Real Options

REAL OPTIONS AS AN EXTENSION OF NPV TELECOMMUNICATIONS INDUSTRY OF THE PHILIPPINES

I.

Introduction

Telecommunications in the Philippines Over the years, the Philippine telecommunications industry has come over a long way. Fixed line telecom services with nationwide connections are now available in seemingly out of reach places, or in remote areas, from being available only in key cities a few years ago. This abundance of fixed lines is said to be attributed to the crash programme of infrastructure expansion that the government introduced in the mid-1990s. However, many lines that were installed remained dysfunctional. Today, the issue is not so much that lines are unavailable but rather that those in place are underutilized. The Philippines also has long had one of the most deregulated telecom environments in the world. For instance, in the early 1990s when other countries were looking to introduce competition into their local networks for the first time, the Philippines had more than 60 local operators. In the value-added market, too, any company that chose to enter the business was allowed to provide services. However, this liberalization and lack of regulation has not translated into true competition. The weak regulatory regime has allowed the incumbent operator to maintain, and even strengthen, its dominant position. Until the early part of 2000, the mobile sector was rather moribund. Unlike in other countries, where mobile services had already become very popular, only about one Filipino in 30 had a mobile phone even after more than a decade of service availability. Then, the situation radically changed. Growth is usage exploded and now, nine years later, about over 80% of Filipinos are subscribers. This growth was driven by the popularity of SMS, known locally as texting. The Philippines was the first country to adopt the service to any great extent, and remains the texting ‘capital’ of the world. The reasons for the success of SMS texting are numerous, one of which is the fact that Filipinos are believed to be both gregarious and good communicators. Texting provided an inexpensive means of keeping in touch. In general, other wireless data services are still in their infancy in the Philippines. Services such as WAP, GPRS and MMS are being adopted only slowly. 3G is now starting to be deployed. The Internet is still not well used except in the main urban areas such as Manila. Despite the relatively early introduction of the Internet to the Philippines, the service has not been anywhere near as successful as in many other countries. Registered subscribers still represent only about 5% of the population.

E-commerce is also still at an early stage. Although there is much discussion and publicity about the service (which may be preparing the ground for the future), very little business is actually being conducted online at present. Broadband services are now deployed in Metro Manila and other major conurbations, but the said service is still largely unavailable in most rural areas. The range of technologies being used where broadband is available includes DSL, fixed wireless, coaxial cable and satellites. The pay-TV industry has considerable potential. There are more than nine million TV households in the country, but only about 1.2 million subscribe to pay-TV. An accurate estimate of the number of pay-TV households is, however, difficult to come by because of under-reporting by the operators. Government charges are levied on the number of viewers, so it is in the operators’ interest to downplay their viewing figures. The Philippines is one of the least developed telecom markets in the Asia-Pacific region. That being so, it has greater investment potential than the more mature markets provided that the economy continues to develop and further social unrest is avoided. II. Net Present Value Evaluation A. NPV A traditional analysis of a capital project simply involves adding all the costs and benefits, then subtracting the former from the latter. This type of analysis is inadequate because rational economic agents do not value pesos from the future years as much as they value pesos today. A 100 peso-bill that will be received 5 years from the present is worth less than 100 pesos today. The Net Present Value (NPV) analysis allows for the conversion of future pesos into present pesos through the use of a discount rate. The discount rate represents the cost of borrowing. In order to perform an NPV analysis, here are the four basic steps: 1. Forecast the benefits and costs for each year. 2. Determine a discount rate. 3. Use the following formula to calculate the net present value.

4. Compare the net present values of each of the alternatives. Generally, the higher the NPV, the better. B. How it is used in the telecom industry The net present value method is the most preferred capital budgeting tool of most companies. In the telecommunications industry, apart from determining the value of future projects and investments, the net present value method is also used for other things. It is used to determine the fair value of financial instruments not listed in the active market. It is also used to review the performance of assets who seem to be having difficulty generating cash flows. An analysis is performed using net present value to determine if the asset should be considered impaired and if an impairment loss should be charged to the carrying value of the asset. C. Limitations Although net present value analysis is one of the most commonly used valuation methods, it has certain limitations that must be noted. First of all, it is quite difficult to accurately forecast future costs and benefits. A project could have benefits and costs that are intangible and difficult to value monetarily. Actual revenues can also fall short of expectations, and unanticipated costs can arise. Net present value analysis is also vulnerable to manipulation. There is no universal discount rate or standard method of determining discount rates. Therefore, through selecting the “appropriate” discount rate, net present values can be made to appear higher or lower. Furthermore, the only way that net present value analysis incorporates project risk is by setting higher discount rates. Using a single parameter to represent the different sources of risk, especially in situations where risk premiums are not yet firmly established, makes it even more difficult to choose an appropriate discount rate. Although mature companies who operate in a stable business environment might be able to have semi-exact forecasting of the next year’s cash flows, and therefore have no difficulty with the net present value method,

