Real Options in Foreign Investment:

A South American Case Study

Michael J. Naylor*, Jianguo Chen and Jeffrey Boardman School of Economics and Finance,

College of Business

Massey University

Private Bag 11 222

Palmerston North

New Zealand.

* Corresponding author; M.J.Naylor@massey.ac.nz.

___________________________________________________

Acknowledgements

The authors acknowledge the support and guidance of Alister Ryan, Peter Holdaway and other

executives of Sky City, Village Roadshow and Force Corporation. We wish to thank participants at

the 2012 Multinational Finance Association conference and departmental colleagues for

comments and support.

Disclaimer

Nothing in this report should be taken as comment on the actual investment choices of Force

Corporation, Village Roadshow or Sky City. Note that Force did not create a real options appraisal

so our results are entirely hypothetical and are created for illustrative purposes only.

Version 1.3: 2nd August 2012

mailto:M.J.Naylor@massey.ac.nz

Real Options in Foreign Investment: A South

American Case Study

_______________________________________________________________________________

Abstract

The ability to make foreign acquisitions, especially into emerging markets, is now a core

corporate skill. The quality of appraisals is a key part of this. We argue that foreign emerging

market investment appraisal is often best carried out using a real options framework and

structured as a series of investment options.

The track record of foreign investment in practice has often been dismal. This is because

emerging markets appraisals involve additional risks and far more complexity, so that valuing

these investment proposals via conventional discounted cash flow approach is problematic.

The core of the article is a case study, which recreates an investment in cinemas in Argentina,

and serves as useful practical illustration of the use of real option in foreign investment appraisal.

JEL classification: F36, F37, G12, G15, G34

Keywords: Real Options, Foreign Investment, Property Investment, Project Valuation.

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1 Introduction

Trends in globalization have caused profound changes to the way companies conduct their

business, so that the ability to expand globally, especially into emerging markets, is now a core

corporate skill. The track record of foreign investment in practice has, however, often been dismal.

Companies that accurately appraise their foreign alternatives will have a strategic advantage,

whereas making wrong decisions can severely erode their competitiveness.

This paper reviews methods of appraising FDI, with a focus on real options, via the use of a case

study involving Force Corporation’s failed investment in cinemas in Argentina, via Village South

America, in 1996-2005. We use this case-study to argue that the valuation of foreign investment

opportunities in emerging markets often has to be treated differently to domestic investment and

is normally best structured as a series of investment options, and it is essential that a real options

framework is added to the appraisal process. The case study thus serves as useful practical

illustration of the use of real options in foreign investment appraisal.

2 Foreign Direct Investment Appraisals

Investment appraisal is quite different for international as opposed to domestic capital budgeting

decisions, as foreign investments expose companies to a collection of new and complex risks that

are not found in a domestic context. A foreign direct investment (FDI) appraisal in an emerging

market will need to, for example, evaluate the issues around the impact of foreign exchange

volatility on asset and debt value, the typically higher level of economic and financial volatility, as

well as impacts from the underlying financing structure. Accurate appraisals should also combine

aspects of strategy, management and finance. Lee & Kwok (1998) argue that FDIs, while increasing

profit, typically lead to large increases in the variance of profits, which can impact on share price.

Lee & Kwok (1998) found that FDIs had a higher level of early bankruptcy than domestic

investments.

Markides et al (1994) argues that because of the large potential sunk costs and variations in

profits it is crucial that companies value FDIs accurately. Overpaying during an investment will

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leave a company behind the break-even point before the operation even starts. It will also leave

the MNC overexposed to financial and other risks in relation to profitability. These difficulties are

accentuated by the aspect that for emerging market investment many of the risks are difficult to

quantify at the initial valuation stage process, and there is a scarcity of accurate information.

Lee and Caves (1998) also argue that often that there is a large element of learning in FDIs so that

the risks and real costs of emerging market investments do not become apparent until the

investment has been made. Purty (1979) and Davidson (1980) found that it is common practice for

companies to incorporate this element of learning by making their initial investments in culturally

similar countries first, even if profit potential is lower. After this first investment has created a

higher level of accumulated experience, companies can then move on with more success to more

culturally distant countries. FDI appraisals need to take account of the need for learning by using

staged FDI, with re-evaluation and re-appraisal at the end of each stage.

The issues with volatility and information scarcity mean that emerging market FDI appraisals

cannot, in general, be solved by using more complicated methods. In fact, in practice, Keck,

Levengood & Longfield (1998) found that for emerging market FDI appraisals, financial

practitioners often use using less information, rather than more, with an increase in the use of

heuristics or rules of thumb.

3 VSA Case-study Background 3.1 Origin of Village South America

Force Corporation commenced operations in New Zealand in 1986, and initially it operated as a

successful private property development company. However from the early 1990’s falling

commercial property values restricted profitable development opportunities so Force sought to

diversify. Since New Zealand had, in 1991, a low number of modern multiplex cinemas per capita,

Force formed a joint venture relationship with Australian cinema company Village Roadshow to

build multiplex complexes. This was regarded as simply enhanced property development, with a

guaranteed core tenant. Force contributed property development expertise, and Village Roadshow

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contributed management expertise at an operational level and guaranteed access to timely, top

quality, film product.

