.8. Average Weekly Wholesale Price of Electricity Per MWh at the California Power Exchange in 1999.
60 elec.price 20 0 30 40 50
10
20
30 Index
40
50
80
Here are 4 modeling options.
Your rst task is to settle on a suitable model for electricity prices. Figure III.8 plots the historical time-series from Table III.1. How can you model this process? You have many choices, among them the following four: 1. You can model electricity prices as being drawn from a stationary distribution:
Pt = a + noiset1,t . (III.24)
Price is constant plus noise.
This process is equivalent to drawing a straight horizontal line in the graph. Table III.1 shows that your best estimate for a would be its historical mean of $28.09, and you would believe that the noise has a standard deviation of $10.11. This process does not t the historical data: For example, prices in February were all clustered around $18-$19. Prices in November and December were mostly about $30. If formula III.24 were accurate, it would be highly unlikely that your historical prices would have been as persistent as they were. Thus, you can conclude that this is probably not a good process to describe history.
Price is constant and trend plus noise.
2. You can model prices as being driven by a trend:

Pt = a + b Week Numbert + noiset1,t . (III.25)
This process is equivalent to drawing a slightly diagonal line from about $18 in the rst week to about $40 in the last week. Although better, this process does not t your data too well, either. It is true that the ending price was higher than the starting price, but the trend is not that of a constant increase. Specically, after October, the price fell and staid low. (But even in earlier weeks, such as week 30, your best forecast would likely not always be a point on the straight diagonal line. Instead, prices seem to be sticky.)
Price is driven by something else you already know.
3. You can model prices as being driven by some third variable that you know today. For example,
Pt = a + b Known Stock Pricet52 + noiset1,t . (III.26)
Alas, you have neither reason to believe that the stock price one year ago is indicative of the future electricity prices, nor is it likely that you know any good variables today with which to predict future electricity prices. (However, there are situations in which other historical variables do predict well. For example, an airplane takes one year to build. Purchases of airplane parts by manufacturers can be good predictors of nished airplane production one year later.)
AR processes are often the best modeling choice for time-series.
4. You can model prices as being related to past prices. Such processes are also often called univariate time-series processes, because there is only the one variable itself in the model. A common univariate time-series specication is the auto-regressive process (AR process), in which the current value depends on past values:
AR(n) : Pt = c0 + c1 Pt1 + c2 Pt2 + ... + cn Ptn + noiset1,t . (III.27)
You have already seen at least one such process: a simple random walk is Pt = 0+1Pt1 , a special form of an AR(1) process. Supercially, this process seems to t electricity prices: weeks in which the prices were high (low) are more likely to be followed by weeks in which the prices were still high (still low). Figure III.9 makes this even easier to see: it plots the current electricity price against last weeks electricity price. Indeed, it appears as if the weekly price does have an inuence on the next weekly price.
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We now specify the regression to estimate the AR process.
Lets settle on a simple AR(1) autoregressive process, called AR(1) because we posit that only the most recent price (1 lag) has any inuence:
Pt = a + b Pt1 + noiset1,t . (III.28)
To determine the best coecients a and b, you must estimate a linear regression. (In Excel, this requires loading the Analysis Toolpak in the Tools/Data-Analysis menu. In OpenOce, you can use the LINEEST facility.) In regression terminology, Pt is the dependent (Y ) variable, and Pt1 is the independent (X) variable. So, create a column next to the actual electricity price that is the past electricity price. (The column is shifted down one, with the end points suitably truncated.)
your Y A 1 2 3 4 5 6 Week Jan1-Jan2 Jan3-Jan9 Jan10-Jan16 Jan17-Jan23 ... B Cur Prc 12.89 23.14 24.13 20.78 ... your X C Lag Prc #N/A 12.89 23.14 24.13 ...
You can now instruct your spreadsheet to estimate a regression with Y being the B-column and X being the C-column. The Excel regression output is in Table III.2.
Excel can estimate good AR(1) parameters.
Table III.2. Excel Regression Output Estimating Pt = a + b Pt1 + noiset1,t

SUMMARY OUTPUT
Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.709117 0.502848 0.492905 7.105866 52
ANOVA df Regression Residual Total 1 50 51 SS 2553.59 2524.666 5078.254 MS 2553.59 50.49332 F 50.57278 Signicance F 4.01E-09
Coecients Intercept X Variable 1 8.920441 0.693261
Standard Error 2.909205 0.097485
t Stat 3.06628 7.111454
P-value 0.003492 4.02E-09
... ... ...
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Collect what you need for the next step: First, the coefcients.
Your rst step is to read o the coecients. The estimated process is

Pt 8.92 + 0.69 Pt1 + noiset1,t . (III.29)
Figure III.9 plots the price of electricity as a function of the past price. The tted AR(1) line (y = 8.92 + 0.69 x) is also plotted in the gure. The gure conrms that there is a strong relationship between the lagged electricity price and the current electricity price.
Figure III.9. Electricity Price Vs. Previous Electricity Price.

60 elec.price 20 30 40 50
20
30
40 elec.price.lag
50
60
Collect what you need for the next step: Second, the noise variability.
You second step is to estimate the variability of your forecast error. The more variable the noise, the more valuable your real option. (The mean of noise is always 0.) The regression output informs you that the noise has a standard deviation of 7.1058... . What do your residuals look like? Figure III.10 plots them. You only have 51 data points, so the histogram is not perfect. Still, with some imagination, you can see that your electricity residual seems to follow a somewhat bell-shaped distribution. Thus, you may take the liberty of assuming that your noise is distributed as if it were drawn from a normal distribution with a mean of 0 and a standard deviation of 7.1.
Digging Deeper: There is also other interesting price information in the regression output. The R 2 tells us that you can explain about 50% of the variation in the electricity price. The t-statistic on the X-variable is above 7, indicating very high statistical signicance. (PS: We are ignoring some special issues with time-series process, called stationarity, which will prevent the coecient estimate on Pt1 to approach 1 even if the underlying process has a coecient of 1.)
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Figure III.10. Histogram of AR(1) Residuals (Noise).