companies operating in a dynamic market will find it hard to achieve such certainty in predicting their cash flows. Finally, net present value analysis fails to consider the multiple options that come with investments. Expected cash flows and discount rates change over time. As a result, projects with negative present values at present may have positives net present values in the future. Therefore, firms have the option of delaying a project. In real life, firms also have the option of expanding a current project or abandoning it. The net present value method fails to reflect what really happens when firms invest. III. Real Options Valuation Real Options (RO) Valuation (ROV) is an extension of financial options theory to options on real assets; the options involve “real” or “tangible” assets as opposed to financial ones. The real option theory of investment is a method of valuing the options that exist when new investments are made in real assets that are subject to irreversibility and uncertainty. The term "Real Options" was first coined by Stewart Myers in 1977; he was the first who identified investments in real assets as mere options. A real option (“real”, rather than financial, asset investments) is a permit with different value at different time periods to undertake some business decision, typically an option to make a capital investment. Real options are opportunities embedded in capital projects that enable managers to alter their cash flows and risk in a way that affects project acceptability. These opportunities are more likely to exist in large “strategic” capital budgeting projects, hence they are sometimes referred to strategic options. Real options can value important “real” options, such as value of land, offshore oil reserves, or patent that provides an option to invest. There are four major types of real options – abandonment, flexibility, growth and, timing. Option type

Description

Abandonment option

The option to abandon or terminate a project prior to the end of its planned life. This option allows management to avoid or minimize losses on projects that turn bad. Explicitly recognizing the abandonment option when evaluating a project often increases its NPV.

Flexibility option

The option to incorporate flexibility into the firm’s operations, particularly production. It generally includes the opportunity to design the production process to accept multiple inputs, use flexible production technology to create a variety of outputs by reconfiguring the same plant and equipment, and purchase and retain excess capacity in capital-intensive industries

subject to wide swings in output demand and long lead time in building new capacity from scratch. Recognition of this option embedded in a capital expenditure should increase NPV of the project. Growth option

The option to develop follow-on projects, expand markets, expand or retool plants, and so on, that would not be possible without implementation of the project that is being evaluated. If a project being considered has the measurable potential to open new doors if successful, then recognition of the cash flows from such opportunities should be included in the initial decision process. Growth opportunities embedded in a project often increase the NPV of the project in which they are embedded.

Timing option

The option to determine when various actions with respect to a given project are taken. This option recognizes the firm’s opportunity to delay acceptance of a project for one or more periods, to accelerate or slow the process of implementing a project in response to new information, or to shut down a project temporarily in response to changing product market conditions or competition. As in the case of the other types of options, the explicit recognition of timing opportunities can improve the NPV of a project that fails to recognize this option in an investment decision.

(Gitman 478) These options, when embedded in making a capital budgeting decision would likely alter the cash flow and risk of a project and therefore change its NPV. Option theory takes into account the interaction between sunk costs and uncertainty, by explicitly recognizing these options, managers can now make use of two kinds of NPV’s: strategic NPV and the traditional NPV.

Using attractive real options in determining NPV can cause an unacceptable project under traditional NPV to become acceptable under strategic NPV, the failure to acknowledge real options in capital budgeting decisions can cause managers to reject projects that are otherwise acceptable.

Real Options as in the Telecommunications Industry of the Philippines Throughout the 50’s, Philippines kept the same pace as its neighboring countries in building basic infrastructure. During the 70’s and the 80’s, as the Marcos regime dominates, our country lagged behind in terms of development. In 1988, two years after the EDSA Revolution, there were only 600, 000 telephone lines for the nation’s