A key initial lesson was the existence of a strong first mover advantage, as this reduced expansion

opportunities for competitors. Speed of construction was thus vital, even if initial rentals did not

sufficient rental income. Force thus built a number of new multiplex developments, giving it a

dominant market share in a relatively short period. Force capitalized on this in 1995 by a reverse

listing on the NZ stock exchange via Ascot Management Corporation, enriching founding

shareholders.

The initial success of Force’s venture, however run into difficulties when the existing competitor,

Hoyts, fought back with its own expansion program. The number of multiplexes in New Zealand

thus more than doubled between the years of 1991 and 1999, saturating the market. In 1996,

Force, facing restricted future opportunities, responded by selling non-core assets and scouting for

more lucrative overseas opportunities. Joint venture partner Village Roadshow was by now a fully

diversified international competitor with interests in over 800 screens in 14 different countries.

Given that developed markets were all similarly saturated with multiplex developments by 1995,

scope for profit seemed strongest in emerging markets.

Argentina and Fiji were identified as suitable investment opportunities, because of inadequate

local cinemas and growing markets. To gain local expertise in Argentina, Force and Village

Roadshow identified Eduardo Astrada, a local property developer, as a suitable joint venture

partner. Village South America (VSA) was subsequently registered in May 1996.

Force’s non-core NZ$30M disposal program ensured that by October 1996, Force had no term

debt, substantial NZ and Fiji assets, and most future earnings allocated to VSA. An initial

investment involving a 10-screen multiplex in the western Argentinean city of Mendoza, which had

just over 1 million people, was soon developed. This opened in December 1996, and proved very

popular and financially successful. The solid performance highlighted the great untapped potential

of this market. Domestic competitors, however, such as National Amusements and Cinemark

reacted to VSAs arrival by making their own investments and international rival Hoyts started

investing. The intensity of competition emphasized the importance of closing down opportunities

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for competitors by developing strategic sites and induced VSA to speed up its construction

program, while suitable cinema development sites were still available.

In April 1997, Force went to the market to raise additional equity to help fund its future proposed

Argentine expansion. NZ$17.45M was raised, to fund the development of 37 screens in

multiplexes in the regional cities of Pilar, Avellaneda and Rosario during 1997/98. In the Pilar

development a related retail complex was developed, which proved profitable by itself, and

attracted additional cinema patronage. This became the model for subsequent developments.

3.2 Key Project Risks in 1997:

Foreign Exchange Risk: Due to past currency-related disasters the Argentine Peso was pegged to

the US$ at a 1:1 ratio. Economic Indicators such as GDP, and inflation were stable, meaning that

the peg was likely to hold in the short to medium term. However, there was a high foreign

exchange risk associated with the peg over the long term, which would be non-linear and increase

rapidly over time.

Inflation: Inflation was extremely low at 0.3%. Inflation risk is highly correlated with foreign

exchange risk, so the government needed to keep inflation low in order for the peg to hold.

Conversely low inflation (below 1%) can hamper economic growth, and the medium term prospect

was for economic growth to slow.

Economic Risk: The success of Argentina’s economy was largely dependent on the preservation of

the peg and growth in key trading partners. Low productivity from government, corruption, and

high bureaucratic spending also presented major economic risks.

Political Risks: The left-wing Peronist party traditionally represented a threat to foreign investors.

Poor economic management and corruption are recurring problems. However since the economic

crisis in 1990, Peronist fiscal management and responsibility was encouraging.

3.3 Investment Phases

In 1997 subsequent investment was divided into 3 phases of investment, which when completed

would make VSA the predominant cinema operator in the country, with a substantial related retail

presence. Force’s joint venture partners were keen to proceed through all three phases as fast as

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possible to close out competitors. The initial appraisal report, by Grant Samuel1 gave a summary of

key considerations at the time of decision:

Advantages of Phase 1 Investment:

Population per screen in Argentina was very high by world standards.

Cinema attendance per capita was low with good prospects for improvement

Multiplex theatres were virtually non-existent in Argentina prior to 1996. Hence there was a

short-term opportunity for new companies to establish a dominant position in the

marketplace.

Force had considerable experience in the development of multiplexes. Multiplexes are more

economic than smaller cinemas and maximize operating efficiencies, and when combined with

retail complexes can be very profitable.

A large number of available sites had been identified for redevelopment.

Constraints Associated with Investment:

Argentina has traditionally been a volatile economic environment with high country risks.

Cultural distance may cause monitoring and agency cost problems. Corruption also represents

a problem.

Force’s comparatively small size meant that VSA represented a comparatively large amount of

capital relative to Force’s asset base. This was not the case for Village Roadshow.

The main opportunity was to invest directly in Argentina. Other available alternatives to Force

included Chile. However, VSA had proven successful and Force had substantial learnt knowledge

from its initial experiences. Development plans including actual investment opportunities had also

already been quantified and costed. Because of these reasons, and the high promise of the

Argentinean market, Force decided that VSA’s expansion of phase 1 was the preferable option.

An alternative existed where Force could purchase key development sites and delay

development whilst collecting rentals from existing tenants. However, Force had incentives to

1 This information is taken from Grant Samuel (1999), Mandeno & Cotter. It is assumed Force’s management had this

information at its disposal at the time of decision.

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invest immediately because of the strong initial performance, threat of imminent competition and

pressure from its joint venture partners. Purchasing strategic properties and delaying construction

would probably not provide a big enough disincentive to stymie a competitor’s construction

program. Given that there were alternative sites available2 the only effective way to discourage

competitors was to establish a sizable retail/ cinema complex. The option to delay was therefore

assumed not to be a viable alternative at this stage3.

