optdelay - Real Option Applications: The Option to Delay...

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Aswath Damodaran 1 Real Option Applications: The Option to Delay Aswath Damodaran
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Aswath Damodaran 2 The Option to Delay n When a firm has exclusive rights to a project or product for a specific period, it can delay taking this project or product until a later date. n A traditional investment analysis just answers the question of whether the project is a “good” one if taken today. n Thus, the fact that a project does not pass muster today (because its NPV is negative, or its IRR is less than its hurdle rate) does not mean that the rights to this project are not valuable.
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Aswath Damodaran 3 Valuing the Option to Delay a Project Present Value of Expected Cash Flows on Product PV of Cash Flows from Project Initial Investment in Project Project has negative NPV in this section Project's NPV turns positive in this section
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Aswath Damodaran 4 Insights for Investment Analyses n Having the exclusive rights to a product or project is valuable, even if the product or project is not viable today. n The value of these rights increases with the volatility of the underlying business. n The cost of acquiring these rights (by buying them or spending money on development, for instance) has to be weighed off against these benefits.
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Aswath Damodaran 5 Example 1: Valuing product patents as options n A product patent provides the firm with the right to develop the product and market it. n It will do so only if the present value of the expected cash flows from the product sales exceed the cost of development. n If this does not occur, the firm can shelve the patent and not incur any further costs. n If I is the present value of the costs of developing the product, and V is the present value of the expected cashflows from development, the payoffs from owning a product patent can be written as: Payoff from owning a product patent = V - I if V> I = 0 if V I
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Aswath Damodaran 6 Payoff on Product Option Present Value of cashflows on product Net Payoff to introduction Cost of product introduction
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Aswath Damodaran 7 Obtaining Inputs for Patent Valuation Input Estimation Process 1. Value of the Underlying Asset Present Value of Cash Inflows from taking project now This will be noisy, but that adds value. 2. Variance in value of underlying asset Variance in cash flows of similar assets or firms Variance in present value from capital budgeting simulation. 3. Exercise Price on Option Option is exercised when investment is made. Cost of making investment on the project ; assumed to be constant in present value dollars. 4. Expiration of the Option Life of the patent 5. Dividend Yield Cost of delay Each year of delay translates into one less year of value-creating cashflows Annual cost of delay = 1 n
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Aswath Damodaran 8 Valuing a Product Patent: Avonex n Biogen, a bio-technology firm, has a patent on Avonex, a drug to treat multiple sclerosis, for the next 17 years, and it plans to produce and sell the drug by itself. The key inputs on the drug are as follows:
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This note was uploaded on 03/01/2012 for the course FINS 3641 taught by Professor Hyip during the Three '11 term at University of New South Wales.

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optdelay - Real Option Applications: The Option to Delay...

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