20 Frequency 0 5 10 15
10
0 Value
10
20
Digging Deeper: Your model is probably not the best process. First, you did not explore further lagged price terms. However, exploration shows that this happens not to matter: further lags have no extra signicance. Second, your relation in Figure III.9 exhibits heteroskedasticity: that is, when the electricity price is high, the residual also tends to be high. You could improve both your coecient and risk estimation if you took this into account. For simplicity, we wont. Third, you are ignoring seasonalities. (Of course, here you do not have the data from earlier years to model it, anyway.) Fourth, even in your process, you are actually underestimating your uncertainty: you also have parameter uncertainty (about a and b), and farther out prices tend to have more parameter uncertainty. Fifth, your process allows the electricity price to become negative. This is an avoidable aw: A better alternative may be to estimate the price process in logarithms instead of levels. Here is how you could do this: Estimate
log
Pt Pt1
= a + b log
Pt1 Pt2
+ c log
Pt2 Pt3
+ ... + noiset1,t .
(III.30)
A good process is estimated to be
log
Pt Pt1
= 0.0087 + (0.279) log
Pt1 Pt2
+ noiset1,t ,
(III.31)
where the noise has a residual standard error of 0.2179. To use this model to predict, start with the two nal prices in the series, $28.31 and $28.89. The log of their ratio is 0.02028. Thus, your prediction would be
log
Pt Pt1
= 0.0087 + (0.279) 0.02028 + noise 0.00304 + noise .
(III.32)
Given the price of $28.89, you would thus predict
log
Pt $28.89
= 0.00304 + noise
Pt $28.98 enoise .
(III.33)
Should you put all faith in this deus ex machine of modeling? No. In many situations, there is inadequate historical data to build a quantitative model of the future. In other situations, realworld experience and qualitative judgment are outright better tools than quantitative modeling. But most often, the best practice combines practical experience with quantitative modeling. It is not dicult to informally incorporate soft qualitative information into your hard quantitative price process. For example, you may have additional information that is not contained in historical prices. You may know that Congress has just passed an energy subsidy, which will lower the electricity price by $1/MWh. You could use this knowledge to reduce the constant from 8.92 to 7.92. Or, you may know that next year, a new uptrend in electricity prices may
Use soft information to improve quantitative forecast.
84
occur that will increase the time-series coecient by 0.05. Or you may know that next years electricity price uncertainty will be higher than this years, so you may choose to increase the standard deviation from 7.1 to 10.0.
Solve Now!
Q III.10 Is it typically better when an estimated process has residuals that have lower variance?
Q III.11 Estimate the constant model and the trend model from the text. Do they t better? Do their residuals have more or less variance than the AR(1) process?
Q III.12 Estimate an AR(2) model. Does it t better? Do its residuals have more or less variance than the AR(1) process?
34.B. Monte Carlo Simulation: Modeling The Electricity Price Future

Your starting point is the electricity time-series process. How to generate random numbers that are (Gaussian) normal.
You now have an estimate of the time-series process driving electricity prices. Your next step is to use your process to simulate a model of the futurea testbed upon which you can test out operating strategies. Both Excel and OpenOce have built-in random number generators. The functions are called RAND(), and return a uniformly distributed random number. To produce a random number from a bell-shaped normal distribution, you need to use the NORMSINV() function, which translates the uniform random number into a normally distributed random number with a mean of 0 and a standard deviation of 1. You want the noise to have a standard deviation of 7.1, so you must multiply it by 7.1. So the formula to obtain a single simulated residual is
= 7.1 NORMSINV(RAND()) . (III.34)
If you were to repeat this a million times, you would nd that the distribution of these values indeed looks like a bell-shaped curve with a mean of 0 and a standard deviation of 7.1.
How to generate a single price scenario (all 52 weeks).
You can now generate possible future price scenarios, each being one column. Each scenario starts with the last known price in 1999 of $28.89in the rst row. The next price, in row 3 below, is the formula
Pt = 8.92 + 0.69 Pt1 + 7.91 NORMSINV(RAND()) (III.35)
Some sample future price scenarios so generated might be:

A 1 2 3 4 5
A B
B Week Scenario 1 28.89 23.54

A
H Scenario 2 28.89 33.92

B
N Scenario 3 28.89 35.72

B
T ... ... ... ... ...
12-1999 1 2 3
36.28B 41.01B
21.83B 38.89B
31.84B 26.53B
The formula in this cell is: = 8.92 + 0.69 B2 + 7.91 NORMSINV(RAND()). The formula in this cell was copied as a formula from A. The spreadsheet automatically changes the reference.
Upon a recalculation (the F9 key), the spreadsheet will draw new random values (due to the RAND() function use), and dierent price scenarios will appear.
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Solve Now!
Q III.13 Replicate the spreadsheet in Table ??. Stare at what happens when you recalculate repeatedly ( F9 ).
34.C. A Detour: Comparing Electricity Price Processes You now have two electricity price processes for the future: the simple binomial one, posited in the previous section, and the time-series estimated process, posited in this section. How do they dier? Figure III.11 plots the distribution of the average electricity price just in the nal fth quarter. The line with the smooth spikes is your binomial process; the squiggly line is the simulation of the weekly time series process (Formula III.29 on Page 82). Note that it can be rewritten as
Pt 8.92 + 0.69 Pt1 + noiset1,t
Comparing the binomial process with the time-series estimated process.
(III.36)
= (1 0.69) 28.77 + 0.69 Pt1 + noiset1,t ,
which states that the price is a weighted average of the last price and $28.77. Thus, the long-run tendency of the electricity price is to return to $28.77, but only about 31% of any deviation from $28.77 is typically corrected in the following week. Such a process is called mean-reverting, and it is intuitively the reason why the electricity price tends not to wander too far away from $28.77. Inspection of Figure III.11 shows that, although the two processes have similar means, medians, and most-likely price in the fourth quarter, they nevertheless dier drastically: the binomial process is a lot more variable than the time-series process. Thus, your new electricity price processfrom the time-series estimation in this sectionwill cause your estimate of the value of the plant to be lower than it was under the binomial process of the previous section. The real option to shut down and reopen once per quarter will be estimated to be less valuable.
The mean reversion causes lower variance!
Solve Now!
Q III.14 How would Figure III.11 look if the process were

