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Assume that you have just been hired as a financial analyst by Tropical Sweets Inc., a mid-sized California company that specializes in creating exotic candies from tropical fruits such as mangoes, papayas, and dates. The firm's CEO, George Yamaguchi, recently returned from an industry corporate executive conference in San Francisco, and one of the sessions he attended was on real options. Since no one at Tropical Sweets is familiar with the basics of real options, Yamaguchi has asked you to prepare a brief report that the firm's executives could use to gain at least a cursory understanding of the topics.

What are some types of real options? 1) Abandonment Option: This is an option to sell or close down a project. It is an American put option on the project's value. The strike price of the option is the liquidation (or resale) value of the project less any closing-down costs. When the liquidation value is low, the strike price can be negative. Abandonment options mitigate the impact of very poor investment outcomes and increase the initial valuation of a project.

What are some types of real options? 2) Expansion Option. This is the option to make further investments and increase the output if conditions are favourable. It is an American call option on the value of additional capacity. The strike price of the call option is the cost of creating this additional capacity discounted to the time of option exercise. The strike price often depends on the initial investment. If management initially chooses to build capacity in excess of the expected level of output, the strike price can be relatively small.

What are some types of real options? 3) Contraction Option. This is the option to reduce the scale of a project's operation. It is an American put option on the value of the lost capacity. The strike price is the present value of the future expenditures saved as seen at the time of exercise of the option.

What are some types of real options? 4) Option to defer. One of the most important options open to a manager is the option to defer a project. This is an American call option on the value of the project. 5) Option to extend. Sometimes it is possible to extend the life of an asset by paying a fixed amount. This is a European call option on the asset's future value.

What are the five steps for analyzing a real option? 1. DCF analysis of expected cash flows, ignoring the option. 2. Qualitative assessment of the real option’s value. 3. Decision tree analysis. 4. Standard model for a corresponding financial option. 5. Financial engineering techniques.

c. Tropical Sweets is considering a project that will cost $70 million and will generate expected cash flows of $30 per year for three years. The cost of capital for this type of project is 10 percent and the risk-free rate is 6 percent. After discussions with the marketing department, you learn that there is a 30 percent chance of high demand, with future cash flows of $45 million per year. There is a 40 percent chance of average demand, with cash flows of $30 million per year. If demand is low (a 30 percent chance), cash flows will be only $15 per year. What is the expected NPV?

Analysis of a Real Option: Basic Project Initial cost = $70 million, Cost of Capital = 10%, risk-free rate = 6%, cash flows occur for 3 years. Annual Demand Probability Cash Flow High 30% $45 Average 40% $30 Low 30% $15

Approach 1: DCF Analysis E(CF) =.3($45)+.4($30)+.3($15) = $30. PV of expected CFs = ($30/1.1) + ($30/1.12) + ($30/1.13) = $74.61 million. Expected NPV = $74.61 - $70 = $4.61 million

Investment Timing Option If we immediately proceed with the project, its expected NPV is $4.61 million. However, the project is very risky: If demand is high, NPV = $41.91 million. If demand is low, NPV = -$32.70 million

Investment Timing (Continued) If we wait one year, we will gain additional information regarding demand. If demand is low, we won’t implement project. If we wait, the up-front cost and cash flows will stay the same, except they will be shifted ahead by a year.