population of about 65 million. The teledensity was 0.92. More than 80% of the operational telephone lines were located at the National Capital region while 50% of the about 1600 municipalities had no telephones. Under the Ramos administration, the teledensity rose from less than 1% in 1992 to 9.08% in 1998. To offset the dominance of PLDT in the telecommunications sector, the government introduced the controversial mechanism Service Areas Scheme (SAS). SAS drove substantial investment in fixed line infrastructure development. Upon the implementation of SAS, companies can acquire public network franchises for the metro places such as Davao, Cebu or Manila in exchange of the obligation to build networks in unreached areas. Six companies met their building targets: Bayantel, Digitel, Globe, Smart, Piltel and PLDT. The concentration of telephone lines in Metro Manila was reduced to about 40%. This fixed line strategy, however, resulted in a tremendous under-utilization of infrastructure. The increase in capacity was not matched by the market demand. There was only about 50% occupancy of the installed fixed lines. The mobile cellular phones emerged as well as other troubles. In 1997, the Asian economic crisis drove some foreign partners and local consolidation to withdraw. PLDT acquired Smart and Globe merged with Islacom. PLDT continued to dominate the industry and SAS was abandoned in 2002. This decision falls under the one of the major real options categories, abandonment option for projects that turned bad. Some of the Major Players The success of the telecommunications industry in the Philippines was boosted by the sensational growth of mobile and text messaging services. Since 2000, the mobile phone subscribers have grown about five-fold to 32.5 million. What fueled this growth is the prepaid pricing strategy, the utilization of the short message service (SMS) as an alternative to voice calls and the tapping of the middle to low income areas. Some of the current major players in the Philippine telecom industry are the Philippines Long Distance Telephone Company (PLDT), Globe Telecom, Inc. and Digital Telecommunications Phils., Inc. (Digitel).

PLDT The Philippine Long Distance Telephone Company was incorporated on November 28, 1978 under the Old Corporation Law of the Philippines. PLDT provides the most massive and diversified telecom services across the country’s most extensive fiber optic backbone and wireless, fixed line and satellite networks. Over the years, PLDT has invested on trunk networks that now play a crucial part in the country’s positioning as a rising location for global call centers and business process outsourcing. In relation to PLDT’s investments, Ken Zita, president of Network Dynamics Associates stated, “The country has more than 350 Gbps of international capacity on a variety of regional and trans-Pacific submarine cables (APCN-1, APCNII, GPT, C2C, G-P,BMP, East Asia) as well as satellite services coverage (ACeS, Agila-

II, among others) The domestic network is comprised of six fiber optic rings…” (14). Hence, through wireless, fixed line and information and communications technology, PLDT is the leading telecommunications provider in the Philippines. These investment decisions can be related to the real option types, growth option and timing option. PLDT spent for the country’s most extensive fiber optic backbone and one of the returns it got is the retention of its market leadership. NTT Communications Corporation acquired 15% economic and voting interest in the common stock of PLDT on March 24, 2000. Concurrent with NTT Communications’ investment, PLDT obtained Smart Communications, Inc. The leading wireless services provider of the Philippines is Smart. Less than two months after the National Telecommunications Commission awarded Smart its 3G license, Smart launched on a free-trial basis its 3G services on February 14, 2006. Smart became the first telecom service provider to offer 3G services in the Philippines. Living up to its environmental and social responsibilities, Smart has extensively operated stand-alone wind-powered cell sites. In 2008, there were about 74 Smart cell sites run by renewable energy. As with PLDT, Smart’s exercise of the growth and timing options strengthened its position as the market leader.

Globe Globe Telecom, Inc. is the second largest telecommunications company in the Philippines. The Globe Group is comprised of Globe Telecom, Innove Communications, Inc., G-Xchanfe, Inc., Entertainment, Gateway Group Corp And EGGstreme Ltd. and GTI Buiness Holdings, Inc. As part of an industry-academe linkage program, Globe launched Globe Labs in University of San Jose – Recoletos in Cebu in order to improve the learning experience of information technology (IT) students. The Globe Labs project can be related to the real option types of flexibility option and growth option. Giving the students access to the Globe mobile applications and chance to design their own mobile phone application is like hitting two birds in one stone. On one side, this project will do good to the company’s image. It will be perceived as socially responsible and will be linked to the idea that Globe cares for the student youth. As a profit maximizing firm on the other hand, Globe will lessen its expenses on research and development since it will not be paying developers to improve and or develop mobile phone applications that it will later sell but instead, it will tap the student sector that is just so eager to develop new things. Globe just launched its “Tingi Load” scratch cards that are supposed to be distributed almost everywhere from the counters of the fast food chains to the taxi drivers even up to the takatak boys in every corner. In relation to real options, in this project, Globe opted to invest on the advertising og the project. TV commercials are not very cheap. Although relatively less expensive, radio commercials also cost

something. The print ads and other events and promos are also not for free. In considering this project, Globe chose to spend on some intangible advertisements to launch in the same market the innovation in the prepaid services that Globe offers.

