768  Flexibility manufacturers makes it unattractive for managers to defer a decision to launch new product versions with innovative features such as voice- control or foldable-screen technology until there is more information about potential demand for such features. • Payoffs. What payoffs are linked to these decisions? Bear in mind that there should be a positive NPV to be captured in some realistic future state of the world. This NPV should be derived from sustainable com- petitive advantages. For example, some investors attribute high value to certain e-commerce start-ups as “options for future growth,” often based on multiples of enterprise value over unique website visitors per month. But website visits alone do not create value. Moreover, the value of e-commerce start-ups depends upon their future cash flows. Start-ups can represent valuable options only if they build sustainable, competitive business models in some plausible future scenarios. Valu- ing start-ups as options requires articulating what the scenarios are, as well as predicting their likelihood of success and associated businesses cash flows. With regard to structuring flexibility, some projects or strategies have predefined, built-in flexibility. Take, for example, research and development (R&D) investments in pharmaceutical products where the outcomes of clinical or patient trials provide natural moments to decide whether to stop or pro- ceed with investments. But in many other cases, flexibility can be incorporated into a project to create maximum value. One example would be redesigning infrastructure investments in ports or airfields in stages such that future ex- pansion takes place only if and when needed. Another would be reshaping a growth strategy in such a way that it explicitly includes options to redirect resources as more information becomes available. In the end, flexibility has value only if managers actually manage it—that is, use new information to make appropriate changes to their decisions. There- fore, companies should ensure that their managers face proper incentives to capture potential value from flexibility. For example, the option to pull out of a staged-investment project when intermediate results are disappointing has no value if managers do not act on the information. As is sometimes the case, managers will point to nothing more than large sunk costs as the rationale for their inaction. But they forget that value is determined only by future cash flows, so that sunk costs are always irrelevant. In the case where a company bases its strategy on creating growth options through a string of acquisitions, those options generate maximum value only if the company delays further acquisitions until new, positive information about their potential arrives. The company leaves the option value on the table if it proceeds with additional acquisitions in the dark. Methods for Valuing Flexibility  769 To help managers recognize, structure, and manage opportunities for cap- turing value from flexibility, we segment options into the categories described in Exhibit 39.5 and provide some examples. Methods for Valuing Flexibility As mentioned earlier in this chapter, the two methods for contingent valuation are decision tree analysis (DTA) and real-option valuation (ROV) using formal option- pricing models. We will illustrate each method with a simple example: the oppor- tunity to invest $105 at the end of one year in a mining project that has an equal chance of returning either $150 or $50 in cash flow, depending on the mineral price. The risk-free rate, rf, is 5 percent, and the weighted average cost of capital (WACC) for the project is 10 percent. The present value (PV) of the cash flows today is: PV = + = 0 5 150 0 5 50 1 10 90 9 . ($ ) . ($ ) . $ . EXHIBIT 39.5  Classification of Real Options Option type Financial equivalent Definitions Example(s) Option to defer investment Call option The option to defer an investment until the present value of an asset rises above the development costs The ability of a leaseholder of an undeveloped oil reserve to defer development and investment until oil prices have elevated the value of the reserves above their development costs Abandonment option Put option The option to abandon a project if its present value falls below its liquidation value Long-term rental leases of airplanes that give the lessee the flexibility to prematurely dissolve the contract and return the plane to the lessor at a prespecified termination fee Follow-on (compound) option Series of options on options The option to invest in stages, contingent on performance A factory, R&D program, new-product launch, or oil field built so that management can continue the project at each stage by investing additional funds (an exercise price) or abandon it for whatever they can fetch Option to expand or contract Call or put option The option to resize an investment depending on performance A production facility built so that it can be easily expanded or contracted if a product is more or less successful than anticipated Option to extend or shorten Call or put option The option to shorten or extend the life of an asset or contract Real estate leases with clauses that allow lessors to extend or shorten the term of the lease Option to increase scope Call option The ability to increase or decrease the number of activities in the future A hotel designed so that the owner can easily diversify beyond lodging services, such as by adding conference facilities Switching options Portfolio of call and put options The ability to switch the operation of a project on and off—or to switch operations between two distinct locations A flexible manufacturing system that can produce two or more different products, peak-load power generation, or the ability to exit and reenter an industry