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Part - III
Real-Option Valuation of using Tinting Systems
Installing of tinting systems can be valued as a real option. This is because the decision to go for tinting systems has an embedded option and thus cannot be valued by normal DCF techniques. The decision of when to exercise the option i.e., make the investments is something that is left to the company. The discount rate for such a project is also difficult to estimate. It would not be the same as the Cost of Capital of the firm. Also, the payoffs would have an inherent volatility because using such a system would affect the operations of the current retailers and the return on invested capital would not be stable. There is also the question of whether customers would accept the systems thus increasing volatility of payoffs. In the current model, the parameters used are as follows: -
S = Present Value of additional profits and savings generated, the present value being at the time the option is exercised. The discount rate used here is the cost of capital of the company.
X = Exercise Price. It is the cost of setting up the tinting systems, calculated as: Cost of a single system´ number of systems set up initially. It should be mentioned here that the cost includes a fixed cost of buying the software and variable costs of hardware and other investments. So the fixed costs are apportioned over the number of tinting systems installed.
T = Time after which investment is made. For simplicity, it can be considered as the time when the software is purchased.
 = Variability in the Return on Invested Capital
rf = Risk-free rate, taken to be 11% for India
In the present example, we use Goodlass Nerolac's 2000 financial figures for valuation. We assume that it can exercise the option after 1 year. We assume that by exercising the option it's market share increases by 5%. Also, their inventory reduces by 10 days and the raw material costs by 5%. Since fewer inventories has to be maintained, less manufacturing of finished goods is done, leading to lesser purchase of raw materials. The cost of capital is taken to be 17%3. The calculated Beta for GNP is 0.7. Assuming a marker risk premium of 8%, cost of capital comes to 16.6%, which we round off to 17%. The present value after 1 year is calculated assuming a growth rate of 7% and this value is discounted to the present date to get the value of S. The value is Rs 261 crores as shown in Exhibit 9 (Click on Exhibit 9 to view it).
We assume that they set up 500 tinting systems all over India and each costs Rs 20 lakhs. So the value of X = Rs 20 lakhs ´ 500 = Rs 100 crores.
For , the proxy chosen is the variability in returns of the Goodlass Nerolac stock. Here it is found to be 53.19%.
Using these values and a Black-Scholes model for valuation, we get the value of the option to be Rs 171 crores.
In this case, had we used a NPV, the value would have been Rs 261 crores - Rs 100 crores = Rs 161 crores. But this does not take into account the embedded options. It is only a coincidence that the DCF value and the option value are so close here.
This option carries options for further options-like putting tinting systems with every retailer, diversifying into the business of manufacturing tinting machines etc. so, the option price would actually be higher than the calculated value.
Conclusion
Thus we see that there are ways of cutting costs in a supply chain while increasing responsiveness. The inventory management model suggested here can be used in other industries like automobiles, defence factories, electric motors etc. where product variety is large and forecasting demand is difficult. Option-pricing models are industry specific but similar models can be applied to say, an automobile industry where there are product-related options, e.g. TELCO's launch of the Magna can be valued using a real option model. This paper attempts to bring forward some of the possibilities that exist in supply chain analysis.
Concluded.
3 http://www.india-today.com/btoday/20010306/mvatab1.pdf
* Contributed by -
Rajit Ghosh,
Done MBA from IIM Bangalore,
Currently working with Tata Strategic Management Group as a Consultant.
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