Pt = (1 0.1) 28.77 + 0.1 Pt1 + noiset1,t , (III.37)
and
Pt = (1 0.9) 28.77 + 0.9 Pt1 + noiset1,t , (III.38)
Q III.15 How would Figure III.11 look if the time-series process had noise with a standard deviation of $1 instead of $7.1?
Q III.16 Warning: Tedious. Warning: Solve only if you know statistics. Set the electricity price change in a down move to 0.89 (a 11% change), and the up price move at 1.11 (+11%). Compute the electricity price mean and standard deviation of this process in the nal quarter. Repeat the binomial tree valuation.
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Figure III.11. Comparing Processes Predicted Electricity Prices in the 5th Quarter
Density 0.00 0.05
0.10
0.15
20
30
40
50
60
Average Electricity Price, 5th Quarter

The smooth spikes represent the binomial distribution used in the previous section. Its mean is $31.89, its standard deviation is $11.13. The squiggly distribution is from 50,000 simulations of the time-series estimated process Pt 8.92 + 0.69 Pt1 + noiset1,t , where the noise has a standard deviation of $7.1. In the nal quarter, the average electricity price is $28.77 with a standard deviation of $6.31..
34.D. Exploring the NPV of One Particular Heuristic Strategy

How to model your behavior: a managerial strategy is a pair of critical prices.
As a manager, what strategies can you choose? Your managerial strategy is a rule that decides whether to operate or not to operate your turbines. You can condition your choice on the current state of the plant and on the current electricity price. For example, you may follow the heuristic strategy If the plant... was running (t 1) was shut (t 1) Operate If Pt $24 Pt $26 Close If Pt < $24 Pt < $26
Table III.3 shows how you obtain the plant NPV given this strategy and given one particular price scenario. Note how we keep the critical strategy values in D1 and D2, so that you can easily try other strategies later.
Keep track of the plants operating state.
In the C column (next to the price column B), you keep the current state of your plant. It contains the formula
If(Ot1 = 1,
then
If(Pt > 24, If(Pt > 26,
then
1,
else
0), (III.39)
else
then
1,
else
0)) .
87
Keep track of operating state change costs.
In the D column, you keep track of incurred reopening costs ($500,000) and incurred reclosing costs ($200,000) with the formula
If(Ot1 = 1,
then
If(Ot = 0,
then
500, 000,
else
0), (III.40)
else
If(Ot = 1,
then
200, 000,
else
0)),
In the E column, you compute the revenue (0 if you are not operating),
If(Ot = 1,
then
7 24 400 (Pt $25),
else
0) .
(III.41)
Keep track of electricity sales. Then add it all up and discount it appropriately.
In the F column, you keep the appropriate discount factor. Assume that the beta of the plant with the stock market is such that the appropriate quarterly discount rate is 2.5%.
Dt = Dt1 . (1 + 2.5%)1/13 (III.42)
The G column contains the (suitably discounted) cash ows to obtain the value, given your assumed simulated price at this point, and given your particular strategy heuristic. The sum of all numbers in the G column is the net present value of the cash ows for ve quarters (65 weeks), given your simulated price process. Each time F9 is pressed, the spreadsheet recalculates: it draws a new set of random numbers, which ultimately results in a new NPV in cell G60. The average of many (thousands) of such price scenarios is the expected NPV of your plant given the one heuristic strategy (opening and closing critical prices) that you are exploring. How many dierent price path scenarios should you entertain? Of course, the more the merrier. But, are 100 enough? Are 1,000 enough? This depends on the situation and the computing power available. In our case, about 10,000 draws generate reliable values. But even only 100 draws (possible futures) are better than assuming that there is only one possible future! Alas, writing down the many thousands of possible NPVs to nd the correct NPV of the project is painful. You need some automation: you want to recalculate, and then store away the single outcome price-scenario G72, so that you end up with thousands of single outcome pricescenario G72 calculations, over which you can compute the grand average. You have three choices: You can learn the OpenOce macro language, and/or rely on the OpenOce macro in Appendix Section a below. (This is my own choice.) You can learn the Excel macro language, and/or rely on the Excel macro in Appendix Section b below. You can spend $1,500 to purchase an add-on for Excel called Crystal Ball, which does these simulations in a much more convenient manner.
Digging Deeper: This technique also allows keeping track of other interesting statistics. For example, you may want to know how frequently you shut down or reopen your plant. Or you may be interested in how often you experience cash crunches. For example, you can build a spreadsheet that starts with a cash balance of say, $1 million, and each week adds current revenues. If you go below a critical value, the company would be declared cash-crunched, and you could determine how often you would end up in such a bankrupt state.
Each random price scenario gives a different NPV outcome for a specic strategy.
Writing a spreadsheet macro?
Solve Now!
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Table III.3. Single Price Scenario Valuation under Given Heuristic Strategy
A 1 2 3 4 5 6 7 8 9 10 11 ... 70 71 72 One NPV: $27,172,047Q Week 12-1999 1 2 3 4 5 6 ... 65 Price $28.89A $23.69B $21.23 $18.79
C C
D $24 $26
F Shutting Cost Opening Cost
G $200,000 $500,000
Strategy: Critical Shutdown Price if Operating: Strategy: Critical Opening Price if Shut:
State 1D 1E 0 0
F F
Chg-Cost $0G $0H $200,000 $0

I I
Oper.CF $261,408J $87,780K $0 $0

K K
DiscFct 1.00L 0.9981M 0.9962

N N
DiscCF
not yet ours
$87,614O $199,242P 0P $150,016P $358,493P $366,683P ... $39,697
0.9943
$30.19C $30.39
C
1F 1
F
$500,000I $0
I
$348,840K $361,914
K
0.9924N 0.9905
N
$30.52C ... $25.67C
1G ... 1G
$0I ... $0I
$370,885K ... $44,914K
0.9887N ... 0.8839N
A B CF D E
Known Starting Value, $28.89 Formula: = 8.92 + 0.69 B5 + 7.91 NORMSINV(RAND()).