4 Valuation using conventional DCF We start by setting out the classical discounted cash flow (DCF) analysis. This starts by generating

the best possible estimates of future revenue and capital investment, normally derived after

discussion with marketing and engineering staff. Then a discount rate is estimated, which for many

practitioners is the hardest part and is particularly complex for international investing. Political and

economic risk can be approximated by using the credit spread or differences in government bond

rate between respective countries as this provides a market consensus of country risk. Following

Luehrman (1998b) we assessed country risk volatility at 40%, which is a conservative minimum

plausible estimate4. The market for multiplex cinema development was not well established in

Argentina, so a discount is required to reflect market unfamiliarity. The adjustment reflects such

costs as additional labor costs needed in order for employees to familiarize themselves with

operations, and time required to generate managerial economies of experience. The VSA phase 1

DCF estimates are summarized in table 1, as at the end of 1996, which is regarded as ‘year 0’. Note

that this return is dominated by the terminal value.

2 Source: Force Corporation Annual Report (1997).

3 Standard real option theory does not always hold in oligopolistic situations because future returns do not follow a

random walk. Real option analysis assumes that individual players in the market cannot affect other’s actions. Game

theory can be incorporated into real option analysis but this is highly complicated. 4 We wanted to make the estimate as conservative as possible because property ownership was involved. It is likely that

a figure well in excess of 40% could have been justified. In 1996, Argentine market volatility was 61.63%. Eiteman et

al. (2001) Page 480.

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Table 1 : Estimated VSA phase 1 cash inflows and cash outflows, as at end 1996 (US$M)

Year

1996 1997 1998 1999 2000 2001 2002

Cash flow

0.03 1.13 2.03 2.98 4.34 4.67

Terminal Value

17.78

Less Invested Capital

2.73 3.43 11.73

Net Cash flow (US$m): -2.73 -3.40 -10.59 2.03 2.98 4.34 22.44

Discount Factor (21.21%) 1.0000 1.2021 1.4451 1.7372 2.0883 2.5104 3.0178

Present Value -2.73 -2.82 -7.33 1.17 1.42 1.73 7.44

NPV = -1.12

The DCF model depended on estimated investment parameters which are used to estimate a

risk-adjusted discount rate, and a business volatility measure. The results are summarized in the

table 2.

Table 2 : VSA phase 1 market parameters

Market Return

11.50%

Beta of proposed cinema construction activity: 1.60

Risk Free Rate (NZ govt bond 1 yr yield): 6.78%

Project Cost of Capital:

14.33%

US Government Bond Rate 5.48%

Argentina Government Brady Bond Interest Rate: 12.66%

Credit Spread:

7.18%

Less:

Estimated NZ Bond Credit Spread 1.30%

Country Risk Discount:

5.88%

Required Rate of Return:

20.21%

The business volatility (standard deviation) 40%

Despite forecast revenues considerably exceeding forecasted costs, using the estimated discount

rate of 20.21% meant that the project value, NPV, was negative at US$ -1.12m. The negative value

was not a surprise to the management as the phase 1 was not regarded as a stand-alone project,

with consideration based mainly its success creating further investment opportunity. Profits were

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expected to come from phase 2, whose construction was expected to start in 1999. Phase 2

cashflow projections are shown in the Table 3.

Table 3 : Estimated VSA phase 2 cash inflows and cash outflows, as at end 1996 (US$M)

Year

1996(0) 1997 1998 1999 2000 2001 2002

Cash flow (Million US)

2.12 3.64 4.87 5.14

Terminal Value

24.65

Less Invested Capital

17.33 7.33

Net Cash flow: 0.00 0.00 0.00 -15.20 -3.68 4.87 29.79

Discount Factor (21.21%)

1.0000 1.2021 1.4451 1.7372 2.0883 2.5104 3.0178

Present Value = 0.00 0.00 0.00 -8.75 -1.76 1.94 9.87

NPV =

1.30

Table 2 shows an estimated phase 2 NPV of US$ 1.30m. Phases 1 and 2 thus have a combined

NPV of US$ 0.18m. Note that, while the combined NPV is positive, it is still not very attractive, as

the rate of return from the NPV appraisal on the total investment value of US$ 27.17m is less than

0.7%.

Calculating NPV and IRR Return to Force in NZ$ requires adjusting for foreign exchange changes

taxation. The return is greater than that given in the VSA analysis because of an expected

devaluation in the New Zealand dollar. This result should be given precedence over VSA’s NPV as it

is important to evaluate projects on the basis of net returns to the parent company.

Once we have the inputs for an NPV we can easily calculate an APV. The advantage of using APV

is its greater information content. An APV breaks cash-flows down into different income streams,

(i) Cash-flows derived from equity (direct cash-flows from the investment), (ii) Cash-flows derived

from the financial mix. This approach makes it easy for managers to analyze the value creation

derived from areas within the project. Because cash-flows derived from debt (income tax credits)

are less risky than cash-flows derived from the investment (forecast customer receipts) it is more

accurate to use different discount rates for the various cash-flows. Projects which are heavily

reliant on high levels of debt to become economic need to be carefully scrutinized.

