Finance management cengage 2013 chapter 013

What is real option analysis?• Real options exist when managers can influence the size and riskiness of a project’s cash flows by taking different actions during or at the end of a proje

Real Options and Other Topics in

Capital Budgeting

Identifying Embedded Options Valuing Real Options in Projects

Chapter 13

What is real option analysis?

• Real options exist when managers can influence the

size and riskiness of a project’s cash flows by taking different actions during or at the end of a project’s life

• Real option analysis incorporates typical NPV capital

budgeting analysis with an analysis of opportunities resulting from managers’ responses to changing

circumstances that can influence a project’s outcome

What are some examples of real options?

• Growth/expansion options

• Abandonment/shutdown options

• Investment timing options

• Flexibility options

Investment Timing Option

• Project X has an up-front cost of $100,000 The

project is expected to produce cash flows of

$33,500 at the end of each of the next four years (t = 1, 2, 3, and 4) The project has a WACC = 10%

• The project’s NPV is $6,190 Therefore, it appears

that the company should go ahead with the project

• However, if the company waits a year they will find

out more information about market conditions and the impact on the project’s expected cash flows

Investment Timing Option

• If they wait a year:

– There is a 50% chance the market will be strong and the expected cash flows will be $43,500 a year for four years.

the expected cash flows will be $23,500 a year for four years.

– The project’s initial cost will remain $100,000, but it will be incurred at t = 1 only if it makes sense at that time to proceed with the project.

• Should the company go ahead with the project

today or wait for more information?

Investment Timing Decision Tree

• At WACC = 10%, the NPV at t = 1 is:

– $37,889, if CF’s are $43,500 per year, or

– -$25,508, if CF’s are $23,500 per year, in which case the firm would not proceed with the project.

50% prob.

50% prob.

0 1 2 3 4 5 Years

-$100,000 43,500 43,500 43,500 43,500

-$100,000 23,500 23,500 23,500 23,500

Should we wait or proceed?

• If we proceed today, NPV = $6,190

• If we wait one year, Expected NPV at t = 1 is

0.5($37,889) + 0.5(0) = $18,944.57, which is worth

$18,944.57/1.10 = $17,222.34 in today’s dollars (assuming a 10% WACC)

• Therefore, it makes sense to wait

Issues to Consider with Investment Timing Options

• What is the appropriate discount rate?

• Note that increased volatility makes the option to

delay more attractive

CFs will be $53,500 a year, and a 50% chance the subsequent CFs will be $13,500 a year, expected NPV next year (if we delay) would be:

t = 1: 0.5($69,588) + 0.5(0) = $34,794 > $18,945

t = 0: $34,794/1.10 = $31,631 > $17,222

Factors to Consider In Decision of When to Invest

• Delaying the project means that cash flows come

later rather than sooner

• It might make sense to proceed today if there are

important advantages to being the first competitor

to enter a market

• Waiting may allow you to take advantage of

changing conditions

Abandonment/Shutdown Option

• Project Y has an initial, up-front cost of $200,000, at

t = 0 The project is expected to produce cash flows

of $80,000 for the next three years

• At a 10% WACC, what is Project Y’s NPV?

0 1 2 3 -$200,000 80,000 80,000 80,000

10%

NPV = -$1,051.84

Abandonment Option

• Project Y’s cash flows depend critically upon

customer acceptance of the product

• There is a 60% probability that the product will be

wildly successful and produce CFs of $150,000, and

a 40% chance it will produce annual CFs of

−$25,000

Abandonment Decision Tree

• If the customer uses the product, NPV is

$173,027.80

• If the customer does not use the product, NPV is

-$262,171.30

-$200,000

60% prob.

40% prob.

1 2 3 Years 0

150,000 150,000 150,000

-25,000 -25,000 -25,000

) 3 171 ,

262

$ ( 4 0 )

8 027 ,

173 ($

6 0 )

NPV (

Issues with Abandonment Options

• The company does not have the option to delay the

project

• The company may abandon the project after a year,

if the customer has not adopted the product

• If the project is abandoned, there will be no

operating costs incurred nor cash inflows received after the first year

NPV with Abandonment Option

• If the customer uses the product, NPV is $173,027.80

• If the customer does not use the product and it can be

abandoned after Year 1, NPV is −$222,727.27

-$200,000

60% prob.

40% prob.

1 2 3 Years 0

150,000 150,000 150,000

-25,000

) 27 727 ,

222

$ ( 4 0 )

8 027 ,

173 ($

6 0 )

NPV (

Should an abandonment option affect a

project’s WACC?

• Yes, an abandonment option should have an effect

on the WACC

• The abandonment option reduces risk, and

therefore reduces the WACC

Growth Option

• Project Z has an initial cost of $500,000

• The project is expected to produce cash flows of

$100,000 at the end of each of the next five years, and has a WACC of 12% It clearly has a negative NPV

• There is a 10% chance the project will lead to

subsequent opportunities that have an NPV of

$3,000,000 at t = 5, and a 90% chance of an NPV of -$1,000,000 at t = 5

NPV with the Growth Option

• At WACC = 12%,

100,000 100,000 100,000 100,000 100,000

-$500,000

10% prob.

90% prob.

1 2 3 4 5 Years 0

100,000 100,000 100,000 100,000 100,000-$1,000,000

$3,000,000

NPV with the Growth Option

• If the project’s future opportunities have a negative

NPV, the company would choose not to pursue them

• The bottom branch only has the -$500,000 initial

outlay and the $100,000 annual cash flows, which lead to an NPV of -$139,522

• The expected NPV of this project is:

NPV = 0.1($1,562,758) + 0.9(-$139,522)

= $30,706

Flexibility Options

• Flexibility options exist when it’s worth spending

money today, which enables you to maintain flexibility down the road