Real Optios for Egieerig Systems J: Real Optios for Egieerig Systems By (MIT) Stefa Scholtes (CU) Course website: http://msl.mit.edu/cmi/ardet_2002 Stefa Scholtes Judge Istitute of Maagemet, CU Slide What are we up to? Two sides of the coi Egieerig systems desig Maagemet of risk ad opportuity Take-aways: Kowig how to value flexibility ad kow how to icorporate it ito the desig of techology systems Appreciatig the differeces betwee real optios ad traditioal fiacial optios Uderstadig orgaisatioal barriers to implemetatio Formal objectives Uderstadig the optios paradigm Experiece i valuig risky projects Stefa Scholtes Judge Istitute of Maagemet, CU Slide 2 Today s ageda Theme: go/o go decisios for techology projects Makig a ecoomic case for a project Break eve aalysis Rate of retur Net preset value A critique of traditioal NPV How does NPV cope with ucertaity? How does NPV cope with flexibility? It s ot so simple Stefa Scholtes Judge Istitute of Maagemet, CU Slide 3 Page
Project valuatio Project valuatio: Makig a ecoomic case for a techology project Covice the board that the compay ca do othig better with the ivestmet capital tha ivestig it i the project Compare project payoffs with alterative ivestmet opportuities withi the compay ad i the market place Take existig portfolio of projects ad log-term strategic cosideratios ito accout (aligmet of project with existig stregths ad strategic positioig of the compay) Desig optimisatio: addig desig features to techology projects to make them ecoomically more attractive Stefa Scholtes Judge Istitute of Maagemet, CU Slide 4 CFO s poit of view Fiace departmet: A project cosists of a iitial ivestmet followed by a stream of future cash flows Ivest i the project oly if there is o better alterative ivestmet opportuity Two major problems: Ucertaity: Cash flows of the project deped o exteral ucertaities Flexibility: Cash flows deped o our (ad our competitors ) maagemet decisios durig the life time of the project How ca we compare streams of ucertai payoffs which deped o future decisios (which i tur deped o ucertai evets)? Let s first look at how projects are evaluated i practice Stefa Scholtes Judge Istitute of Maagemet, CU Slide 5 Traditioal tools for project valuatio Break-eve aalysis Accoutig rates of retur Net preset value See Traditioal Project Appraisal.xls Stefa Scholtes Judge Istitute of Maagemet, CU Slide 6 Page 2
Break-eve aalysis Iput: Iitial ivestmet Projected cash flows over a umber of periods Break-eve poit: Number of periods ecessary for the sum of discouted cash flows to exceed the iitial ivestmet Makig a case for the project: Compare break-eve poit with compay bechmark Stefa Scholtes Judge Istitute of Maagemet, CU Slide 7 Accoutig rates of retur Iput: Projected book value of ivestmet over the life time of the project Projected profits of the project over its lifetime Accoutig rate of retur: average profit / average book value Makig a case for the project: Compare the ratio with compay bechmark Stefa Scholtes Judge Istitute of Maagemet, CU Slide 8 Net preset value Most popular valuatio criterio Iputs: Iitial ivestmet Projected cash flows over the life time of the project Discout rate NPV = Preset value of cash flows mius iitial ivestmet Makig a case for the project: NPV>0 Let s have a closer look at NPV Stefa Scholtes Judge Istitute of Maagemet, CU Slide 9 Page 3
NPV: uderlyig alterative ivestmet opportuities The NPV criterio is equivalet to comparig the project with a sigle alterative ivestmet opportuity: Suppose you ca ivest a arbitrary amout i a portfolio of ivestmet opportuities with a guarateed retur of r% p.a. How much do you eed to ivest ow to be able to withdraw the project cash flows whe they occur? If the life time of the project is T periods with cash flows x=(x,,x T ) the T xt y = (discretediscouti g) t (+ r) y = t= T t= rt e x (cotiuous discoutig) t y is called the preset value (PV) of the cash flow stream Net preset value NPV = PV iitial ivestmet Ecoomic case: Ivest i the project if NPV>0 Stefa Scholtes Judge Istitute of Maagemet, CU Slide 0 First problem with NPV: Which discout rate? Discout rate should reflect opportuity cost of capital Opportuities: Portfolios of alterative ivestmets Returs of portfolios Are radom Deped o risk