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Economic Variables: YEAR NZD/ USD USD/ ARSDiscount Rate 21.21% 1996 0.6761 1.000

First Time Discount 1.0% 1997 0.6876 1.000

Argentinean Inflation 0.3% 1998 0.6793 1.000

US Inflation 2.8% 1999 0.6400 1.000

NZ Tax Rate 33% 2000 0.6100 1.000

Effective NZ Tax Rate (Double Tax negotiation) 3% 2001 0.6100 1.000

Expected Divergence from Forward Rate 0% 2002 0.6027 1.000

It is assumed that NZD/ USD forwards are unbiased predictors of future currency rates

It is assumed that USD/ ARS forward rate predicts no change in the peso peg

It is assumed that NZ tax credits can be offset against other profits in New Zealand

It is assumed Force negotiates a double tax agreement with Inland Revenue so effective NZ tax is only 3%

It is assumed that the US devaluation will have no effect on relative costs in Argentina (eg loan costs)

The 2002 forward rate for NZ/ US was not available in 1997, I estimated it as .6027.

Assumptions:

1996 and 1997 are avg

actuals. Source:

www.rbnz.govt.nz

First I downloaded

forward rate quotes from

1/6/ 97 (2002 is

estimated). 1996 is

included to incorporate

the costs of Mendoza

Table 4: APV of Investment Phases (gives return in NZ$)

The major issue with the NPV appraisal is that it ignores the element of the flexibility of the

second phase investment. Intuitively attractive strategic projects are often rejected by NPV

methods, because NPV fails to adequately value long-term potential and the ability to respond to

the changing business environment.

Because the business environment was highly volatile, (annual standard deviation is about 40%),

the NPV appraisal deals with this by imposing a high discount rate. Because the majority of the

return is embodied in the terminal value, the estimated return is heavily discounted. Note also

that the high variation in possible profit means a point estimate like US$ 0.18m is meaningless.

In actual fact the investment returns could be substantially higher or lower than that estimated,

and would not be clarified until after the two years of trial in phase 1. The project also had a lot of

Year: 0 97 98 99 00 01 02

Remittable Cash Flow -USD 2,975,000 -USD 4,621,942 -USD 5,538,853 -USD 3,988,306 USD 318,162 USD 1,173,308 USD 35,804,412

Currency Exposure:

Estimated Currency Rate:

Currency Rate NZ$/ USD 0.6761 0.6876 0.6793 0.6400 0.6100 0.6100 0.6027

Force's NZ$ Cashflow: (4,400,237)$ (6,721,846)$ (8,153,179)$ (6,231,728)$ 521,578$ 1,923,455$ 59,408,661$

Less New Zealand Tax: (17,903)$ 65,928$ 125,097$ 135,322$ 336,136$ 403,674$

Net Cashflow After Tax: (4,400,237)$ (6,703,943)$ (8,219,107)$ (6,356,825)$ 386,256$ 1,587,319$ 59,004,987$

Force Post Tax NPV: $295,349

Force Post Tax IRR: 21.62%

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flexibility. VSA’s management deliberately used the two years in phase 1, 1997-98, to learn more

about market and economic conditions and competitor strategy. The investment involved in

second phase would only be implemented if phase 1 was successful and business conditions were

favorable. Alternatively, VSA could elect to expand in different localities, increase developments,

or even delay future investment should market conditions not warrant further expansion. The

possible substantial future profits from phase 3 are also ignored. APV and NPV methods do not

take into account this flexibility, and treat investment in Phase 2 as if it were mandatory.

FDI appraisal needs to explicitly recognize the flexibility involved in a phased investment strategy,

with progression to a subsequent stage only if the present stage is successful needs to be explicitly

recognized. Phase 1 investment should thus not be seen as a stand-alone project, but valued as

expanding the investor’s future possible opportunities. This is best captured as real option

methodology, which views future investments more realistically as opportunities under

uncertainty. The recognition of this option will potentially add some positive value to the project.

Force had a guarantee agreement from the Village Roadshow that 80% of the phase 1 investment

(US$ 14.22m) could be expatriated if business conditions were adverse. Village Roadshow agreed

to this as they were keen to gain access to Force’s property expertise. For Force this arrangement

was very useful as the volatile economic environment in Argentina posed obvious risks, and in a

downturn the investment would be unsellable for a period. Because of Force’s small size, the VSA

investment represented a large and undiversified risk. This did not apply to Village Roadshow, due

to their far larger size and international diversity. This guarantee created another option (a put)

which adds value.

5 Valuation using Real Options A real option exists if a company has the right (but not an obligation) to make a decision at a

future point in time. For example the rights to delay an investment, to make a further investment,

or the right to disinvest, are options which add to the value of an investment. The investment

return should thus also include the added value of the real options created. We use open form

binomial analysis as this can incorporate expert predictions of future values, whereas the Black

Scholes relies on distributions from the normal probability curve. This assumption does not usually

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hold in real-life situations5. Triatis and Borison (2001) also argue that the binomial offers more

flexibility. Black Scholes calculations can be found in the Appendix.

5.1 Call option based on phase 2 investment (expansion option) Call option based on phase 2

investment (expansion option)

The call option could also be calculated with binary model, which is based upon the following

parameters as follows:

Σ 0.4

Risk-free rate (Rc) 12.66%

Up (eσ) 1.4918

1+rf 1.1266

Down(e-σ) 0.6703

Exercise 23.42

We have used the standard deviation of the underlying asset value to estimate the up (eσ) and

down (e-σ) movement levels (the standard deviation of the binary model is 0.402; which is a close

enough in practice). With these parameters, we can get the risk-neutral probability, p=[(1+Rf)-

D]/(U-D)=0.555. We then create a binomial tree with two different values generated on an annual

basis. Each node in the tree has a subsequent upward or downward possibility. The asset value

movements as follows:

Here the value for each subsequent year equals the earlier year value multiplied by u or d. An

inflation adjustment can be made to this by using u(1+infl).