B formula is your modelled price process.
Copied Formula From B (The spreadsheet updates the references). Known Starting Value, Plant Operated. Formula: = if(C5 = 1, if(b6 < $D$1, 0, 1), if(b6 > $D$2, 1, 0)).
E formula says if you operate, and price is too low, stop; if you do not operate and price is too high, start.
F G H I J K L M N O P Q
Copied Formula from E (The spreadsheet updates the non-dollared references). Known Starting Value: 0. (No Cost) Formula: = if(C6 = 0 and C5 = 1, $G$1, if(C6 = 1 and C5 = 0, $G$2, 0))
H formula says if you just switched plant state, you have to pay.
Copied Formula from H (Spreadsheet updates non-dollared references). Formula: = if(C5 = 1, 7 24 400 (B5 25), 0).
this is operating revenues IF you operate.
Copied Formula from J (Spreadsheet updates references). Known Discount Factor Value Today: 1. Formula: = F 5/(1 + 0.001901237).
each week, the discount factor declines by (1 + 2.5%)1/13 .
Copied Formula from M (Spreadsheet updates references). Formula: = F 6 (D6 + E6).

PV is sum of revenues and opening/shutting costs.
Copied Formula from O (Spreadsheet updates references). Formula: = sum(G6 : G70).

Q sum is one simulation NPV, not the average NPV!
Sidenote: the only dierences between Excel and OpenOce are [1] that the latter uses semicolons as separators in the IF statement, while the former uses commas; and [2] the logical AND is written as C6=0 and C5=1 in Excel and as AND(C6=0;C5=1) in OpenOce.
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34.E. Optimizing For the Best Managerial Strategy by Trial-and-Error (Monte Carlo) You now have all the necessary tools to nd the best strategy. Each strategy is a pair of critical prices (at which you reopen, and at which you reclose). Given a strategy, you know how to obtain a plant NPV, using many thousand simulated price scenarios. Thus, you can now try out dierent strategies, and experiment until you nd the strategy pair that yields the maximum NPV. It is relatively easy to try out broad strategies such as ($25,$25), ($24,$26), ($24,$30), etc., to get a good idea of an approximate reasonable strategy. With 50,000 price scenarios, my own average NPV results for some symmetric strategiessymmetric because the critical prices center around your cost of $25are in Table III.4.
Try many different strategies to determine a good strategy.
Table III.4. NPV and Frequency of Plant Changes under Various Heuristic Strategies
Symmetric Strategies Reclose if price is below $25.00 $24.00 $23.00 $22.00 $21.00 $20.00 $19.00 $18.00 $17.00 $16.00 $15.00 $10.00 $5.00 $0.00 Reopen If price is above $25.00 $26.00 $27.00 $28.00 $29.00 $30.00 $31.00 $32.00 $33.00 $34.00 $35.00 $40.00 $45.00 $50.00 Strategy NPV $22.5 $23.1 $23.6 $23.8 $23.9 $23.8 $23.6 $23.4 $23.0 $22.6 $22.2 $19.7 $17.5 $16.6 Frequency of Close/Reop 24% 21% 18% 16% 14% 12% 10% 9% 8% 7% 6% 3% 1% 0%
If you try out additional price pairs not in Table III.4, you will nd that the best symmetric strategy is about $21.08 and $28.92 in my simulations, producing $23.9 million in NPV. Fortunately, the dierence between a strategy of ($21.00,$29.00) and even ($22.00,$29.00) is typically relatively modest, which means that there is no need to optimize the strategy down to the last centyour price model uncertainty is considerably worse than your Monte Carlo accuracy. Incidentally, the last column in Table III.4 is an unnecessary fun statistic that you can keep track of: it describes the frequency with which you see a change in operating procedure (a closed plant reopening or an open plant reclosing). If you ignore reopening/reclosing costs that is, your strategy asks for shutting down and reopening at P = $25you are changing plant state in about one in four weeks. If you are smarter, at your optimal strategy, you would incur the reopening/reclosing costs only in about 14% of all weeks.
Digging Deeper: There are some numerical optimization pitfalls. This is due to the random nature of the price path scenariosit is better to compare multiple strategies on the same price paths than each strategy on its own set of price paths.
Do not look for too much accuracy.
Other fun statistics.
We are pretty much done. Lets just recap the performance of dierence strategies and scenarios. If you set the costs of reopening and reclosing in your program to zero, you end up with a non-path-dependent plant value of $27.8 million. Similarly, if you set the cost of reclosing the plant to a huge number, you end up with a non-path-dependent plant value of $15.9 million. You have already computed the optimal strategy, given changing costs, above as shutting down if the price falls below $21 and reopening if it goes above $29: the NPV is $23.7 million.
Different strategy scenarios in overview.
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Side Note: For sick fun, I wrote a program that estimates the value if you allow only quarterly plant changes, so that in comparing with the value estimates from the previous section, you can see what is due to our ability to change more often, and what is due to our dierent price processes. This value is $16.2 million, because the mean reversion makes it very rarely optimal to close down for a full quarter even at a low price. This is much below the $25.197 million from the previous section, so you can conclude that our revised price process plays a very important role in our value estimate.
Always Operate Plant Quarterly Changes Permitted

(Changing is rarely optimal, due to the mean-reversion)
$15.9 million $16.2 million
Weekly changes permitted, with changing costs

