1. IHC Asia Pacific Pte. Ltd.
The true value of a multi-purpose vessel
Unlocking the embedded value of Real Options in the offshore industry
Written by K.J. Mulder and A.J. van Oers
Amsterdam / Singapore
July 2014
Introduction
Traditional valuation methods do not always reveal the true value of an asset. Today, it is popular for
financial engineers to spend a good amount of their time developing new financial derivatives customers
did not ask for and barely understand. While these new instruments continue to be created, few, if any,
resources are typically dedicated to examining a more basic, and more vital, consideration: the value of
Real Options. In any investment decision, a missed Real Option value has an ultimately negative impact
on the overall decision. To incorporate Real Options into one’s investment decision is to create value.
This paper focuses on the application of Real Option theory in the offshore industry and plumbs a real-
life case to explore the additional value of options and their impact on investment decisions regarding
vessels. In any industry, but particularly in a volatile one such as offshore, looking at only part of the
picture leads to decisions that can make an organization sink instead of swim. Unlocking the embedded
value of Real Options is in the best interest of all stakeholders and crucial to any investment
consideration.
History of Real Option Theory
The term ‘Real Option’ was introduced by Stewart Myers1
in 1977 to point to the section of the
investment picture that traditional measures, like Net Present Value (NPV) and Discounted Cash Flow
(DCF), could not identify. Such tools, Myers suggested, were comments on the present. Real Options,
by contrast, represent future decision opportunities.
1
Myers, S.C. (1977). Determinants of Corporate Borrowing. Journal of Financial Economics, 5 (2), 147-175

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Real Options do not lend themselves to straightforward value calculation, like those modeled by Black
and Scholes2
in 1973. They are therefore often overlooked, as are any other instruments that demand a
lens into the future. To make a sound investment decision, however, one must consider all sides: what
goes into the value, how the value is seen today, and how the value may change tomorrow. By asking a
critical question—how the worth of the potential investment may change over time—Real Options
provide a vital perspective into the overall investment picture.
Financial Options vs. Real Options
Financial derivatives and options, developed originally to allow investors to distribute risk and exposure
within the marketplace, now appear in a variety of incarnations. While they are used in large part to
anticipate valuation adjustments, such instruments are only as useful as the people who manage them.
There are an unfortunate number of examples of companies that have found themselves in financial
distress due to the inappropriate use, or outright mismanagement, of financial options and related tools.
If there is one general failing that can be pointed to as a cause of such situations, it is that the inherent
risk was underpriced in the first place, leading to unforeseen and unalterable exposure later.
Real Options, on the other hand, have a different character, offering the investor the possibility to adjust
the initial investment during its lifecycle. Traditional NPV and DCF methods assume all data related to
the investment period to be available at t=0. From the viewpoint of these tools, modeling all of the
known data equals calculating all of the known value. Real Options acknowledge that not all decisions,
in fact, are to be taken at t=0, and that a true valuation must include recognizing the potential for future
adjustments. Omitting this important consideration means leaving a crucial part of any investment
decision aside. A common result is opportunities being overpriced by those analyzing them—and, in
turn, recommendations to postpone or abandon the opportunity, when in many cases it might have been
in the interest of shareholders to proceed.
2
Black, F. & Scholes, M. (1973). The Pricing of Options and Corporate Liabilities. Journal of Political Economy, 81 (3), 637-654

