Real Options and Other Topics in Capital Budgeting

CHAPTER 13
Real Options and Other

Topics in Capital Budgeting
Identifying embedded options

Valuing real options in projects
Evaluating projects with unequal
lives
13-1
What is real option

analysis?
Real options exist when managers can

influence the size and riskiness of a
projects cash flows by taking different
actions during the projects life.
Real option analysis incorporates
typical NPV budgeting analysis with an
analysis for opportunities resulting from
managers decisions.
13-2
What are some examples

of real options?
Investment timing options

Abandonment/shutdown
options
Growth/expansion options
Flexibility options
13-3
Investment timing option
Project X has an up-front cost of $100,000.

The project is expected to produce aftertax 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 projects 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 about the projects
expected cash flows.
13-4
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.
There is a 50% chance the market will be weak
and the expected cash flows will be $23,500 a
year for four years.
The projects 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?
13-5
Investment timing decision

tree
50% prob.
50% prob.
-$100,000
43,500
43,500
43,500
43,500
-$100,000
23,500
23,500
23,500
23,500
Years
At WACC = 10%, the NPV at t = 1 is:
$37,889, if CFs are $43,500 per year, or

-$25,508, if CFs are $23,500 per year, in
which case the firm would not proceed
with the project.
13-6
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
todays dollars (assuming a 10%
WACC).
Therefore, it makes sense to wait.
13-7
Issues to consider with

investment timing options
What is 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 > $18,945
13-8
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.
13-9
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% WACC, what is Project Ys
0
1
2
3
NPV?
10%
-$200,000
80,000
80,000
80,000
NPV = -$1,051.84
13-10
Abandonment option
Project Ys 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.
13-11
Abandonment decision tree

60% prob.
-$200,000
40% prob.
0
150,000
150,000
150,000
-25,000
-25,000
-25,000
Years
If the customer uses the product,

NPV is $173,027.80.
If the customer does not use the product,
NPV is -$262,171.30.
E(NPV) = 0.6($173,027.8) + 0.4(-$262,171.3)
= -$1,051.84
13-12
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.
13-13
NPV with abandonment

option
150,000
60% prob.
-$200,000
40% prob.
0
150,000
150,000
-25,000
1
Years
If the customer uses the product,

NPV is $173,027.80.
If the customer does not use the product,
NPV is -$222,727.27.
E(NPV) = 0.6($173,027.8) + 0.4(-$222,727.27)
= $14,725.77
13-14
Should an abandonment
option affect a projects
WACC?
Yes, an abandonment option

should have an effect on the
WACC.
The abandonment option
reduces risk, and therefore
reduces the WACC.
13-15
Growth option
Project Z has an initial 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, 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.
13-16
NPV with the growth

option
100,000
10% prob.
-$500,000
90% prob.
0
100,000
100,000
100,000
100,000
$3,000,000
100,000
100,000
100,000
-$1,000,000
100,000
100,000
Years
At WACC = 12%,
NPV of top branch (10% prob) =

$1,562,758.19
NPV of lower branch (90% prob) = $139,522.38
13-17
NPV with the growth

option
If the projects 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 value of this project should be:
NPV= 0.1($1,562,758) + 0.9(-$139,522)
= $30,706.
13-18
Flexibility options
Flexibility options exist when its

worth spending money today,
which enables you to maintain
flexibility down the road.
13-19
Evaluating projects with

unequal lives
Projects S and L are mutually exclusive, and will
be repeated. If WACC = 10%, which is better?
Expected Net CFs
Year Project S Project L
0 ($100,000)
($100,000)
1
59,000
33,500
2
59,000
33,500
3
33,500
4
33,500
13-20
Solving for NPV,

with no repetition
Enter CFs into calculator CFLO register

for both projects, and enter I/YR =
10%.
NPV = $2,397
S
NPVL = $6,190
Is Project L better?
Need replacement chain and/or
equivalent annual annuity analysis.
13-21
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.
0
10%
-100,000
59,000
59,000
59,000
-100,000
-41,000
NPVS = $4,377 (on extended basis)
4
59,000
13-22
Equivalent Annual Annuity
Using the previously solved for project

NPVs, the EAA is the annual payment that
the project would provide if it were an
annuity.
Project S
Project L
Enter N = 2, I/YR = 10, PV = -2397, FV = 0;

solve for PMT = EAA = $1,381.
Enter N = 4, I/YR = 10, PV = -6190, FV = 0;
solve for PMT = EAA = $1,953.
Project L is better!
13-23

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CHAPTER 13

Real Options and Other

Identifying embedded options

What is real option

Real options exist when managers can

What are some examples

Investment timing options

Investment timing option

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

Investment timing option

If they wait a year:

There is a 50% chance the market will be strong

Should the company go ahead with the

Investment timing decision

At WACC = 10%, the NPV at t = 1 is:

$37,889, if CFs are $43,500 per year, or

If we proceed today, NPV = $6,190.

Issues to consider with

What is the appropriate discount rate?

Factors to consider when

Delaying the project means that

Project Y has an initial, up-front cost

Project Ys A-T net cash flows

Abandonment decision tree

If the customer uses the product,

Issues with abandonment

The company does not have the

NPV with abandonment

If the customer uses the product,

Yes, an abandonment option

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

NPV with the growth

NPV of top branch (10% prob) =

NPV with the growth

If the projects future opportunities have a

Flexibility options exist when its

Evaluating projects with

Solving for NPV,

Enter CFs into calculator CFLO register

Use the replacement chain to calculate an

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

Equivalent Annual Annuity

Using the previously solved for project

Enter N = 2, I/YR = 10, PV = -2397, FV = 0;

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