# Real Options and Other Topics in Capital Budgeting

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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

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?
Growth/expansion options Abandonment/shutdown options Investment timing options Flexibility options

Investment Timing Option
Project X has an up-front cost of \$100, The project is expected to produce after-tax 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 about 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. 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 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
-\$100, , , , ,500 50% prob. -\$100, , , , ,500 50% prob. Years 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.

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, / 1.10 = \$17, 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. 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

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% WACC, what is Project Y’s NPV? -\$200, , , ,000 10% NPV = -\$1,051.84

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
150, , ,000 60% prob. -\$200,000 -25, , ,000 40% prob. Years If the customer uses the product, NPV is \$173, If the customer does not use the product, NPV is -\$262,

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
150, , ,000 60% prob. -\$200,000 -25,000 40% prob. Years If the customer uses the product, NPV is \$173, If the customer does not use the product, NPV is -\$222,

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 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.

NPV with the Growth Option
\$3,000,000 100, , , , ,000 10% prob. -\$1,000,000 -\$500,000 100, , , , ,000 90% prob. Years At WACC = 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 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 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.

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