($21.00 and $29.00 critical values)
$23.7 million
Weekly changes permitted, no changing costs
$27.8 million
Solve Now!
Q III.17 Replicate the table with the ultimate payos. Are your results exactly the same?
Q III.18 Why is the NPV of $23.7 million less than the $28.6 million that you computed in a back-of-the-envelope fashion in Section 32.B?
Q III.19 What is the average NPV for the ($15,$25) strategy; i.e., if you shut down an operating plant when the electricity price drops below $15, and reopen a shut plant when the price is above $25? Is it better or worse than the ($25,$25) strategy?
Q III.20 What is the average NPV for a ($13,$27) strategy; i.e., if you shut down an operating plant when the electricity price drops below $13, and reopen a shut plant when the price is above $27? Build a spreadsheet to explore this strategy.
34.F. Discussion
The techniques from this chapter are powerful. Use them for: Better process estimation.
The three techniquesstatistical modeling, Monte Carlo simulation, and optimizationcan handle a wide range of problems. Here are some examples: You could replace the price process with a more sophisticated model that takes into account such factors as seasonalities, the reality that prices cannot go negative, nonnormal error distributions, etc. You could value dierent kinds of real options. For example, the factory may not be reopenable for 1 month once shut down. Or, you might be able to produce more output by adding another $300,000 in maintenance per week. Each of these constraints/options would require clever additional if-then expressions in the spreadsheet to model them. But all modeling principles would remain the same. You could explore non-symmetric strategies (in which the price to reopen the plant might have been $30 and the price to reclose it might have been $24). The computational optimization complexity would increase, but the methods would remain the same.
Other types of real options.
Other kinds of strategies.
91
Multivariate processes (e.g., to estimate beta).
You could not only model the electricity price as a univariate time series process, but as a process that has a correlation with the stock market. (Perhaps the stock market goes down when electricity prices rise.) In this case, you would have an additional column with simulated stock market returns, and you could determine what the correlations of your strategized cash ows with the stock market would be. This would eventually give you a market-beta, which would help you improve on your cost of capital estimate (here, 2.5% per quarter). You could model your cash position. For example, you may start with $1,000,000 in cash, and the operating cash ows net of transaction costs cumulate into your cash position. If your cumulative cash balance ever falls below $0, you could introduce additional costs (either to borrow more cash, or to model your bankruptcy costs). You could then use this to determine whether you really need $1,000,000 in cash, or whether you can settle for $500,000. (Monte Carlo methods are probably the right way to think about managing working capital!) You could also easily obtain estimates of the uncertainty. For example, how likely is it that you will end up with an NPV that is below $20 million? More than $30 million? This is easy to compute: instead of computing the mean NPV over your 50,000 price scenarios, just count the fraction of outcomes that satisfy your criterion. The combination of these three techniques is tremendously powerful, but using them requires a good amount of sophistication and experience. However, do not be deceived: there are many real-world problems that may be in principle solvable with these techniques, but that in practice may require more time to solve than the universe has seconds. (This typically happens with multi-dimensional sources of uncertainty and multiple strategy choices.) So, in the end, these quantitative techniques often help with critical choices, but only after economic qualitative knowledge has been used to suitably simplify the problem. And, never forget the most important test: have you used common sense in your model inputs, and does the model output make sense to you? If not, dive deeper into your model. Never use a black box that you do not understand and that does not make sense to you.
Keeping track of cash and avoiding cash crunches.
Estimate project risk (losing your job!).
OK, so the techniques are not easy. But they are exible and often extremely useful.
Solve Now!
Q III.21 Assume that you start with a cash position of $550,000. How likely is it that you will run out of cash in any one week, if you follow strategy ($25,$25) vs ($20,$30) vs. ($15,$35)? Assume you earn no interest.
92
35. Summary
The chapter covered the following major points: Real options are embedded in real production activities. They are the value of your future exibility. Real options are more valuable when there is more uncertainty about the future. Combine both quantitative and qualitative information when assessing the value of real options and when simulating plausible futures. Some problems are more suited to the former (e.g., uncertainty for which you can get data from a long history); other problems are more suited to the latter (e.g., a mission to Mars). You can work many real option problems with a binomial tree. The two rules to remember are work backwards, and keep track of the current state of your plant. Path-dependent trees are more complex, because the best action at any given node depends not only on the current node, but also on the state of the asset (which depends on the path you took in the tree). Path dependence often arises if there are costs to changing. Valuation by Replication is not a requisite tool to valuing real options. However, in the occasional case where forward contracts on the underlying risky basis are available, it can become a useful alternative to estimating ones own discount factor and future probabilities of better/worse times. This can make value calculations in the binomial tree more reliable. If you abandon binomial trees, you can instead rely on more general modeling of the underlying uncertainty. That is, you can use statistical forecasting to estimate both mean and uncertainty. You can model/simulate the future, given the statistical properties that worked in the past. You can always informally add qualitative knowledge to your quantitative estimates. Scenario analysis can help you understand the range of possible future outcomes. Each scenario is the outcome in one particular future price scenario. Monte Carlo analysis can automate scenario analysis.
le=web-realoptions.tex: RP Section A. Advanced Appendix: Monte Carlo Repeated Drawing.
93 Appendix
A. Advanced Appendix: Monte Carlo Repeated Drawing

