An application of real options in valuation under uncertainty / Claudine Neethling

This thesis aims to illustrate how real options embedded in business concerns may beidentified and quantified for valuation purposes. Traditionally, Discounted Cash Flow(DCF) and Net Present Value (NPV) techniques are central to valuation underuncertainty. However, option pricing-theory, applied to real or non-financial assets, isintroduced as a means of bridging the gap between real world valuation practicalities andstandard theory. This central theme is complemented by the valuation of the processpatent and plant breeder rights held by Peppadew International (Pty) Ltd. The real optionvaluation is conducted in conjunction with an independent valuation of Peppadew by theaccounting firm KPMG. Keeping the options analysis in line with the generally acceptedand well-understood NPV methodology, renders it intuitively understandable andacceptable to managers and investors alike.The first part of the study illustrates that standard NPV analysis alone is an inadequatevaluation tool in the presence of real assets. Valuing the process patent and plant breederrights of Peppadew International by means of a real option analysis highlights the fact thatsome inherent value remains unaccounted for by traditional methods. The company wasundervalued when applying the Discounted Cash Flow model only - not because theexpected cash flows were too low, but simply because the model ignores the options thatthe company has, via its patents and breeder rights, to increase future investment and takeadvantage of business success. Specifically, the real option analysis of Peppadewdemonstrates that uncertainty can create va!ue.The second part of this study illustrates how the results from the real options analysis ofPeppadew International may be applied to engineer an enhanced funding strategy for thecompany. Specific requirements are set forth by a large governmental lender and theserequirements are met through a uniquely stmctured putable bond for Peppadew.The findings of this study emphasise that strategists, analysts and valuation experts can nolonger overlook real options as an analysis tool. Identifying real options not only adds substantial economic value but also introduces a paradigm shift in understandingflexibility, i.e. the ability to successfully adapt to unforeseen changes as uncertaintyunfolds. The overall result of this work is a clear and logic demonstration of how realoption analysis is an extension (to non-financial assets) of the ways in which financialmarkets value options on stocks or shares.