766  Flexibility We can formally derive the key value drivers of real options from the pricing theory of financial options such as, for example, call and put options on equity shares. In our original example, the deferral option is identical to a call option with an exercise price of $6,000 and a one-year maturity on an underlying risky asset that has a current value of $6,000 and a variance de- termined by the cash flow spread of $400 across outcomes.6 As with finan- cial options, the value of a real option depends on six drivers, summarized in Exhibit 39.4. These drivers of option value show how allowing for flexibility affects the valuation of a particular investment project. Holding other drivers constant, option value decreases with higher investment costs and more cash flows lost while holding the option. Option value increases with higher value of the un- derlying asset’s cash flows, greater uncertainty, higher risk-free interest rates, and a longer lifetime of the option. With higher option values, a standard DCF calculation that ignores flexibility will more seriously underestimate the true value of an investment project. Be careful how you interpret the impact of value drivers when design- ing investment strategies to exploit flexibility. The impact of any individual driver described in Exhibit 39.4 holds only when all other value drivers re- main constant. In practice, changes in uncertainty and interest rates not only affect the value of the option but usually change the value of the underlying 6 The current value of the underlying risky asset is the present value of expected annual cash flows of $300 into perpetuity, discounted at a 5 percent cost of capital. EXHIBIT 39.4  Drivers of Flexibility Value Flexibility value Time to expire More time to learn about uncertainty increases flexibility value Present value of cash flows Higher value of underlying project cash flows increases flexibility value Cash flows lost to competition Losing more cash flows to competitors when deferring investment reduces flexibility value Investment costs Higher costs of exercising flexibility reduce flexibility value Risk-free interest rate Higher interest rate increases time value of deferral of investment—but may reduce present value of underlying cash flows Uncertainty (volatility) about present value More uncertainty increases option value— but may reduce present value of underlying cash flows Managing Flexibility  767 asset as well. When you assess the impact of these drivers, you should as- sess all their effects on the option’s value, both direct and indirect. Take the case of higher uncertainty. In our example, we increased the uncertainty of future cash flows by widening the gap between future cash flows in the favor- able and unfavorable scenarios from $400 to $600. But we kept the expected value of the future cash flows unchanged at $300 so that their present value remained constant. However, if greater uncertainty lowers the expected level of cash flows or raises the cost of capital, the value of the underlying asset declines so that the impact on the value of the option could be negative. The same holds for the impact of an increase in the risk-free interest rate. Higher interest rates reduce the present value of the required investment, thereby increasing the option value—if the value of the underlying asset is assumed constant. But if higher interest rates lead to an increase in the cost of capi- tal, the present value of cash flows on the underlying asset would decrease, which could lower the option’s value. Managing Flexibility Contingent valuation is an important tool for managers trying to make the right decisions to maximize shareholder value when faced with strategic or operating flexibility. In actual practice, however, flexibility is never as well defined and straightforward as in the preceding examples. Much depends on management’s ability to recognize, structure, and manage opportunities to create value from operating and strategic flexibility. A detailed discussion is beyond the scope of this book,7 but we provide some basic guidelines here. To recognize opportunities for creating value from flexibility when assess- ing investment projects or strategies, managers should try to be as explicit as possible about the following details: • Events. What are the key sources of uncertainty? Which events will bring new information and when? A source of uncertainty is important only if relevant new information about it is likely to trigger a decision change. For example, investing in a pilot project for a product launch makes sense only if there is a chance that the pilot outcome would actu- ally change the launch decision. Similarly, options to switch inputs for manufacturing processes are valuable only if the input prices can be expected to diverge significantly. • Decisions. What decisions can management make in response to events? It is important that managers have some discretion to react to a relevant event. For example, intense competition among smartphone 7 For a more in-depth discussion, see, for example, Copeland and Antikarov, Real Options, or Trigeorgis, Real Options.