© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Real Options and Other Topics in Capital Budgeting Identifying Embedded Options Valuing Real Options in Projects Chapter

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 13-2

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. What are some examples of real options? Growth/expansion options Abandonment/shutdown options Investment timing options Flexibility options 13-3

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 13-4

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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? 13-5

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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 % prob Years -$100,000 43,500 43,500 43,500 43,500 -$100,000 23,500 23,500 23,500 23,500

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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, in today’s dollars (assuming a 10% WACC). Therefore, it makes sense to wait. 13-7

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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: t = 1: 0.5($69,588) + 0.5(0) = $34,794 > $18,945 t = 0: $34,794/1.10 = $31,631 > $17,

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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. 13-9

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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? $200,000 80,000 80,000 80,000 10% NPV = -$1,051.84

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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,

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Abandonment Decision Tree If the customer uses the product, NPV is $173, If the customer does not use the product, NPV is -$262, $200,000 60% prob. 40% prob Years0 150, , , , , ,000

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. NPV with Abandonment Option If the customer uses the product, NPV is $173, If the customer does not use the product and it can be abandoned after Year 1, NPV is  $222, $200,000 60% prob. 40% prob Years0 150, , , ,000

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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 =

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. NPV with the Growth Option At WACC = 12%, – NPV of top branch (10% prob.) = $1,562, – NPV of lower branch (90% prob.) = -$139, , , ,000100, ,000 -$500,000 10% prob. 90% prob Years0 100, , , , ,000 -$1,000,000 $3,000,000

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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,

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Flexibility Options Flexibility options exist when it’s worth spending money today, which enables you to maintain flexibility down the road