The following are spreadsheet macros that instruct their spreadsheets to recalculate a formula, and copy the results of each scenario into a range of cells. The formula itself can be as complex as the user desires, as it can be copied from spreadsheet calculations anywhere. The number of iterations in these particular macros is handled dierently: it can be set in the macro in OpenOce and in the spreadsheet itself in Excel. The functionality of the macros is basically the same. a. An OpenOce Macro
REM REM REM REM REM REM REM REM REM REM REM REM REM REM REM REM REM REM ***** BASIC for OpenOffice calc *****
(C) Ivo Welch, 2004. The input NPV must be in cell $G$72. (you can change this.)
Each individual simulated NPV is put into cell $I$73, and earlier simulations will be pushed downward (beginning with $I$73). Thus, the function can be executed as often as desired, and more simulation outputs will thereby be added. To restart with a new strategy or simulation, just erase the entire column I with all its numbers. Your spreadsheet can then compute the mean and standard deviations of column I, as is done in the sample spreadsheet provided on the books website. You can also download this macro by downloading the OpenOffice spreadsheet used to work our electricity plant example.
REM ---------------------------------------------------------------------REM run_500_simulations makes this faster. sub run_500_simulations for counter=1 to 500 record_one_simulation_run next counter end sub
REM ---------------------------------------------------------------------sub record_one_simulation_run REM ---- ooffice bookkeeping: define variables dim document as object dim dispatcher as object REM ---- ooffice bookkeeping. get access to the document document = ThisComponent.CurrentController.Frame dispatcher = createUnoService("com.sun.star.frame.DispatchHelper") REM ---- now our own macro begins. first, go to cell $G$72 and copy it. dim args1(0) as new com.sun.star.beans.PropertyValue args1(0).Name = "ToPoint" args1(0).Value = "$G$72" dispatcher.executeDispatch(document, ".uno:GoToCell", "", 0, args1()) dispatcher.executeDispatch(document, ".uno:Copy", "", 0, Array()) REM ---- now, go to $I$72 and copy it; dim args3(0) as new com.sun.star.beans.PropertyValue args3(0).Name = "ToPoint"
94
args3(0).Value = "$I$72" dispatcher.executeDispatch(document, ".uno:GoToCell", "", 0, args3()) dim args4(5) as new com.sun.star.beans.PropertyValue args4(0).Name = "Flags" args4(0).Value = "SVDNT" args4(1).Name = "FormulaCommand" args4(1).Value = 0 args4(2).Name = "SkipEmptyCells" args4(2).Value = false args4(3).Name = "Transpose" args4(3).Value = false args4(4).Name = "AsLink" args4(4).Value = false args4(5).Name = "MoveMode" args4(5).Value = 4 dispatcher.executeDispatch(document, ".uno:InsertContents", "", 0, args4()) REM ---- make it a dollar formatted figure dim args6(0) as new com.sun.star.beans.PropertyValue args6(0).Name = "NumberFormatValue" args6(0).Value = 103 dispatcher.executeDispatch(document, ".uno:NumberFormatValue", "", 0, args6()) REM ---- finally, paste it. dim args5(0) as new com.sun.star.beans.PropertyValue args5(0).Name = "Flags" args5(0).Value = "V" dispatcher.executeDispatch(document, ".uno:InsertCell", "", 0, args5()) end sub
b. An Excel Macro
Ken Wieler was kind enough to create this Excel macro for me. Sub RunMonteCarlo() Dim intStartRow As Integer, intEndRow As Integer Read in Start and End Values strStartCell = Range(B1).Value strEndCell = Range(B2).Value Find actual row number intStartRow = Right(strStartCell, (Len(strStartCell) - 1)) intEndRow = Right(strEndCell, (Len(strEndCell) - 1)) Find out Column and make sure the start and end are in the same column strStartCol = UCase(Left(strStartCell, 1)) strEndCol = UCase(Left(strEndCell, 1)) If strStartCol <> strEndCol Then Exit Sub End If Blank the range of Cells Range(strStartCell, strEndCell).Value = (") Do While intStartRow <= intEndRow strWriteCell = strStartCol & intStartRow strValue = Range(B3).Value Range(strWriteCell).Value = strValue intStartRow = intStartRow + 1 Loop End Sub
In the Excel sample output below, you merely compute the NPV if the outcome from operating next year is uniformly distributed between $400 and $600, but a guarantee exists that oers $500 as the minimum. The spreadsheet calculates that at a discount rate of 5%, the NPV of this project is around $505, although the standard deviation is plus or minus $30.
le=web-realoptions.tex: RP Section A. Advanced Appendix: Monte Carlo Repeated Drawing. A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 Expected Value Standard Deviation $504.57 $31.29 If Operating If Not Operating Discount Rate $513.87 $500.00 5%
a random variable, uses rand()
95
C D $476.19 $490.88
=B5; think transfer station
B D1 D20 $489.40
Your Starting Cell is: Your Ending Cell is: To-Be-Copied Result
$555.32 $543.40
My Result (e.g., NPV)
$489.40
=max(b7,b8)
$476.19 $476.19 $536.20 $476.19 $476.19 $527.91 $476.19 $476.19 $542.77 $507.82 $476.19 $540.24 $476.19 $549.21 $535.82 $476.19
Entries in C3C7 describe entries to the left; entries in C22C23 describe entries to the right.
96 c. A C++ Program To Work Out the Binomial Tree
In case you are a computer programmer with good knowledge of C++, you may enjoy the following recursive program that solves for the price of the plant in the binomial case.
#include <stdio.h> #include <assert.h> // // Sep 2005: This is a recursive function that solves the binomial // tree example in the real options chapter. The answer is something // like 25.01168. // /****************************************************************/ static const double revenues(const double p) { return 400*2191.5*(p-25); } static const double revmill(const double p) { return revenues(p)/1000000; } const static int OPEN=1; const static int CLOSE=0; static struct params { double closingcosts; double openingcosts; double upfrac; double dnfrac; double r; params() { init(0.2, 0.5, 1.2, 0.85, 0.025); } public: void init(const double cc, const double oc, const double u, const double d, const double rin) { closingcosts=cc; openingcosts=oc; upfrac=u; dnfrac=d; r=rin; } } p; /****************************************************************/ const double presentvalue(const double price = 28.89, const int state =OPEN, const int quarter =0, const struct params p =p) { // sanity checks assert(price<1000.0); assert(quarter<=5); assert( (state==0) || (state==1) );
double p_up = (price*p.upfrac); double p_down = (price*p.dnfrac); double ret_val; const char *say_action, *say_stateis; double say_netrev; if (state==OPEN) { const double pcomeopen_doclose = (-p.closingcosts) + ((quarter>=4) ? 0.0 : (0.5* presentvalue(p_up, CLOSE, quarter+1, p) + 0.5* presentvalue(p_down, CLOSE, quarter+1, p))/(1.0+p.r)); const double pcomeopen_keepopen = revmill(price) + ((quarter>=4) ? 0.0 : (0.5* presentvalue(p_up, OPEN, quarter+1, p) + 0.5* presentvalue(p_down, OPEN, quarter+1, p))/(1.0+p.r)); ret_val= (pcomeopen_doclose > pcomeopen_keepopen) ? pcomeopen_doclose : pcomeopen_keepopen; say_action = (pcomeopen_doclose > pcomeopen_keepopen) ? "-do-close--" : "-keep-open-"; say_netrev = (pcomeopen_doclose > pcomeopen_keepopen) ? -p.closingcosts : revmill(price); say_stateis = "is-open"; } else { const double pcomeclosed_doopen = (revmill(price)-p.openingcosts) + ((quarter>=4) ? 0.0 : (0.5* presentvalue(p_up, OPEN, quarter+1, p) + 0.5* presentvalue(p_down, OPEN, quarter+1, p))/(1.0+p.r)); const double pcomeclosed_keepclosed = (0.0) + ((quarter>=4) ? 0.0 : (0.5* presentvalue(p_up, CLOSE, quarter+1, p) + 0.5* presentvalue(p_down, CLOSE, quarter+1, p))/(1.0+p.r)); ret_val = (pcomeclosed_doopen>pcomeclosed_keepclosed) ? pcomeclosed_doopen : pcomeclosed_keepclosed ; say_action = (pcomeclosed_doopen > pcomeclosed_keepclosed) ? "--do-open--" : "keep-closed"; say_netrev = (pcomeclosed_doopen > pcomeclosed_keepclosed) ? revmill(price)-p.openingcosts : 0.0; say_stateis = "is-clsd"; } for (int i=0; i<quarter; ++i) putc( , stdout); // add some indentation printf("Q%d: Price=%.3f, enter %s(=%d): Optimal=%s (Rev=%.3f, PV=%.3f)\n", quarter, price, say_stateis, state, say_action, say_netrev, ret_val); return ret_val; } int main() { printf("The present value is %.5f\n", presentvalue()); return 0; }
le=web-realoptions.tex: RP Section A. Advanced Appendix: Monte Carlo Repeated Drawing.
97 Solutions and Exercises
1. Yes. If the variance is suciently high, your real option may be more valuable. 2. At $28 production cost, at an average output price of $28.09, the rst technology would have earned us 9 cents per MWh, which would come to $315,360 in revenues. At $29 production cost, there would have been 18 weeks where production was worthwhile ($32.26, $40.80, ..., $31.26), with an average price of $39.13. Thus, the revenues would have been 400 18 7 24 $10.13 $12 million. Clearly, in the typical week, the rst technology would provide a better outcome, but it is not the higher PV technology! 3. Variable cost.
4.
Do it! As an aid, if P = $29.468, the current net revenue is R(P ) = +M$3.916. The expected discounted downstream value if operating is either $18.700 or $2.107, for an expected net revenue of M$10.403, which discounts to M$10.150. Therefore, the value is M$14.066.
M$14.018,
5.
The correct answers are already in the gures. For P = $29.468, if you arrive open, you have a value of which is
V = R( $29.468 ) + value today +