5 Luehrman (1998a) details how these assumptions can cause a +/- 10% variation in option valuations. He argued that in

the uncertain world of investments, a near enough valuation is the best possible result.

US$M 1996 1997 1998

32.90

22.05

14.78

14.78

9.91

6.64

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If we use the option terminal value CT=Max(0, ST-E), we can get the option values at the end of

year 1998. The risk-neutral method is used to get the present option value, which is US$2.30m6.

US$M 1996 1997 1998

9.48

4.67

2.30

0.00

0.00

0.00

5.2 Put option based on phase 1 property investment guarantee (reversibility option)

We use the present value of all the phase 1 capital investment as the starting (end of year 1996)

property value. In Force’s situation the time to expiry is 6 years, with settlement date and expiry of

Option 1 scheduled for 2002. The exercise price is the value at which it becomes economic to

exercise the option to sell. In this case we assume Force will use the option and sell to Village

Roadshow if the market value of the 25 % share falls below the exercise price US$14.22m.

We work out the value of two options, Option 1: The Reversibility Option and Option 2:

Investment in Phase 2, using the binomial approach. The Black Scholes valuation is in the

appendix. The same market parameters used in the above call options are applied in the put

option calculation. The five year binary movements are as follows:

1996 1997 1998 1999 2000 2001 2002

150.88

101.14

67.80

67.80

45.45

45.45

30.46

30.46

30.46

20.42

20.42

20.42

13.69

13.69

13.69

13.69

9.18

9.18

9.18

6.15

6.15

6.15

4.12

4.12

2.76

2.76

6 This binary model call option uses the same assumption as the first call option, which shows that the binary model

plays the equivalent function as Black-Sholes in the call option of this case.

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1.85

1.24

The terminal put option formula is PT=Max(E-ST,0), and the exercise price is 14.22 which is 80% of

the total investment capital value (80% of 17.78). The same risk neutral option (as shown in above

call) is used. The resultant put option value is US$1.17m.

1996 1997 1998 1999 2000 2001 2002(T)

0.00

0.00

0.00

0.00

0.03

0.00

0.26

0.08

0.00

0.67

0.62

0.21

1.17

1.38

1.46

0.53

2.11

2.72

3.45

3.64

5.05

8.07

5.82

8.50

8.44

11.46

10.77

12.98

The whole project value calculation (both Black-Scholes and Binary) is summarized in the following

table (US$m):

Phase I II

Sum

NPV -1.12 1.30

0.18

Call

Binary -1.12 2.30

1.18

B-S -1.12 2.14

1.02

Put Rev

Binary -1.12 2.30 1.17 2.35

B-S -1.12 2.14 1.30 2.32

The NPV consider the phase 1 and phase 2 cash flows only; the NPV is US$0.18m. The second

phase is actually a real option, which could be abandoned if the business is not moving in the

favorite direction. Modifying the phase 2 condition, we have the project value of 1.02 (with Black-

Scholes model) or 1.18 (with Binary model). Additionally if the cash reversible promise (or

contract) is enforceable, this put option could add another value which is estimated as US$1.17m

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or US$1.30m and the whole project will become US$2.35m (in Binary model) or US$2.32m (in

Black-Sholes model).

The final analysis provides strong justification for Force to make an investment in Phase 1, even if

it cannot arrange an exit option with Village (Option 1). The value created by the flexibility of

investment (as opposed to compulsory investment) changes the negative DCF result substantially.

This supports the strategic advantages of the project that managers would have otherwise

considered intuitively. Conversely, if Force were to commit to both Phase 1 and 2 now, it is likely

that the risks would not justify the return. This is the reason why we have a negative NPV.

True Value of Investment Opportunity (US$m)

Phase One DCF $ -1.12

Call Option on Phase 2 $ 2.14

Put Option on Guaranteed Price $ 1.30

Total PV of Phase 1 $ 2.32

The justification for investment in VSA is largely based on the present value of the option to

invest further in Phase 2. The present value of Phase 2 incorporates not just the underlying cash-

flows, but reflects the flexibility offered by this future investment opportunity. The Argentine

economic climate was highly uncertain, and the greater the uncertainty the greater the value

created by retaining options as opposed to making a direct investment. In practice, using a DCF

methodology assumes volatility is only negative, so that the high possible project volatility meant

an increase in the discount rate, so that NPV was strongly decreased, especially the terminal value.

Using a real options approach recognizes that high volatility increase the chance of strongly

positive outcomes, as well as strongly negative. If the project can be phased so that subsequent

phases can be postponed or exited then high volatility can be positive.

Note however, there are problems in practice associated with storing large value in options,

because it is difficult to stop competitors from getting in first and destroying their value. This

problem is worst when there are only a few competitors in the market and high barriers. VSA and

other competitors are an oligopolistic industry, and speed of construction was important.

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At the time, these competitive factors were largely unknown, but it is likely that these factors

may distort the results. The distortions to our valuation model should be balanced by Argentina’s

high volatility. The inherent volatility of Argentina’s economy ensures that Option 2 retains a high

worth regardless.