Which portfolio? Need for optimal portfolio But: riskier portfolios are likely to have larger returs Portfolio maagemet: Retur depeds o maagemet ( re-balacig ) of portfolio Theoretical questios addressed by Capital Asset Pricig Model (CAPM) uder certai assumptios see e.g. Brealey ad Myers, Priciples of Corporate Fiace or Lueberger, Ivestmet Sciece Stefa Scholtes Judge Istitute of Maagemet, CU Slide Risk premium Approach: Discout rate = risk free rate + risk premium Should the risk premium be costat over time? Assumes risk to be costat over time Techology projects: Most risks get resolved very quickly (techological risk, demad for ew product, regulatory ucertaity, etc.) Stefa Scholtes Judge Istitute of Maagemet, CU Slide 2 Page 4
Practical approaches to discout rates Maagerial praxis I: Use compay-iteral hurdle rate Techology projects have ofte log time horizos Sesitive depedece o discout rate at 0% over a period of 20 years is worth > 7 at 5% over a period of 20 years is worth < 3 Maagerial praxis II: Fid portfolio with the same risk profile as the ew project ad maximal expected retur ad use this maximal expected retur as bechmark discout rate Techology projects: Which project portfolios have similar risk profile? Flaw of averages Lesso : It is ot clear which discout rate should be chose i practice? Stefa Scholtes Judge Istitute of Maagemet, CU Slide 3 Secod problem with NPV: The forecast is always wrog Let s have a look at a spreadsheet example (ope NPV.xls worksheet Project Pla) Cash flow calculated o the basis of forecasted demad Demad i period t is ucertai ad depeds o edogeous (price) ad exogeous (ecoomy, fashio, competitors) variables Ukow demads i periods,,t- may help us to predict demad i period t more accurately (statistical depedece) Lesso 2: NPV is a fuctio of ucertai quatities ad therefore itself ucertai Stefa Scholtes Judge Istitute of Maagemet, CU Slide 4 Let s formalize this Mathematically: NPV depeds o ucertai quatities X,,X (radom variables): NPV=NPV(X,,X ) A fuctio of a radom variable is itself a radom variable A sigle umber (eve the mea) is very limited iformatio about a radom variable Ca make a better ecoomic case from kowledge of the NPV distributio If we ca t get the distributio the we wat at least some of its characteristics: expected NPV variace of NPV 95% cofidece iterval for NPV Stefa Scholtes Judge Istitute of Maagemet, CU Slide 5 Page 5
Distributios ad Value at risk NPV cumulative distributio fuctio 00.0% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 0.0% 0.0% -,500,000 -,000,000-500,000 0 500,000,000,000,500,000 2,000,000 2,500,000 0% VAR is roughly 500,000 5% VAR is roughly 800,000 Stefa Scholtes Judge Istitute of Maagemet, CU Slide 6 The flaw of averages I practice, decisios are ofte made o the basis of expected NPV aloe Assumes that variability (i.e. risk) is captured i discout rate Naïve approach: Let s work with expected demads Let s assume marketig departmet has give us a price of 000 ad expected demads for that price Is the NPV the the expected NPV? Let s look at a example (NPV.xls) Lesso 3: The flaw of the averages : Pluggig expected values ito ucertai cells i a spreadsheet does ot give expected values of the formula cells Mathematically: E( f ( X)) f ( E( X)) Stefa Scholtes Judge Istitute of Maagemet, CU Slide 7 The flaw of averages ad discout rates Recall practical advise: Take as discout rate the average retur of the best portfolio with the same risk level as the ew project However: NPV depeds o-liearly o the discout rate (flaw of the averages) Way out: simulate, usig historic period returs istead of averages Jese s iequality: the NPV calculatio o the basis of average rate of retur is lower tha the expected NPV based o historic returs See Flaw of the averages for discout rates.xls But: Returs of ew project ad bechmark portfolio are correlated What s right? Stefa Scholtes Judge Istitute of Maagemet, CU Slide 8 Page 6
