INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY

Chapter 14

Real Options and Other Topics

in Capital Budgeting

Valuing Real Options in Projects

• Timing Option
• Abandonment/Shutdown Option
• Growth Option
• Flexibility Option
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 INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY

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.

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 INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY

What are some examples of real options?

• Investment timing options

• Abandonment/shutdown options
• Growth/expansion options
• Flexibility options

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 INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY

Investment Timing Option

• Project X has an upfront 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.
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 INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY

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?
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 INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY

Investment Timing Decision Tree

-$100,000 43,500 43,500 43,500 43,500

50% prob.
-$100,000 23,500 23,500 23,500 23,500
50% prob.
0 1 2 3 4 5 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.

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 INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY

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 today’s
dollars (assuming a 10% WACC).
• Therefore, it makes sense to wait.

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 INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY

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 > $17,222

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 INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY

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.

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 INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY

Abandonment/Shutdown Option

• Project Y has an initial, upfront 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?
0 10%
1 2 3

-$200,000 80,000 80,000 80,000

NPV = -$1,051.84

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 INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY

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 $25,000.

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 INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY

Abandonment Decision Tree

150,000 150,000 150,000

60% prob.
-$200,000
-25,000 -25,000 -25,000
40% prob.
0 1 2 3 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
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 INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY

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.

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 INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY

NPV with Abandonment Option

150,000 150,000 150,000

60% prob.
-$200,000 -25,000
40% prob.
0 1 2 3 Years

• If the customer uses the product, NPV is

$173,027.80.
• If the customer does not use the product and it can
be abandoned after Year 1, NPV is $222,727.27.
E(NPV )  0.6($173,027.8)  0.4( $222,727.27)
 $14,725.77
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 INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY

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.

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 INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY

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 = 5.

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 INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY

NPV with the Growth Option

$3,000,000
100,000 100,000 100,000 100,000 100,000
10% prob.
-$500,000 -$1,000,000
100,000 100,000 100,000 100,000 100,000
90% prob.
0 1 2 3 4 5 Years

• At WACC = 12%,
– NPV of top branch (10% prob.) = $1,562,758.19
– NPV of lower branch (90% prob.) = -$139,522.38
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 INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY

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)
= $30,706.

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 INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY

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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