An application of real options in valuation under uncertainty

Abstract

This thesis aims to illustrate how real options embedded in business concerns may be identified and quantified for valuation purposes. Traditionally, Discounted Cash Flow (DCF) and Net Present Value (NPV) techniques are central to valuation under uncertainty. However, option pricing-theory, applied to real or non-financial assets, is introduced as a means of bridging the gap between real world valuation practicalities and standard theory. This central theme is complemented by the valuation of the process patent and plant breeder rights held by Peppadew International (Pty) Ltd. The real option valuation is conducted in conjunction with an independent valuation of Peppadew by the accounting firm KPMG. Keeping the options analysis in line with the generally accepted and well-understood NPV methodology, renders it intuitively understandable and acceptable to managers and investors alike. The first part of the study illustrates that standard NPV analysis alone is an inadequate valuation tool in the presence of real assets. Valuing the process patent and plant breeder rights of Peppadew International by means of a real option analysis highlights the fact that some inherent value remains unaccounted for by traditional methods. The company was undervalued when applying the Discounted Cash Flow model only - not because the expected cash flows were too low, but simply because the model ignores the options that the company has, via its patents and breeder rights, to increase future investment and take advantage of business success. Specifically, the real option analysis of Peppadew demonstrates that uncertainty can create va!ue. The second part of this study illustrates how the results from the real options analysis of Peppadew International may be applied to engineer an enhanced funding strategy for the company. Specific requirements are set forth by a large governmental lender and these requirements are met through a uniquely stmctured putable bond for Peppadew. The findings of this study emphasise that strategists, analysts and valuation experts can no longer overlook real options as an analysis tool. Identifying real options not only adds substantial economic value but also introduces a paradigm shift in understanding flexibility, i.e. the ability to successfully adapt to unforeseen changes as uncertainty unfolds. The overall result of this work is a clear and logic demonstration of how real option analysis is an extension (to non-financial assets) of the ways in which financial markets value options on stocks or shares.