Investment decision techniques for long-term network planning: Real Options Valuation Sofie...

Investment decision Investment decision techniques for long-term techniques for long-term

network planning: network planning: Real Options ValuationReal Options Valuation

Sofie Verbrugge

Didier Colle, Mario Pickavet

GBOU Ghent University – IMEC – IBBT 2

Network planning processNetwork planning process

networkplanning

physical constraints

equipmentcost

existing network

technical constraintsnetwork

deployment plan

customerdemand

timeequ

ipm

ent

cost

old technology

new technology

timeto

tal t

raff

ic d

eman

d

Which investmentsshould be made

at which points in time ?


OutlineOutline

• Classical investment decision rules

• Real options valuation

• Network planning problems to be seen as investment decision problems

• Conclusions


ni

FC

)1(

Present value of future cash flowsPresent value of future cash flows

• Positive time value of money:– prefer receiving now– prefer spending later

• Discount future expenses to present values

where

C = current valueF = future expensei = interest raten = years into the future 0

20

40

60

80

100

120

now year 1 year 2 year 3 year 4 year 5

Current value of 100 euro to be spent in the future


Investment decisionsInvestment decisions

• “Should the investment be made or not?”• Consider all cash flows CF for the project

– Initial investment (-)– Additional revenues (+)

• Cash flows used:– Incremental, operational, after taxes, economical lifetime

2004 2005 2006 2007 2008 2009 2010

time- 200 +40 +40 +40 +40 +60 +0

Initial investment:

buy a machine

Annual revenue: sell produced goods End of the

project: resell the machine


Net Present ValueNet Present Value

• Definition– Present value of all cash flows in the investment project, discounted

using the minimum required return on investment

– r = minimum required return for considered project, grows with project risk (riskless project: interest earned on bank account)

• Objective– NPV >= 0

• Advantages– Takes into account all CFs– Takes into account timing– Takes into account size of the project

n

tt

t

r

CFNPV

0 )1(


OutlineOutline




• Conclusions


Real Options compared to NPVReal Options compared to NPV

• Net Present Value (NPV)– Discounts CFs using fixed discount rate– Evaluates now-or-newer investment decisions– For risky project: difficult to determine appropriate discount

rate

• Real Options Valuation (ROV)– Includes the options that may be present in an investment

project with uncertain parameters– Includes flexibility in decision process– Uses risk-free discount rate

• ROV is extension of NPV technique– Value of a project = NPV + value of the options


Origin: financial optionsOrigin: financial options

An option gives the buyer the right to buy or sell an asset for a predetermined exercise price over a limited time period.

– Right, not obligation– Asset: Asset for which the option holds, can be anything:

stocks, real estate, precious metals, …– Exercise price = strike price: Price for which option holder

can exercise the option, fixed over exercise time– Exercise date: option is no longer valid after this date

(remaining time = Time To Maturity)


TerminologyTerminology

• European option– can only be exercised on the exercise date

• American option– can be exercised till the exercise data

• Option price = option premium– Price to acquire the option, price to acquire to right

• Exercise price = strike price– Price for which option holder can exercise the option (fixed)

• Call option– option holder has right to buy the asset

• Put option– option holder has right to sell the asset


Value of call option on exercise dateValue of call option on exercise date

• Call option = right to buy (a stock)– Predetermined exercise price: X– Market value of the stock on exercise date: S

• On exercise date– S < X

• the option is useless • everyone buys on the market

– S > X• the option is valuable• Value of the option: S - X

• Option always has a positive value• Value call option at exercise date = MAX(0,S-X)

S = value share on exercise dateva

lue

call

on e

xerc

ise

date

X


Value of option before exerciseValue of option before exercise date date

• Value of option = end value + time value• End value

– Value the option would have if today was the exercise date

• Time value– Grows with a growing time to maturity

• Over longer time chance is bigger that good changes will occur

– Grows with volatility of share value• Big volatility, big chance the value will change a lot before exercise

date, bigger option value• Remark: traditional valuation vs. option valuation

– Small when difference between S and X is big• Big |S-X|: value of the option (+ or -) not likely to change, small time

value• Small |S-X|: big chance the option value will change, big time value


Option valuationOption valuation

• Binomial method– for European call option– assumes 2 possible end values for the stock value

– can be expanded for more time periods: software needed

• Black-Scholes – formula– assumes arbitrage-free pricing, stock prices follow Brownian motion

• Simulations– Monte Carlo simulation– Tools available: e.g. Crystal Ball

SU

D


Financial versus real optionsFinancial versus real options

Stock option Real option

X exercise price of the option

investments required to carry out the project

S value of the underlying stock

NPV of the cash flows generated by the investment project

volatility of the stock risk grade of the project

r the risk-free interest rate risk-free interest rate

t life time of the option time period where company has the opportunity to invest in the project


