Explaining the value of flexibility with Real Options and why DCF undervalues volatile assets - The Case of Tethys Oil's 89% Acquisition Premium

Abstract

This paper provides a quantitative comparative analysis of traditional Discounted Cash Flow (DCF) valuation and Real Options Analysis (ROA) in the context of a natural resource extraction company, using Tethys Oil as a case study. The purpose is to quantify the value of managerial flexibility under uncertainty. Methodologically a static Net Present Value (NPV) was created with the help of DCF, subsequently a ROA model was constructed using the binomial option pricing model and stochastic analysis through Monte Carlo simulations. The static NPV gives an enterprise value of $152.3 million compared to the expanded NPV resulting in a valuation of $225.6 million, the significantly higher valuation underscore the limitations of DCF in a high volatility environment, and how the added managerial flexibility of the options to abandon, contract, and expand contribute to a combined $73.3M in added value. The option to expand accounts for $53.9 million, showing how valuable growth opportunities are in the oil industry. The findings demonstrate how DCF undervalues investments with both high volatility and strategic flexibility which confirms previous academic research on the subject.