6.
Incoming State Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed
[1/2 (M$18.700) + 1/2 (M$2.107)] = 1 + 2.5% disc exp value next quarter .
$14.066 (III.43)
Quarter Q0 Q1 Q1 Q1 Q1 Q2 Q2 Q2 Q2 Q2 Q2 Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4
Price $28.89 $24.556 $24.556 $34.668 $34.668 $20.873 $20.873 $29.468 $29.468 $41.602 $41.602 $17.742 $17.742 $25.048 $25.048 $35.361 $35.361 $49.922 $49.922 $15.081 $15.081 $21.290 $21.290 $30.057 $30.057 $42.434 $42.434 $59.906
Optimal Action Keep Open Keep Closed Keep Open Open Up Keep Open Keep Closed Close Down Open Up Keep Open Open Up Keep Open Keep Closed Close Down Keep Closed Keep Open Open Up Keep Open Open Up Keep Open Keep Closed Close Down Keep Closed Close Down Open Up Keep Open Open Up Keep Open Open Up
R( P )
M$3.41 M$0
V
M$24.625 M$6.075 M$6.174 M$35.316 M$37.316 M$0.579
-M$0.389
M$6.475 M$8.475 M$0
-M$1
M$1.916 M$3.916 M$12.553 M$14.553 M$0
-M$0.421
M$11.876 M$13.876 M$43.249 M$45.249 M$0
-M$1
M$0 M$0.042 M$7.083 M$9.083 M$19.847 M$21.847 M$0
M$1
M$1.187 M$1.716 M$16.7 M$18.7 M$42.228 M$44.228 M$0
-M$1
M$0
-M$1
M$0
-M$1
M$2.433 M$4.433 M$13.282 M$15.282 M$28.599 M$30.599
-M$1
M$2.433 M$4.433 M$13.282 M$15.282 M$28.599 M$30.599
Q4 $59.906 Is Open Keep Open Note: History dependent nodes are boldfaced.
98
7.
Incoming State Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Optimal Action Keep Open Keep Closed Keep Open Open Up Keep Open Keep Closed Close Down Open Up Keep Open Open Up Keep Open Keep Closed Close Down Keep Closed Keep Open Open Up Keep Open Open Up Keep Open Keep Closed Close Down Keep Closed Keep Open Keep Closed Keep Open Open Up Keep Open Open Up
Price $28.89 $24.556 $24.556 $34.668 $34.668 $20.873 $20.873 $29.468 $29.468 $41.602 $41.602 $17.742 $17.742 $25.048 $25.048 $35.361 $35.361 $49.922 $49.922 $15.081 $15.081 $21.290 $21.290 $30.057 $30.057 $42.434 $42.434 $59.906
R( P )
M$3.41 M$0
V
M$23.518 M$2.605 M$4.167 M$29.055 M$37.055 M$0
-M$0.389
M$0.475 M$8.475 M$0
-M$4 -M$4.084
M$3.916 M$6.553 M$14.553 M$0
-M$4
M$5.34 M$13.34 M$37.249 M$45.249 M$0
-M$4
M$0 M$0.042 M$1.083 M$9.083 M$13.847 M$21.847 M$0
-M$4
M$0 M$0.618 M$10.7 M$18.7 M$36.228 M$44.228 M$0
-M$4
M$0
-M$4
M$0
-M$3.252
M$0 M$4.433 M$7.282 M$15.282 M$22.599 M$30.599
-M$3.252
M$0 M$4.433 M$7.282 M$15.282 M$22.599 M$30.599
le=web-realoptions.tex: RP Section A. Advanced Appendix: Monte Carlo Repeated Drawing. 8.