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Leonos Trigeorgis3
has categorized Real Options into seven different classes according to effect on the
investment decision: defer, stage, alter, abandon, switch, accelerate or interact. Lander and Pinches4
take
a different tack, classifying Real Options instead into 17 areas of specific application, from natural
resources to real estate, research and development to mergers and acquisitions, hysteric effect and
corporate behavior to environmental development and protection. The goal of each of these taxonomies
is to establish a multi-faceted view of the total value project. Testing Trigeorgis’ and Lander and
Pinches’ groupings allows us to look more deeply into the potential decision at hand, unlocking a
decisive part of the picture.
Consider the usefulness of options in the following two investment scenarios:
Option to expand. A network provider requires new cable trenches. At the moment of the initial
investment, spare capacity is created, causing higher early-stage costs. The return
on the investment is represented by the potential need for more capacity in the
future, but it is not known if or when more capacity will be required. At the same
time, by not including the option for expansion up front, expansion in the future
will be regarded as even more expensive. By valuing the option for future
expansion, the NPV calculation will be positively impacted.
Option to switch. Vessel fleet extensions are based on the NPV of future cash flows of the vessel. In
the initial investment phase, macroeconomic data, as well as detailed market
information, are used to forecast future costs (capital expenses and operational
expenses) and revenues (day rates) by vessel type. Including Real Options in the
investment analysis will show that the value of a given vessel is higher than that
reflected by using traditional valuation methods without the application of Real
Options.
3
Trigeorgis, L. (1993). Real Options and Interactions with Financial Flexibility. Financial Management, 22 (3), 202-224
4
Lander, D.M. & Pinches, G.E. (1998). Challenges to the Practical Implementation of Modeling and Valuing Real Options. The Quarterly Review of Economics and
Finance, 38 (3), 537-567

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In both circumstances, adding Real Options to the investment consideration has a significant impact on
the overall picture of value.
Case Study: Offshore Support Vessels
In cooperation with IHC Asia Pacific, we examined the embedded option value of a specific group of
offshore support vessels. We chose these particular vessels because they are variations of a base model
that offers different outfitting and, directly relevant to our purposes, the possibility of modification over
time5
.
The basic model of this vessel is called the Platform Supply Vessel (PSV). Variations on this theme are
versions of the PSV with other equipment or features that enable them to be deployed for certain
specific offshore sub-markets. These vessels can be customized, with features added to facilitate utility
in a specialized market segment, then removed again later, or modified for yet a different sub-segment.
In other words, the value of a single vessel may be altered multiple times during its lifetime, hence this
group of vessels offers an appropriate subject for our examination
We have defined the following five vessel types, each with its own distinct level of specifications: (1)
Platform Support Vessel (PSV), (2) Construction Support Vessel (CSV), (3) Work Class Remote
Operated Vehicle Vessel (WROV), (4) Diving Support Vessel for air diving (DSVAIR), and (5) Diving
Support Vessel for saturation diving (DSVSAT).
5
IHC Packhorse™ and Packhorse™-Maxi:
http://www.ihcmerwede.com/about-ihc-merwede/media/news/article/ihc-merwede-introduces-new-ihc-packhorseTM-offshore-support-vessels/

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Modeling: Value Calculation with Real Options
With the ultimate goal of establishing a manner for making more thorough, more accurate investment
decisions for vessels, we have developed a model for revealing the Real Option value, a calculation that
in turn has the potential to refine our picture of the overall initial investment. Inputs required for this
model include day rates, operating expenses, utilization rates, initial investments, costs of modification,
tax rates and financing. Assumptions for the input of the model are based on market reports, industry-
specific sources and discussions with several industry experts.
The first step in the model is a Net Present Value (NPV) analysis for each of the five vessel types. By
using the traditional Discounted Cash Flow (DCF) method, where each of the future cash flows
generated by the vessel is discounted to today’s value, we calculate the present value of the vessel as
follows:
Base value of the vessel6
The total forecast period is seven years: two years pre-delivery of the vessel (design and construction)
and five years post-delivery (operational), with a residual value at the end of year 7 (seven) equal to a
fixed percentage of the replacement value for a new build.
If the simplified NPVA—the base value of the vessel minus the investment (VA - IA) —is greater or equal
to zero, we would have to say that the investment appears worthwhile, since the risk-adjusted return on
the investment is higher than the hurdle rate, incorporated in the discount rate.
But let us step back a moment and consider the larger picture. For a vessel that has embedded Real
Options, our initial view is dangerously simple; it significantly undervalues the correct NPV. If there are
other factors that may serve to add value at this moment in time, they must be taken into account, or we
are knowingly making decisions based on an incomplete view.
6
Where VA is the present value, FCF is the free cash flow in a particular period, r the discount rate or Weighted Average Cost of Capital (WACC), and n the number
of periods.