6 Analysis of Results and Development of Strategy

Luehrman (1998a) developed a framework to assist managers make decisions using real option

analysis. He emphasized the importance of not just looking at the NPV of the investment but also

the forecast variance. By considering volatility we can extend the NPV ‘invest now/ do not invest’

criteria into a three-dimensional framework. The framework can help managers to review the

strategic effect of an increase or decrease in the volatility of the investment opportunity.

Luehrmann’s (1998a) graph shows 6 different investment opportunities. The value to cost axis is

simply the NPV(q); and the volatility axis is simply σ/ t .

Source: Luehrman (1998a) Page 97.

Position F is analogous to Force’s investment in VSA. Despite having a positive NPV(q), the high

volatility would normally mean that the best strategy is to wait and retain the option to invest at a

later date. The ‘option space’ framework modifies the NPV rule, because option F is likely to offer

an even greater risk-adjusted value if exercised in the future. The reason for this is that options are

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worth more than direct investments when uncertainty increases. However, Force could not afford

to wait, as competitors were threatening to take away the opportunity altogether. Strategies

implemented to protect the value of this option7 were not likely to work.

While, in Force’s situation, the real option analysis is restricted by assumptions, the real options

framework provides a much better strategic insight into FDI decisions than the NPV. Real option

assumptions can be relaxed further and extra accuracy can be gained by adding extra features8 to

our valuation model. Real options provide a useful framework in justifying strategic projects that

are intuitively appealing to management, but have persistently negative NPVs. This situation

occurs frequently when discretionary future investment opportunities are subject to high volatility.

These opportunities often require no capital commitment immediately, but are heavily discounted

by the NPV regardless. In this instance, reliance on a NPV would mean that investment in VSA

might not have gone ahead. Using real options means these opportunities are properly analyzed

and inaccurate adjustments are no longer required.

Factors such as uncertainty and flexibility are important characteristics that should be considered

integral parts to a comprehensive decision-making process. The analysis provides managers with a

superior strategic insight, as well as providing a more accurate valuation of the investment

opportunity.

7 Funding Issues and Project Outcome

7.1 Funding Issues

At this stage the results show that the Phase 1 VSA investment is viable despite having a negative

NPV. However, while phase 1 was financed by Force with equity, VSA planned to finance portions

of Phase 2 with US$ debt. This meant that most of the benefits derived from investing in Phases 1

and 2 occur because of the high present value of debt. This signifies that VSA created most of its

value, not from the core business of cinema operation, but from using debt to finance business in

7 Such as purchasing strategic sites and delaying development.

8 For example: Option values that can take into account extreme crisis (non linear risk), competition, or uncertain future

costs.

~ 18 ~

a risky country. The high leverage was created by the use of debt under the proposed medium

term notes agreement. The analysis so far doesn’t account for this.

For VSA, financing with foreign US$ debt magnified Argentine country risks. This is undesirable,

and management would need to carefully consider whether too much leverage was being used in

Phase 2 under the proposed medium term notes arrangement. While financing in local currency

may on the surface be more expensive, it provides an important means of reducing currency

exposure and political risk, as the value of debt would correlate with the value of assets.

The additional exposure to currency and country risk associated with this foreign debt changed

the nature and risk levels of the investment quite significantly, as the increase in risk would result

in a much higher discount rate for Phase 2, which would bring the viability of the project into

question. It is likely that thorough financial analysis would have provided Force with a substantial

increase in discount rate and given the Phase 2 developments a substantially negative present

value. Heavy borrowings might increase the APV, but will also increase project risks. The added

risks of high levels of debt financing are not incorporated into the project’s discount rate. On the

surface this would make the VSA project appear far more attractive than what it really is.

If Force had stuck to the strategy of financing developments with equity, VSA would have been a

much more attractive proposition, and they would probably have survived the crisis. Despite the

1999 economic crisis, VSA’s earnings remained relatively robust, because its cinemas were still

fundamentally profitable. The financing decision was made after committing funds to investing in

part of Phase 2. The problem for Force was that VSA had already invested in long-term property

assets, and was forced to quickly find a means of funding this. Force had a relatively small asset

base compared to the investment, and had already committed most of its liquid capital to the

Argentinean expansion. Force had already raised new equity capital for Argentina, and a further

additional equity issue would be difficult to justify to shareholders.

The use of foreign currency debt however led to short-term financing issues that caused financial

distress to Force, despite VSA maintaining a positive EBIT. A major issue is that Force relied on the

financial assessments by Village Roadshow, and did not do enough of its own capital budgeting

analysis prior to making these decisions. For instance it is likely that Village Roadshow (a

~ 19 ~

diversified MNC) would have a substantially different cost of capital to Force, so that for the same

project the partners would different appraisal results.

In 1998 country risk in Argentina increased immensely with the government bond credit spread

rising to above 14%9. By June 1998, the Argentine government bond rate increased to above 20%

per annum. It is unlikely that investment in Phase 2 could be justified given the rise in country risk

alone.

7.2 Currency Issues

Foreign exchange risk is conventionally regarded as a symmetrical and thus neutral risk. Keck et

al. (1998) and Lessard (1996), for example, recommend against discounting for foreign exchange

risk because the risk is diversifiable. Profit can go up just as easily as downwards, and hedges can

be used to minimize variance. However, over time foreign exchange risk is not always balanced.