OutlineOutline




• Conclusions


Apply ROV forApply ROV for long-term planning long-term planning

• ROV especially useful for – two-phase investment decisions– with an optional second phase (e.g. only performed if market

situation is favourable)

• OXC introduction in an existing network with growing traffic demand

– can be seen as two-phase decision – phase 1: introduction of the OXC itself (only including

interface cards needed to switch the current traffic)– phase 2: option to expand the OXC with extra interface cards

if needed– Actual decision whether or not to really expand only taken in

phase 1 (uncertainty reduced by then)!!


Case studyCase study

• European backbone network– 16 nodes and 22 links

– initially WDM point-to-point systems are used on all links

– if an OXC is introduced: transit traffic passes the node optically

– time frame 2002 – 2008

– initial traffic: IP traffic from Lion-Cost266 model

– afterwards: 70% annual growth

– links filled to 60% of there capacity

– network equipment costs: relative to the cost of a WDM mux/demux

– linear price model

– price is changing (in a random way)

• In which nodes is OXC introduction beneficial? When?


OXC introduction in BrusselsOXC introduction in Brussels

NPVphase 1

NPVphase 2

NPVproject

ROV phase 2

ROV project

2002 -3,17 -94,44 -97,60 7,34 4,18

2003 -3,17 -87,51 -90,67 17,22 14,05

2004 -3,17 -87,08 -90,25 22,18 19,01

2005 -3,17 -95,8 -98,96 20,37 17,21

2006 -3,17 -117,69 -120,86 10,80 7,64

installation OXC + needed interface

cards 2002

installation of extra line cards in considered years optional installation

of extra line cards in considered years

all > 0: OXC introduction should definitely be considered in Brussels

best timing

for upgrade:

2004


OXC introduction in all nodesOXC introduction in all nodes

• NPV: no OXC introduced in the entire network

• ROV: OXC introduction beneficial in half of the nodes

• Negative ROV project value: OXC not beneficial– Prague, Vienna and Zagreb: overall traffic too low

– Berlin, Munich, London, Lyon and Rome: too little transit traffic

• Positive ROV project value: OXC introduction beneficial – Hamburg, Brussels, Frankfurt, Paris, Strasbourg, Zurich, Milan, Amsterdam

– overall traffic big enough (exceeds router capacity within 2 years), transit traffic fraction > 60%

Value of OXC introduction w ith optional second phase

-200

-150

-100

-50

0

50H

ambu

rg

Ber

lin

Bru

ssel

s

Fra

nkfu

rt

Lond

on

Par

is

Lyon

Str

asbo

urg

Zur

ich

Mila

n

Mun

ich

Pra

gue

Rom

e

Vie

nna

Zag

reb

Am

ster

dam

NPV project value project w ith optional second phase


Case study resultsCase study results

• Net Present Value – unable to correctly evaluate projects that comprise an

optional follow-up investment– project value for OXC introduction < 0

• Real Options Valuation – aimed to valuate projects where uncertainty is involved– project value for OXC introduction > 0– optional character of second phase leads to bigger project

value (postponing decision reduces uncertainty)– disadvantages:

• often very difficult to detect a real option

• correctly estimating the option value difficult (estimating CF)

• Black and Scholes assumptions should be tested carefully


OutlineOutline




• Conclusions


ConclusionsConclusions

• Time value of money– Discount future expenses to present values– Always when comparing/ adding CFs for different time points

• Classical investment decision rules– Net Present Value (NPV) best of classical investment rules– Need to estimate CFs– Need to estimate required interested rate (related to risk)

• Real options valuation– Extension of NPV, to include optional future investments– Originates from world of stock options– Need to estimate CFs– Use of risk free discount rate– Several valuation techniques, best-known: Black and Scholes


ConclusionsConclusions

• Network planning problems seen as investment decision problems

– ROV can be used for two phase investment problems with optional second phase

– disadvantages:• Correct estimation of needed parameters not always easy• Black and Scholes assumptions should be tested carefully

• OXC introduction seen as real option– ROV leads to bigger project value in case of optional follow-up

investment

– According to ROV: OXC introduction beneficial if expected traffic demand exceeds router capacity within next 2 years and the transit traffic fraction surpasses 60%

– Introduction in half of the nodes in considered European backbone

• Future work: use simulations, to avoid B-S constraints


Thanks for your attention!

Investment decision techniques for long-term network planning: Real Options Valuation Sofie...

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