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It is therefore the second part of the model that is paramount to determining the true value of a vessel.
Valuations of Real Options are technically more challenging than more traditional, more straightforward
financial options; but they are constructive, for they force us to acknowledge the future uncertainty
about any project’s value, including management’s ability to respond to changes.
There is much similarity between the modeling of Real Options and financial options. The model we use
for valuing Real Options is that developed by Black and Scholes:
Option value of the vessel7
where
In this case, the current value of the underlying asset (VA
*
- VA) is the difference between the PV of the
FCFs with a particular modification of the vessel at a certain moment in time and the PV of the FCFs in
their basic mode. The strike price (IA
*
- IA) is equal to the PV of the additional investment needed in
order to modify the vessel. The costs of the modification are dependent on the phase in which the vessel
is modified. To calculate the difference in PV of the FCFs, a DCF model is used for each combination
(option), of which there are a total of 360. Each combination represents a different configuration of the
inputs noted above, and therefore different parameters for the investment decision.
Besides the value of the underlying asset and the strike price, a further determinant in the current model
is volatility. For the purposes of this study, we use the historical volatility of the most significant
determinant for the PV, day rates, as a proxy for the volatility of the underlying asset. The value of the
option is highly dependent on the volatility of the forecasted day rates, along with differences in the
evolution of the day rates between sub-segments. The higher the volatility, the higher the upward
potential—and therefore the higher the value. In addition, the impact will be larger when expectations in
day rates for the different sub-segments, and thus vessel types, do not move in tandem.
7
Where CA is the value of the call option, (VA
*
- VA) is the current value of the underlying value, N is the cumulative normal distribution, (IA
*
- IA) is strike price of the
option, r is the riskless interest rate corresponding to the life of the option, T is the life to expiration of the option, and σdr is the volatility of the underlying asset.

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Figure 1: Historical day rates PSV, January 1998 - January 2013; source: www.workboat.com
For each of the different combinations (options), the value of the asset can be calculated by using Black
and Scholes’ formula, after we adjust the formula with parameters suitable for these Real Options. Note
that the value of an option will never be negative. The option to modify the vessel will only be exercised
by management if the value is seen as positive.
In order to have a clear additional value, created by the Real Options, the average option value is
calculated for each vessel type. For the specialized vessels, which we consider to be any of those above
the basic PSV—this results in four Real Option values. The outcome of the first part of the model
(simple traditional NPV), when combined with the outcome of the second part of the model (value
adding Real Options), gives us a complete picture, and the vessel’s true value.
True Net Present Value of the vessel

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Results: Real Options as part of the Value Calculation
If the investment decision at hand is based on a standard NPV calculation without unearthing the
additional embedded value, the expected NPV on a Platform Supply Vessel could be calculated as
negative. By the same token, if the investment calculation on a DSV comes up negative—likely because
the occupation rate in the future is uncertain, or the market prospects are declining over time—the
investment will likewise not be pursued. By combining the base value of these vessels, however, and
taking the critical step of adding the value of the embedded Real Option, we see an important shift
occur: the value can turn positive.
Figure 2 Forecasted day rates, July 2013 - July 2019
Performing the analysis on a CSV operated in Asia with current available information on capital
expenses and operational expenses (costs) as well as day rates (revenues) yields an NPV of US$2.3
million.
The potential option to moderate the vessel to a DSV in the future has an impact on capital expenses,
since its modification will entail separate costs, and in addition we must allow a period of time in which
it will not be operational. Furthermore, the calculation of the value of the overhauled asset is impacted
by operational expenses, since the modified vessel now entails different costs for daily operations, such
as crew, consumables and fuel consumption.

