From a theoretical point of view the key to applying

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: h flow and t=time to expiry, and substituting for the values in this example: 116 ROV=(500e-0.03*5) * {(0.58)} – (600e-0.05*5) * {(0.32)} = $251 million - $151 million = $100 million. The $200 million difference between the NPV valuation of $-100 million and the ROV valuation of $100 million represents the value of the flexibility brought about by having the option to wait and invest when the uncertainties are resolved. From a theoretical point of view, the key to applying real option theory is deciding which variable is assumed to follow a Black and Scholes model. Brennan and Schwartz assume that the spot price (here the oil price) obeys this model. Trigeorgis (1996), Kemma (1993) and Paddock et al. (1988) show a radically different approach in which the analysis is based on the hypothesis that the project itself obeys this model. The difference is important because the theory of option pricing requires a liquid market for the underlying commodity, no transaction costs and no arbitrage. While this is probably true for oil prices, it is doubtful whether a large enough market exists for oil projects (Galli et al., 1999). Concerns have been expressed about all these approaches, usually directly questioning the underpinning assumptions of the Black and Scholes methodology and its appropriateness for valuing real options particularly those with long time horizons (for example, Lohrenz and Dickens, 1993). Buckley (2000) bypasses these criticisms by describing an alternative route to valuing real options involving a decision tree approach. Option theory methods are heralded as an improvement over traditional DCF methods specifically because they allow managerial flexibility to be modelled and included in the investment analysis. However, since the value of an option is, in fact, an expectation or, more precisely, the conditional expectation of the value given the initial conditions, real options, like decision trees, do not give any indications about the uncertainty of the project (Galli et al., 1999). More importantly, a number of professional managers have suggested that while the analogy relating managerial flexibility to options has intuitive appeal, the actual application of option based techniques to capital budgeting is too complex (or certainly more complex than the NPV method) for practical application (see Chapter 6). 117 This section and the ones that precede it (5.2-5.5) have provided an overview of the decision analysis techniques available to petroleum exploration companies to utilise in their investment appraisal decision-making. All the tools described have been applied to upstream investment analysis in the literature, allow risk and uncertainty to be quantified and, crucially, are complementary. They do not represent alternatives. This is important since, as indicated above, each tool has its limitations, so that reliance only on the output of one tool for investment decision-making would be inadvisable. By combining the output from a variety of tools, the decision-maker is more likely to assess the risk and uncertainty accurately. The tools described in the sections above use similar input and, hence their use together does not pl...
View Full Document

Ask a homework question - tutors are online