Third problem with NPV: No maagerial activity NPV assumes that the cash flows of the project are fixed Eve if cash flows are radom ad simulatio is used to evaluate expected NPV, there is o maagerial flexibility i the model Typically, maagemet acts depedig o ufoldig ucertaities Typical actios Postpoe projects Grow project Icrease marketig efforts Abado project Let s look at a example (see NPV.xls, worksheet expasio optio) Stefa Scholtes Judge Istitute of Maagemet, CU Slide 9 Summary Compay should ivest i a project if there are o better ivestmet alteratives NPV-criterio has severe drawbacks: NPV criterio is based o FIXED cash flow projectios ad does ot take maagerial flexibility ito accout (this udervalues the project) Ucertaity is ofte ot take ito accout properly i practice (flaw of averages) What should the discout rate be? Stefa Scholtes Judge Istitute of Maagemet, CU Slide 20 Back to the basics To make a ecoomic case for a ew project we eed to argue that addig the ew project to the existig project portfolio (ad therefore abadoig or dow-sizig other projects) icreases the desirability of the stream of future cash flows Stefa Scholtes Judge Istitute of Maagemet, CU Slide 2 Page 7
Settigs The courtroom paradigm Iocece hypothesis: The project does ot add value to the portfolio Jury: The decisio maker Prosecutor (Egieer): I wat the project i the portfolio Costructs a case that the project adds value to the compay s portfolio I particular: eeds to argue how the portfolio re-balacig should be doe (i.e. where the moey should come from) Defece lawyer (CFO): I do t wat the project i the portfolio Need to reply to the prosecutors case by costructig alterative ivestmet portfolios that do ot iclude the ew project ad arguig that these are more beeficial to the compay tha ivestig i the project Questio: Why do t we use as iocece hypothesis that the project adds value to the portfolio? Stefa Scholtes Judge Istitute of Maagemet, CU Slide 22 Usig a computer Prosecutor: Build a stochastic (sceario-based) computer model of the project, icludig decisio poits ad decisio rules (plas of actio for all possible scearios) Defece lawyer: Build a stochastic model of a sesible alterative ivestmet strategy (usig projects or assets from withi the compay or i the market place), icludig possible decisio poits ad decisio rules Jury: Decide whether there is a case for the project o the basis of the (radom) differece betwee the cash flow streams of the project ad the alterative ivestmet strategy Ca use simulatio to estimate the distributio of the differece betwee the cash flow streams of the two ivestmets for give decisio rules Jury will also take strategic issues ito accout Stefa Scholtes Judge Istitute of Maagemet, CU Slide 23 Simulatio Results 250000 200000 50000 00000 50000 95% Mea 5% 0 periods +2 periods 3+4 periods 5+6-50000 -00000-50000 Differece betwee project cash flow ad alterative ivestmet cash flow Stefa Scholtes Judge Istitute of Maagemet, CU Slide 24 Page 8
What s the problem with this approach? Meaig of optimal decisio rule is ot clear What is optimal for cash flow i period may be bad for cash flow i other periods What is optimal i oe sceario may be bad i aother Approach allows us to compare ivestmets with regard to risk but ot with regard to flexibility Alterative ivestmet is ofte more flexible e.g. ivestmets i stock portfolio vs. ivestig i a ew aircraft project Model is complex But: there may be o simple solutios to a complex problem If we could oly do somethig that was similar to the above but simpler Research: Suggest rules of thumb to practitioers which are coceptually soud but have simple ituitive iterpretatio Academics adds to practitioers cofidece that they are doig the right thig by followig their ituitio Stefa Scholtes Judge Istitute of Maagemet, CU Slide 25 Coclusio NPV criterio has serious pitfalls The courtroom is a sesible model for project appraisal Complexity of cases for or agaist a project is a serious hurdle to acceptace i practice But the agai: there may ot be a simple solutio to this complex problem More questios tha aswers Stefa Scholtes Judge Istitute of Maagemet, CU Slide 26 Appedix: Returs of portfolios A portfolio is a ivestmet of w i i ivestmet opportuity i=,, The retur of the portfolio r w) = r(( w,..., w )) = w r +... + w r ( is approximately ormal if is large (cetral limit theorem) The expected retur is E( r( w)) = E( w r +... + w r ) = w E( r ) +... + w E( r ) Covariace of r i ad r j The variace of returs is i = j = T w w σ = w Σ w i j ij Covariace matrix Stefa Scholtes Judge Istitute of Maagemet, CU Slide 27 Page 9