Incoming State Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Is Open Is Closed Optimal Action Keep Open Keep Closed Keep Open Keep Closed Keep Open Keep Closed Keep Open Keep Closed Keep Open Open Up Keep Open Keep Closed Keep Open Keep Closed Keep Open Keep Closed Keep Open Open Up Keep Open Keep Closed Keep Open Keep Closed Keep Open Keep Closed Keep Open Keep Closed Keep Open Keep Closed
99
Price $28.89 $24.556 $24.556 $34.668 $34.668 $20.873 $20.873 $29.468 $29.468 $41.602 $41.602 $17.742 $17.742 $25.048 $25.048 $35.361 $35.361 $49.922 $49.922 $15.081 $15.081 $21.290 $21.290 $30.057 $30.057 $42.434 $42.434 $59.906
R( P )
M$3.41 M$0
V
M$22.266 M$0 M$1.6 M$6.463 M$37.055 M$0
-M$0.389
M$0 M$8.475 M$0
-M$3.618
M$0 M$3.916
-M$9.263
M$0 M$13.34 M$13.249 M$45.249 M$0
-M$17.447
M$14.553 M$0
-M$6.362
M$0 M$0.042 M$0 M$9.083
-M$12.19
M$0 M$0.618 M$0 M$18.7 M$12.228 M$44.228 M$0
-M$10.153
M$21.847 M$0
-M$8.695
M$0
-M$8.695
M$0
-M$3.252
M$0 M$4.433 M$0 M$15.282 M$0 M$30.599
-M$3.252
M$0 M$4.433 M$0 M$15.282 M$0 M$30.599
9. You should have expected the costs to approach the innite cost benchmark where you would never change the plant state. Cost of Opening
M$0.0 M$0.2 M$1.0 M$4.0 M$16.0
Cost of Opening
M$0.0 M$0.5 M$2.0 M$8.0 M$32.0
Plant Value
M$25.284 M$25.012 M$24.625 M$23.518 M$22.266 M$22.266
Innite
Innite
10.
Yes, it means you t better. Of course, if you t 52 data points with 52 coecients, you will t perfectly. Unfortunately, this also means that your estimates are garbage. You want less noise, but while keeping a small number of parameters only.
11. They t worse. Their residuals have higher variance. 12. They must have less, because you have an extra parameter now and the AR(2) process embeds the AR(1) process. Still, the process does not t much better, so it is not worth keeping the extra parameter.
13. Do it! 14. The former would be much tighter clustered around $28.77, while the latter would be much more variable around $28.77. 15. It would be much tighter around $28.77. 16. The mean would be $28.89, the standard deviation would be $6.41. This would probably be a better process than the one you just wrote down, claiming (our non-existent) managerial intuition. If you repeated the tree valuation, you would solve to nd a plant value of $17.8 million. Sidenote: Below, in Table III.4, you will nd that the plant with weekly shutdown/reopening capability is worth $23.9 million. Thus, the exibility of weekly rather than quarterly exibility and remaining dierences in the electricity price process are together worth around $6 million.
100
17. No. You will probably get dierent price scenario draws, and you did not do innitely many so that we will agree exactly. 18. Primarily due to the electricity price process. you know this, because if you permit only quarterly changes [the other important dierence from the previous subsection], you get much less in value. 19. The result is about $22.3 million, as shown in Table III.4. 20. The result is about $21.2 million, as shown in Table III.4. 21. You must cumulate undiscounted cash ows each week into your cash account, and test whether in any week the total sum is negative. The probabilities of this event is 7.9% for ($25,$25); 2.5% for ($20,$30); and above 15% for ($15,$30).
(All answers should be treated as suspect. They have only been sketched, and not been checked.)

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WEB CHAPTER III

Web Chapter III. Real Options.

31. Types of Real Options

Real Options: Your choice to alter operations in the future.

le=web-realoptions.tex: RP Section 32. Valuing A Gas Turbine Plant.

32. Valuing A Gas Turbine Plant

Mean Standard Deviation Range: Interquartile Range

$28.09 Median $10.11 $12.89$59.84 $20.78$30.95

Web Chapter III. Real Options.

Important: Real options are more valuable if there is more variance.

Many assets are primarily real options.

le=web-realoptions.tex: RP Section 32. Valuing A Gas Turbine Plant.

Electricity price process prediction

The future is not exactly the past.

The future may not even be indicated by the past.

You need a good prediction for electricity prices, standing at $28.89.

Web Chapter III. Real Options.

You need to know the limits of your technology.

You need to know whether all electricity is always sold.

You need to know what other important factors are uncertain.

le=web-realoptions.tex: RP Section 32. Valuing A Gas Turbine Plant.

Web Chapter III. Real Options.

33. The Simpler Method: Binomial Trees and Path Dependence

Decisions are less frequent.

Our specic electricity process.

Figure III.1. Assumed Electricity Price Processfor Planning Purposes

62 33.B. Costly vs. Free Operating Changes

Web Chapter III. Real Options.

1 + 2.5% (1 + 2.5%)2 (1 + 2.5%)3 (1 + 2.5%)4 = (+M$3.410)

1/4 R( $20.873 ) + 1/2 R( $29.468 ) + 1/4 R( $41.602 )

1/8 R( $17.742 ) + 3/8 R( $25.048 ) + 3/8 R( $35.361 ) + 1/8 R( $49.922 )

1/2 (M$0.389) + 1/2 (+M$8.475)

1 + 2.5% (1 + 2.5%)2 (1 + 2.5%)3

1/4 (M$3.618) + 1/2 (+M$3.916) + 1/4 (+M$14.553)

1/8 (M$6.362) + 3/8 (+M$0.042) + 3/8 (+M$9.083) + 1/8 (+M$21.847)

(1 + 2.5%)4 M$22.266 . (III.2)

1 + 2.5% (1 + 2.5%)2 (1 + 2.5%)3 (1 + 2.5%)4 = (III.3) (+M$3.410)

1/4 $0 + 1/2 R( $29.468 ) + 1/4 R( $41.602 )

1/8 $0 + 3/8 R( $25.048 ) + 3/8 R( $35.361 ) + 1/8 R( $49.922 )

1/16 $0 + 4/16 $0 + 6/16 R( $30.057 ) + 4/16 R( $42.434 ) + 1/16 R( $59.906 )

1/2 $0 + 1/2 (+M$8.475)

1 + 2.5% (1 + 2.5%)2 (1 + 2.5%)3

1/4 $0 + 1/2 (+M$3.916) + 1/4 (+M$14.553)

1/8 $0 + 3/8 (+M$0.042) + 3/8 (+M$9.083) + 1/8 (+M$21.847)

1/16 $0 + 4/16 $0 + 6/16 (+ $4.433) + 4/16 (+M$15.282) + 1/16 (+M$30.599)

Action changes are costly.

If Open  Keep Open (KO) d

 If Closed d Keep Closed (KC)

Web Chapter III. Real Options.

Figure III.2. Obvious and Non-Obvious Decisions

P=$24.556 What to do?

P=$25.048 What to do?

P=$20.873 Dont Op.

P=$21.290 Dont Op.

P=$17.742 Dont Op.

P=$15.081 Dont Op.

Web Chapter III. Real Options.

Figure III.3. Tree With Quarter Q4 Worked Out

Web Chapter III. Real Options.

1 + 2.5% disc exp value next quarter

1 + 2.5% disc exp value next quarter

in electricity-sold, so your plant value will be

1 + 2.5% disc exp value next quarter

If Open Keep Open (KO) d

If Closed d Keep Closed (KC)