Business finance ch 12 other topics in capital budgeting

CHAPTER 12Other Topics in Capital Budgeting  Evaluating projects with unequal lives  Identifying embedded options  Valuing real options in projects... What is real option analysis? R

CHAPTER 12

Other Topics in Capital Budgeting

 Evaluating projects with unequal lives

 Identifying embedded options

 Valuing real options in projects

Evaluating projects with

unequal lives

Projects S and L are mutually exclusive, and will

be repeated If k = 10%, which is better?

Solving for NPV,

with no repetition

 Enter CFs into calculator CFLO register for

both projects, and enter I/YR = 10%

-100,000 59,000 59,000 59,000 59,000

-100,000 -41,000

Replacement chain

 Use the replacement chain to calculate an

extended NPVS to a common life

 Since Project S has a 2-year life and L has a

4-year life, the common life is 4 years

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 the project’s life.

 Real option analysis incorporates

typical NPV budgeting analysis with an analysis for opportunities resulting

from managers’ decisions.

What are some examples of real options?

 Investment timing options

 Abandonment/shutdown options

 Growth/expansion options

 Flexibility options

Illustrating an investment

timing option

 If we proceed with Project L, its annual cash

flows are $33,500, and its NPV is $6,190

 However, if we wait one year, we will find out

some additional information regarding output

prices and the cash flows from Project L.

 If we wait, the up-front cost will remain at

$100,000 and there is a 50% chance the

subsequent CFs will be $43,500 a year, and a

50% chance the subsequent CFs will be

$23,500 a year.

Investment timing decision tree

 At k = 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?

discount rate).

 Therefore, it makes sense to wait.

Issues to consider with

investment timing options

 What’s the appropriate discount rate?

 Note that increased volatility makes the option to delay more attractive

 If instead, there was a 50% chance the

subsequent 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:

0.5($69,588) + 0.5(0) = $34,794 > $18,944.57

Factors to consider when

deciding 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 after-tax net cash

flows of $80,000 for the next three years.

 At a 10% discount rate, what is Project Y’s NPV?

0 1 2 3

k = 10%

Abandonment option

 Project Y’s A-T net cash flows depend critically upon customer acceptance of the product.

 There is a 60% probability that the

product will be wildly successful and

produce A-T net CFs of $150,000, and

a 40% chance it will produce annual A-T net CFs of -$25,000.

Abandonment decision tree

 If the customer uses the product,

150,000 150,000 150,000 -25,000 -25,000 -25,000

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,

150,000 150,000 150,000 -25,000

Is it reasonable to assume that the

abandonment option does not affect

the cost of capital?

 No, it is not reasonable to assume

that the abandonment option has

no effect on the cost of capital.

 The abandonment option reduces

risk, and therefore reduces the cost

of capital.

Growth option

 Project Z has an initial up-front cost of

$500,000

 The project is expected to produce A-T cash

inflows of $100,000 at the end of each of the next five years Since the project carries a 12% cost of capital, 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

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

10% prob.

90% prob.

Years 0

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

-$1,000,000

$3,000,000

 At k = 12%,

 NPV of top branch (10% prob) = $1,562,758.19

 NPV of lower branch (90% prob) = -$139,522.38

NPV with the growth option

 If it turns out that the project has future

opportunities with a negative NPV, the company would choose not to pursue them

 Therefore, the NPV of the bottom branch should include only the -$500,000 initial outlay and the

$100,000 annual cash flows, which lead to an NPV

of -$139,522.38

 Thus, the expected value of this project should be: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.