Key15 Watch out for project options
Most investment projects carry implicit options. An option is the right, but not the obligation, to take a specific action on a future date. Options are prevalent in the capital markets. Call options on common stocks convey the right to buy a common stock at a specified price on or before a specified date. These options are now widely traded, as are options on bonds, currencies and commodities. The options implicit in capital investment projects are not publicly traded, and they are often hidden, but they can add great value to a project, so it is important to be alert for them.
Before a project is initiated, it has a postponement option. I can drill a new oil well today, or I can wait for more information about possible future oil prices and the likelihood that there is actually oil at my drilling location. Postponing a project is not always the best decision, but it is important to realize that any project competes with the same project initiated at a later date.
Once under way, most projects also have abandonment options. If I start to drill an oil well, I can stop drilling if prospects are dimming. Alternatively, once a well is operational, I can stop producing at any point if expected revenue over the next period appears insufficient to cover my variable production costs. If I do stop production, I have the option to start up again should the outlook become more favorable, but I also have the option to cap the well and sell my fixed assets.
These options are valuable because they allow a company to react as information arrives and uncertainty is resolved. Rather than being saddled indefinitely with a particular cash flows stream once a project has been initiated, a company has options to expand, contract, abandon, or otherwise modify the project as future prospects become clearer.
Unfortunately, options are not amenable to valuation with standard discounted cash flows techniques. The sudden changes in risk that occur as uncertainty is resolved make it impossible to specify a risk-adjusted discount rate with any precision. Although space does not permit a full discussion of the option valuation techniques that have been developed, one insight that has emerged is especially noteworthy. We tend to think of an increase in risk as being harmful to security prices, but with options the opposite is true. This is because an option’s downside risk is limited by my tight not to exercise it. If I have an option to buy a stock at a fixed price, my upside potential is unlimited. However, if the stock’s market price foes continually downward, I don’t suffer continual losses. Rather, I simply choose not to exercise the option.
This option valuation principle affords a different perspective on the uncertainty surrounding investment projects. As long as I have options to cut my losses, greater uncertainty can actually create opportunities and enhance project value. In the example of the oil well, greater uncertainty about future oil prices can increase the value of an operating well, because if oil prices go up dramatically, I can take full advantage by producing to capacity. On the other hand, if oil prices go down, I have the option to halt production. It is easy to overlook a considerable portion of a project’s true value if the analyst is not alert to the presence of such options.