In Force’s situation the Argentine Peso was fixed to US dollar by a peg, and the risk was thus

asymmetrical in favor of an Argentine devaluation. In addition, Force’s Peso/ US$ currency risk was

largely realized from the financing structure.

Hedging is another important consideration. Village’s assessment argued that that Force’s main

foreign exchange risk was the NZ$/ US$ risk, as currency forecasts showed that Argentina’s peg

looked set to hold in the medium term. Force thus purchased $60 million dollars worth of NZD/

USD forwards, while the US$/AGP risk went unhedged. The US$ financing structure left Force over-

exposed to high levels of long-term risk.

By giving the bank a parent guarantee, Force was writing in effect writing a put option of its own

warranting that Argentina’s currency peg would hold. The US$ financing meant that if economic

conditions deteriorated rapidly (as they had done and often do in volatile countries) the bank

could then exercise the option to seek repayment, even if the project was profitable in Peso In

such volatile environments, guarantees (as highlighted by large value of Option 1) are worth

considerable amounts of money. It is likely that the true cost of debt including the guarantee and

the effects of the incremental foreign exchange risk was substantially higher than the risk-adjusted

returns offered by the investment.

9 See Appendix.

~ 20 ~

7.3 Property Issues

In investment terms, property development is a substantially different activity to property

ownership. Property development is by definition a short-term, higher risk activity; whereas

property ownership is generally typified by long-term low risk investing. The lack of a secondary

market for VSA’s property developments meant that VSA by default became a long-term

commercial property owner. Property investment becomes less attractive in climates with low

inflation because property acts as a shield against inflation. The sensitivity analysis in VSA’s NPV

highlighted Force’s reliance on investment capital gains. A sale and leaseback program would have

substantially increased VSA’s risk adjusted returns. By having a big capital commitment in property

assets, Force was exposed to high levels of asymmetrical non-linear currency and country risk.

7.4 Reversibility

Lastly, our real options analysis highlighted the value of reversibility. At the time, Force

underestimated the illiquidity of its investment in VSA. In terms of resources, Force had made a big

commitment to Argentina and would probably only want to liquidate this in the event of an

extreme downturn. Other prospective purchasers (including joint venture partner Village) would

have exactly the same reasons of not wanting to buy Force’s share without a substantial discount.

The medium term notes agreement (and more importantly the guarantee) rendered Force’s share

virtually illiquid under these circumstances. The financing agreement exacerbated Force’s liquidity

problems in addition to creating additional currency risks and foreign exchange risks.

Many FDIs are illiquid, and smaller companies like Force need to consider liquidity a lot more

carefully than larger, more diversified, companies due to their exposure to debt issues and

currency variability, and will be more exposed than larger MNCs to downturns in individual

markets. Lack of liquidity is another reason why Force should have produced its own investment

analysis.

7.5 Sensitivity Analysis

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It is often advisable to conduct sensitivity analysis to examine how robust the project is in

relation to weaknesses in key variables. Several key variables are selected for analysis: VSA could

withstand a high level of cost increases with a 10% increase in variable costs only reducing profits

by 3%. Similarly, VSA could withstand large increases in the Argentine tax rate. A 10% increase in

the company tax rate reduced after-tax profitability by less than 1%. VSA had the highest levels of

sensitivity to the forecast capital gain variable. The investment return fell to 14.84% if there were

no capital gains in market price. Overall the sensitivity analysis shows acceptable risk tolerance

levels, but highlights Force’s reliance on the value of the investment increasing over time.

8 Conclusion

It is important that investments are made in areas that are the most likely to add value to a

business. Taking intelligent risks is at the heart of running a successful business. In the context of

FDI conventional DCF appraisal techniques are often invalid, as they do not cope with the

additional risks involved. Yet, given the often poor outcomes of FDI, accurate, flexible, appraisal is

vital.

The use of real option methods adds substantial information to the appraisal process and should

be encouraged. Phasing investment as a series of steps, with re-evaluation at each step is also

essential. FDI appraisals should be designed to highlight key areas such as flexibility and sensitivity

to risk. This case-study highlights the importance of adding liquidity to FDI’s.

US Currency Devalues

more than forecast NPV IRR

$295,349 21.6%

-10% 1,569,364$ 23.3%

-20% 3,159,636$ 25.2%

-30% 5,201,705$ 27.3%

-40% 7,921,469$ 29.8%

US Currency Increases

more than forecast NPV IRR

$295,349 21.6%

10% (748,660)$ 20.1%

20% (1,620,165)$ 18.8%

30% (2,358,975)$ 17.5%

40% (2,993,524)$ 16.4%

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Force’s investment was both illiquid and subject to high levels of long-term uncertainty. Initially

the returns justified the risks. However, problems were compounded by an inflexible financing

structure that drastically changed the risk profile of the investment. Force would have benefited

from greater levels of in-house sensitivity analysis. Thorough analysis would have highlighted the

key areas of risk within the investment.

Our analysis shows Force’s Phase 1 investment in Argentina was well justified. However,

subsequent investments in Phase 2 needed much more sophisticated levels of financial

engineering and planning given the increase in risk profile. This was not done by Force.

VSA Project Outcome

The 1999-2002 economic and currency crises in Argentina did not immediately impact on the

viability of VSA as cinema attendance was a cheap entertainment alternative. However the rolling

crisis did sharply reduce property values, and led in January 2002 to an abandoning of the US$ peg.