Digitel Digital Telecommunications Philippines, Inc. was established on August 31, 1987. It is 47.45% owned by the JG Summit Holdings Inc. or JGSHI, one of the massive conglomerates in the country. In September 2001, Digitel established Digital Mobile Philippines, Inc., more popularly known by its corporate brand name Sun Cellular, to provide public and private wireless telecom services. Sun Cellular has more than 1300 operating cell sites for more than 1.8 million subscribers. The number of subscribers was not large relative to other mobile companies so in order to improve capacity and coverage, in 2005, Sun Cellular announced that a major network expansion with approximately $200 million of investment. It was completed in 2006. Hua Wei Technologies in China and Ericsson of Sweden provided network improvement and network equipment. Other companies also contracted for the expansion was Alcatel and Evolium. This is clearly a growth option type of real options. Sun Cellular chose to expand at a very high cost so the expected return must also be very high.

IV. Conclusion In principle, ROA offers potential advantages over traditional net present value (NPV) and discounted cash flow (DCF) approaches, both of which may lead to underinvestment in high-risk areas. It places a positive value on risk by exploiting the opportunity to phase investments and stage key decisions so as to (i) allow termination of initial exploratory R&D projects which turn out to be unsuccessful, and (ii) invest more in those showing positive future prospects. By contrast, NPV and DCF view risk negatively and, by ignoring the option approach, impose higher discount rates to ‘adjust’ for higher risk, thus reducing the value of future expected income streams. The intuition behind this potential outcome is as follows. Traditional investment appraisal techniques can be conceived as being concerned with a one-shot valuation of an investment in an “asset”. The initial investment is followed by a series of (often) uncertain cash flows over time. DCF analysis is the industry standard valuation technique. It takes account of the time-value of money through the use of a ‘risk free interest rate’, and of riskiness by adding a risk premium to the risk free rate in discounting future cask flows. This aproach neglects the insight which arises from recognising the phased nature of many investment decisions, which may begin with exploratory phases before

final “asset” invetsment decisions are made. Many investment projects have in effect an “options phase” prior to the “asset phase”. During the “options” phase, investments are not being made in an asset to generate a stream of cash flows but to establish the opportunity (but not the obligation) to subsequently invest in such an asset. The investment in telecommunications is effectively an “options” - ie an exploratory - phase, which is the necessary precursor in order to allow future investment in the final “asset” phase – which in this case is the further developing facilities, network sites, and offering cheaper, highly reliable communication media. ROA modeling is well developed in financial markets - which have sophisticated and well developed methods of pricing risk and well developed theory justifying the use of those prices. However there are conceptual and empirical problems to be overcome in using the technique to obtain quantitative valuations in real asset investment decision-taking. Nevertheless there are examples of the use of ROA in making such investment decisions, particularly in the pharmaceuticals and telecommunications industries. At present, the principal value of ROA as an aid to telecommunications investment decisions was likely to be in determining the qualitative process to enable analysts to look at a particular investment opportunity and break it down into its component stages. Using ROA as a qualitative discipline and adopting an explicitly phased approach was very valuable in stimulating thinking about the range of investment options available, how these might change with time, where the investment cut-off points were, what the probability of success of each option at each stage in the process might be, and as a learning mechanism for future decisions. ROA was at a relatively early stage of development as a quantitative analytical tool for public sector decision-making, compared with other techniques such as NPV and DCF. Moreover there was some uncertainty as to the extent to which it was used in the private sector and the reasons for its apparently patchy adoption. There was, however, an active international academic and practitioner research interest in its development and application and some major companies were evaluating its potential. There was also interest in evaluating its merits relative to other decisionmaking rules using decision trees or Monte Carlo methods, and in using mixed processes combining ROA insights with NPV calculations. For example, combining base-case NPV figures with ROA to give an expanded NPV figure (E-NPV). Also, where DCF techniques were embedded in company decision-making, ROA techniques might be simple to bolt on. More development work on ROA would be needed before it could be applied quantitatively to the sort of decisions that the TSB were making about the level of investment in particular key technologies. In particular, it was currently not well suited at present to determining investment levels at a high level of generality. It was also sensitive to the fact that the different stages in project investment often carried different levels of risk, and the overall ROA calculations reflected the percentage chance of success at each of the stages.

The difficulty right now in using ROA to help decision-making on the level of investment in different industries was the absence of a consistent set of metrics to input into the ROA process and to measure outputs. Deriving proxies for market value as an output measure was particularly difficult. The fact that input data was often highly uncertain risked invalidating the ROA approach. This absence of consistent metrics and high quality input data also limited the application of ROA to investment decisions in different projects within a particular telecommunications area, although here these effects were likely to be less significant.

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