Abstract
Discounted cash flow (DCF) methodology has long been advocated as the appropriate theoretical underpinning for maritime investments (Bendall, 1979; Evans, 1984; Gardner, Goss and Marlow, 1984). However, its limitations are also well-known and can relegate its practical use to a confirmatory role, or management may override its results in favour of an alternative preferred strategy (Teisberg, 1995; Bendall, 2002). Uncertainty, and the difficulty to value the flexibility that management has in adapting plans after a project is underway are significant limiting factors. This paper considers a maritime investment where there is uncertainty and alternative strategies, and uses real option analysis to value a flexible strategy that adapts to conditions as uncertainty is resolved.
The proposed investment is a new service based on a new technology: high speed container ships (Bendall and Stent, 1998). The service would be based in South East Asia with Singapore as a hub port and offer fast turn-around times to neighbouring ports, Klang and Penang. The level of service that is offered depends on the number of ships purchased for the project. Being a new technology they must be purchased new and, clearly, in discrete units. There is a one year time to build. The demand for the service is the main uncertainty. Besides day to day variations in demand and economic cycles which affect long run achievable load factors, there are the initial uncertainties associated with the new type of service and technology. While market research might reduce this latter uncertainty, it can only be resolved over time as customers gain experience and adapt or otherwise to the particular characteristics. It could be, for instance, that an eventual high level of demand would favour putting two ships on the service whereas an eventual low level of demand might favour just one. Competition is a consideration. Offering an inadequate level of service to either port leaves an opportunity for a competitor and adversely affects a strategy such as servicing just one port initially with a view to extending the service to the other port if conditions prove favourable. Freight rates also have a significant bearing upon the decision. The paper considers the case where demand for the service as well as freight rates are uncertain. It provides a methodology using Real Option Analysis for adapting the number of ships employed to actual market experience.
Real option analysis, ROA, is a methodology for valuing flexible strategies in an uncertain world (Trigeorgis, 1995). It builds on the traditional DCF technique. It owes its quantitative antecedents to the seminal works of Black and Scholes (1973), Merton (1973) and to the binomial approach of Cox, Ross and Rubinstein (1979) in pricing financial options. Like financial options, real options are the owner’s right but not obligation to trade an underlying asset or income stream under predetermined conditions. The simplest financial options are the right to buy (call) or sell (put) the asset at a predetermined price (exercise price) for a predetermined period of time (life of the option). Real option parallels are management’s ability to expand or contract a project in light of actual outcomes after it is underway. Like financial options, management’s strategies can be far more complex than simple calls and puts, such as abandoning or delaying a project. The methodology, including risk-neutral valuation as a general principle, has evolved to price complex financial options and can be applied to real options too. There is the matter of selecting an appropriate underlying asset which spans the project’s uncertain states. Although projects are not usually traded per se, the process of capital budgeting models the market value of their cash flows (Kasanen and Trigeorgis, 1993). Copeland and Antikarov (2000) advance the concept of Marketable Asset Disclaimer to justify the use of the present value of inflexible strategies, estimated by the traditional discounted cash flow techniques, as the appropriate underlying asset. No stronger assumption is required than for the traditional analysis. This is the method employed to value the strategies in the present paper. A simulation model is first built to model particular fixed services. These are the underlying assets. The model provides estimates of their present values which are used as market prices. It also provides estimates of their volatilities and correlations which are used to model the evolution of their prices in a second step when options are valued. The particular option used in the paper is that to exchange one risky income stream for another. The different income streams are the alternative services which are to be valued as a flexible strategy. The methodology is applied to a hub and spoke system. It is readily adaptable to other situations.