There was a subsequent 400% devaluation of the peso. This had a huge impact on Force’s ability to

sustain its US$ debt funding and devastated the value of VSA in Force’s NZ$ annual accounts. In

2001 Force was sold to the NZ casino/ cinema operator, Sky City, who had no interest in continuing

with VSA. The value of VSA was written down in 2003 in Sky City’s accounts to zero. In October

2005 SKYCITY received US$200k from the Argentine partner, Southern Screens Ltd, as an exit

payment for the equity as well the transfer of all loans relating to VSA.

_________________________________________________________________

Appendix Limitations

This research is subject to the following limitations:

Conclusions were drawn on the basis of 1999 appraisal report data. This data is not likely to

provide an accurate depiction of the circumstances Force faced in 1997.

The real options approach and other aspects contained in this report were not widely available

at the time of Force’s investment, and therefore are not meant as a criticism of decisions

made. No criticism is implied on part of any member of the Force management.

~ 23 ~

The analysis is subject to assumptions. Best efforts have been made to keep the analysis as

realistic and accurate as possible, but this may not always be the case.

Inferences drawn from analysis in the report are designed to illustrate how practitioners can

use financial information to reach conclusions on the viability of investment. This is subject to

limitations, hence any conclusion or finding is subject to error.

The options presented in the real option analysis are hypothetical, and are merely designed to

highlight the potential value of real option analysis. It is unlikely that Option 1 would have been

available to Force.

The report does not provide financial analysis evaluating the medium term notes agreement.

This is considered outside the scope of this research report. An absolute opinion about the

suitability of the financing agreement cannot be drawn without further financial analysis.

The framework uses the best methods available given the practicalities of the situation. It is

acknowledged that additional accuracy can be generated (especially in the real option

analysis), but such detail was considered outside the scope of this report.

Country Risk Evolution of Argentina and Latin America (EMBI)

Source: www.dfat.gov.au/geo/argentina/argentina_country_brief.html

~ 24 ~

Black-Scholes Approach

Call option based on phase 2 investment (expansion option)

We use Black-Scholes formula to calculate the call option value;

where;

N(d1), N(d2) = cumulative normal probability

s = annualized standard deviation (volatility) of the continuously compounded return on the stock

(the only unknown)

rc = continuously compounded risk-free rate

We use two valuation methods: 1) Use Phase 2 PV (1996) of expected future incomes as current

asset price and expected future (1998 value) investment as Exercise Price (although the trial

project is phase 1, the real value effect is measured on the Phase 2 cash flows, assuming the phase

2 value moves in the same direction as phase 1 value.); and 2) Use phase 2 NPV (1996 value) as

asset value and 10% of the NPV as Exercise Price.

The necessary inputs are shown in table 4, for the two methods.

Table 4 : Phase 2 Black-Scholes inputs

Inputs: M1 M2

Asset Price (S)

14.78 1.30

Exercise Price (X)

23.42 0.13

Risk-free rate (r)

11.92% 11.92%

Time to expiration (T)

2 2

Standard deviation (s)

0.4 0.4 Black-Scholes Option:

European Call

2.14 2.30

Tσdd

Tσ

/2)Tσ(r/X)ln(Sd

where

)N(dXe)N(dSC

12

2

c01

2

Tr

10c

~ 25 ~

The first method assumes that the future investment value is fixed and the second method

assumes that the project will be abandoned if its NPV has a decline of 90% of the current value – a

subject abandon threshold of 10% NPV. The call option values are 2.14 and 2.30 respectively to the

two methods. These two call option values provide the likely range of possible option value.

The binomial lattice values the option using an open form probability tree. U and D are upward

and downward adjustments that occur at the end of each year based on investment volatility.

There is a 50% chance that the asset value rises during the year (and is multiplied by U), and a 50%

chance that the asset falls at by an inverse amount (and is multiplied by D). If we use 1% NPV as

the new threshold, the call option will be 1.29.

Put option based on phase 1 property investment guarantee (reversibility option)

We can also use the Black-Scholes formula to calculate the put option:

Put option Inputs:

Asset Price (S)

13.69

Exercise Price (E)

14.22

Risk-free rate (rc)

11.92%

Time to expiration (T)

6.00

Standard deviation (s)

0.4

Black-Scholes Option: European Put

1.30

Disclaimer:

The figures used in the financial analysis were based on information obtained from Force Annual

Reports and an investment appraisal report prepared in 1999 by Grant Samuels Ltd. While best

Estimated Option Volatility of VSA ( 40% per annum

U is e 1.492

Risk Free Rate (Argentinean Govt Bonds): 12.66%

d=1/u 0.6703

p= ((1+Rf)-d)/(u-d) 0.5554

1-p 0.4446

~ 26 ~

efforts have been made by researchers to accurately recreate Force’s investment opportunity as at

June 1997, the information contained in this report remains subject to error. All errors and

omissions are the sole responsibility of the authors alone. Much of the theoretical developments

discussed in ‘The Real Options’ framework section were not published at the time of Force’s

investment, hence this cannot be considered a limitation of Force’s analysis. No comment is made

on the adequacy of Force’s medium term notes agreement with ANZ, as this was considered

outside the scope of Force’s 1997 investment decision. The recreated scenarios and results

contained in the analysis do not purport to provide definitive conclusions as to the viability of VSA

project as a whole; their main role is for illustrative purposes only.

~ 27 ~

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