Real Options in Telecommunication - Network Evolution Economics

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Real Options in Telecommunication
Network Evolution Economics
John M. Charnes∗
The University of Kansas
School of Business—FEDS
1300 Sunnyside Avenue
Lawrence, KS 66045
jmc@ku.edu

Barry R. Cobb
The University of Kansas
School of Business—FEDS
1300 Sunnyside Avenue
Lawrence, KS 66045
brcobb@ku.edu

January 19, 2003

1

Introduction

This document describes ongoing work to be performed on a research project during the period 16 September 2002 through 15 September 2003. In subsequent sections we provide background information for the project taken from the research proposal and present some ideas that were sent recently in a progress report to the providers of the research funds. The goals of this research project are: (1) to provide Sprint and Nortel Networks with a usable valuation model for making decisions related to the evolution of the telecommunication network, and (2) to expand the existing base of academic research related to valuation of real options. By using real data and opportunities to accomplish (1), we can determine general techniques that can be published to help accomplish (2).

This document contains preliminary results and is intended to accompany a presentation scheduled for January 24, 2003 in the Finance Seminar at The University of Kansas School of Business. Do not quote, cite, or distribute without permission of the authors.

∗ The authors gratefully acknowledge financial support from Sprint and Nortel Networks through The University of Kansas Center for Research, Inc., FEIN #48-0680117.

1

2

Financial options and real options

An option is the right, but not the obligation, to buy (or sell) an asset at some point within a predetermined period of time for a predetermined price. Real Options Analysis (ROA) has been used recently as an alternate methodology for evaluating capital investment decisions involving a high degree of managerial flexibility, such as research and development projects or new product decisions. Unlike the simple net present value (NPV) method used in traditional finance theory, ROA treats an investment opportunity as either a single option or a compound option (a sequence of options). The traditional NPV method cannot value managerial flexibility correctly because it relies on the false assumption that the investment is either irreversible or that it cannot be delayed.

With a financial option the initial investment in an options contract buys the potential opportunity to enjoy positive cash flow when future price changes of the underlying financial asset favor doing so, but does not carry the obligation to realize negative cash flow if unfavorable conditions prevail. This flexibility adds value to a financial option contract. With a real option —an option on a real asset—the initial investment related to the asset (e.g., an expansion of some portion of a telecommunications network) buys the potential opportunity to continue, expand, or abandon the use of the asset when it is favorable to do so, but does not carry the obligation to realize some losses when unfavorable conditions prevail. Because projects such as network expansion can be viewed as options, financial models similar to those used for determining financial option values can be used to determine the value of the real options embedded in the opportunity for network expansion.

The research proposal describes some of the methods available for valuing real options, and discusses how they can be developed to suit the needs of Sprint and Nortel Networks as they plan the evolution of telecommunications networks over the next two to seven years.

3

Factors affecting option value

The Black-Scholes formula for a European call option on a stock that pays dividends at the continuous rate δ is
C(S, K, σ , T , δ, r ) = Se−δT N(d1 ) − Ke−r T N(d2 ),

(1)

where
d1

=

d2

=

ln(S/K) + (r − δ + 1 σ 2 )T
2

σT

d1 − σ T

2

(2)
(3)

and N(x) is the cumulative normal...
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