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Based on the current model, the value of the option itself may be as big as US$5.0 million, leading to a
total NPV of US$7.3 million.
Remember that the diving equipment, an extra feature, is available at any point during the lifetime of the
vessel. If the day rate for CSV drops, the original crane is dismantled and replaced with diving
equipment, sending the day rate back up in the future. In our model, future day rates (see Figure 1) are
used, however during the lifetime of the asset, these rates can change, and, during the vessel’s lifetime
of 30 years or more, the Real Option can be executed earlier, later or not at all.
Table 1: Example option values for exercising the embedded options in Asia at years 1-6.
Red indicates a decrease in option value compared to the previous year, green an increase.
As shown in the above table, the value of the option to modify a vessel, as determined by the forecasted
day rates, fluctuates appreciably over time. It is thus essential to update the model regularly if one is to
seek ongoing value creation for the organization.
Options 1 2 3 4 5 6
Asia WROV → CSV $0 $0 $0 $0 $0 $0
DSV (air) → CSV $0 $0 $0 $0 $0 $154
DSV (sat) → CSV $2,819,866 $2,560,409 $3,774,660 $3,328,529 $1,364,518 $198,268
CSV → WROV $12,046,608 $11,946,158 $8,656,020 $4,909,561 $2,778,732 $1,551,477
DSV (air) → WROV $40,597 $202,990 $33,326 $78,357 $80,745 $236,264
DSV (sat) → WROV $17,633,445 $17,460,018 $13,974,458 $9,662,831 $4,674,158 $1,428,416
CSV → DSV (air) $11,094,495 $11,180,337 $7,975,757 $5,110,785 $3,428,066 $1,650,171
WROV → DSV (air) $0 $0 $0 $3,876 $426,618 $577,003
DSV (sat) → DSV (air) $13,689,260 $13,359,745 $10,925,274 $7,899,841 $4,279,574 $1,399,033
CSV → DSV (sat) $0 $0 $0 $0 $90,950 $735,823
WROV → DSV (sat) $0 $0 $0 $0 $0 $298,058
DSV (air) → DSV (sat) $0 $0 $0 $0 $37 $345,570

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Real Options in Practice
Recently, Boskalis released two new vessels in Singapore: the Ndeavor and the Ndurance, part of the so-
called N-class. The two new vessels, with accommodation for over 90 persons, were initially ordered by
SMIT as accommodation vessels for offshore support.
In the wake of the merger between Boskalis and SMIT, the Ndeavor and the Ndurance have been
allocated to the former’s offshore fleet. The Ndurance has been converted into a cable-laying vessel, and
the other, with a similar hull, into a multi-purpose stone-dumping vessel with dredging capabilities.
These conversions are both driven by specific, current projects, and can be further added to, or reverted,
in the future depending upon the requirements of the offshore market. The accommodation capacity of
these vessels itself represents an option, since, though most offshore vessels do not require many
persons on board, creating more capacity can thereby increase the vessel’s utilization rate. An option on
multi-purpose projects is included in the value calculation.

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Conclusion
Given that any forward-looking statements necessarily include a high level of uncertainty, Real Options
can be of considerable value to any investment analysis. While the valuation of Real Options is
complex, since their effect on predicted cash flows is always farther into the future than those of the
initial investment, recognizing their contribution is not only critical if one aims to paint a thorough
picture of the investment decision, but also leads to a positive impact on valuation, and therefore the
business proposition, for different stakeholders: investors, by increasing the number of options to invest
in value-adding propositions; financiers, due to the higher residual value of the vessel and its
operational utility in different markets (especially if the default risk of the owner is high); construction
companies, since recognition of the option value will lead to more initial investments being made,
including additional potential re-constructions (modifications) over time; and customers, due to the
higher residual value of the asset and, in turn, more competitive day rates.
It is not only in the interests of today’s company leaders to think in terms of options; it is imperative to
do so, if they seek to make investment decisions based on a broader, more inclusive picture of value
than that generated by traditional models. By unlocking the embedded value of Real Options, we
increase stakeholder value and contribute to the sustainability of the organization over time. This effort
should be made a priority not only by the finance department, but by the entire management team.