REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING

Slide 1 - The previous topic, Basics of Capital Budgeting, presents five techniques that are commonly used to
evaluate long term projects on whether they are worth venturing into or not.

It is also determined that the NPV method is the best method among the five because it gives a direct measure of
the peso benefit of the project to shareholders, it considers the time value of money and all cash flows expected to
be generated during the life of the project, it uses the WACC to discount cash flows, and does not suffer from
multiple IRR problems, and hence can be used even if cash flows are non-normal.

In this topic, we incorporate actual scenarios that may occur whilst undertaking a particular project. Since the NPV
is determined to be the best capital budgeting method, the NPV is the ONLY method that will be used in real
option analysis.

Slide 2 - So what are real options?

Real options are opportunities to respond to changing circumstances. Before undertaking a project, or even when
the project is already accepted and ongoing, managers may be faced with options or scenarios requiring crucial
decisions to be made because the options would most likely affect future cash flows.

That is why real options are called managerial options, because managers make decisions that can affect the
outcome of a project. They are also called strategic options simply because we are dealing with long-term projects
with long-term implications rather than short-term recurring projects.

Real options are named as such because we are dealing with real assets - assets that are tangible. We are not
concerned with financial assets (those that are not tangible, and are just represented by certificates such as stocks
or bonds) in real option analysis. Derivative instruments such as call and put options are also not considered as real
options.

Slide 3 - Because real options are often present in the business world, it is thus essential to know how to analyze
these options to make decisions that can maximize shareholder wealth. An important principle that must be noted
is that real option is an option - a choice. Therefore the manager has the right to choose whether or not to exercise
that option. If the real option adds value, then the manager should exercise the option. If it reduces value, then the
manager should not exercise the option.

The most important computation therefore, is how the option is valued. Option value is computed as NPV with the
relevant option minus NPV without the relevant option.

If the option value is positive, that means the option adds value to shareholders and should be undertaken. If NPV
without the option is greater than NPV with the relevant option, then the project should not be undertaken.

An important principle to take note of is that, even if NPV without the relevant option is greater than the NPV with
the relevant option, we can NEVER have a negative option value because if this happens, the manager would not
have exercised the option anyway. Thus, the lowest possible value of a real option is ZERO.

To do real option analysis, a simple yet important tool could be used. This is called decision tree analysis in which
we are to construct decision tree timelines. The point where the tree branches is called a node and a decision node
is a point at which management makes the decision based on new information.

Slide 4 - Some examples of real options are presented to you. Investment timing option is also known as option to
delay. Sometimes, there are instances where it may not be wise to engage in a project immediately due to
unfavorable market conditions at present. These options are particularly valuable in industries that experience
wide fluctuations (eg. mining industry). If the company waits for a year or two before embarking on the project, it
may allow them to generate higher profits.

Growth options allows the company to expand operations by increasing capacity to meet the demands of its
customers in case that the company is doing well.

Option to contract is the opposite of growth option wherein the company has the option to shrink its operations in
case they are no longer deemed profitable.

Option to extend is an option wherein a project with a life of, let's say 10 years, could be extended to 15 years,
enabling the company to increase the NPV of that project.

Option to switch is an option that allows you to switch projects in case the one originally chosen is later not
deemed to add value to shareholders.
Abandonment or shutdown options allows the managers to end an unprofitable project even before the end of its
life so that losses may be minimized.

Those that are in bold, namely investment timing options, growth/expansion options, and
abandonment/shutdown options are options in the text which would be presented in problem form.

Slide 5 - The question that must be asked in investment timing option is if the project should proceed today or
should the company wait. To answer this question, a comparison of NPV with the option and NPV without the
option should be done. Whichever gives you the higher positive NPV should be chosen.

Slide 6 - One of the issues to consider is the amount of WACC to be used. Since we have discussed that the
presence of option is valuable and thus rendering the project less risky, the WACC used in computing NPV with the
option should be less than the WACC used in computing NPV without the option. However, unless the problem
states otherwise, we will assume that the same WACC is used for all options presented in the problem.

The second issue to note is that the riskier (increased volatility) is the situation, the more value is the option,
because the option can alleviate the negative effect of the volatility.

Factors to consider when deciding when to invest include the following. Taking note of TVM principle, a peso
received today is better than a peso received tomorrow. If the company delays a project, it means that the cash
flows would be received later. However, waiting allows uncertainties to unfold and tells the company if conditions
are favorable or not. But even with the advantages of waiting, one must also consider that waiting would result the
foregoing of first mover advantage and market share may be grabbed by competitors.

Slide 7 - Illustration 1: Investment Timing Option (HTC Corporation)

Slide 7B - We begin by making two decision tree timelines. One to represent Option 1 if HTC proceeds today and
the other to represent Option 2 if HTC delays the project for a year.

Since there are two probabilities, we draw two branches per decision tree timeline. For option 1, good conditions
warrant 10 million cash flows for 3 years while bad conditions warrant 5 million cash flows for 3 years. With an
initial investment of 20 million, the NPV under good conditions is 4,868,519.91 and NPV under bad conditions is
(7,565,740.05). We multiply each NPV with their respectively probabilities and add the products to get the
weighted average NPV if HTC proceeds today worth (1,348,610.07).

For Option 2, we assume that HTC delays the project for a year, that is why under good conditions, the initial
investment comes at Year 1 instead of Year 0. And since waiting will not affect cash flows, 10 million will be
received for 3 years from Years 2 to 4. The NPV under bad conditions is a little tricky though. It is stated in the
problem that HTC can delay the project to conduct a study to determine whether the demand will be strong or
weak. Thus if HTC waits and knows that conditions will be weak, surely he is not going to go through with the
investment and get a negative NPV right. (We know it would be negative because under Option 1, the NPV under
bad conditions is negative). That is why NPV under bad conditions in Option 2 is 0. HTC does not invest at all if
conditions are weak. Multiply each NPV by their respective probabilities and adding these products, we get a
weighted average NPV if HTC delays worth 2,212,963.60.

The action that you would recommend is to follow Option - to delay the project for a year, because you would get
a higher NPV than if you decide to proceed today.

If the problem asks you to compute for the value of the option, the equation is NPV with option - NPV without
option. Value of the option is: 2,212,963.30 - - 1,348,610.07 is 3,561,573.67

Slide 8 - Illustration 2: Investment Timing Options (Nebraska Instruments)

Slide 8B - We begin by making two decision tree timelines. One to represent Option 1 if NI proceeds today and the
other to represent Option 2 if NI waits a year.

Since there are two probabilities, we draw two branches per decision tree timeline. For option 1, good conditions
warrant 500k cash flows for 7 years while bad conditions warrant 50k cash flows for 7 years. With an initial
investment of 1.5 million, the NPV under good conditions is 934,209.41 and NPV under bad conditions is
(1,256,579.06). We multiply each NPV with their respectively probabilities and add the products to get the
weighted average NPV if NI proceeds today worth 386,512.30
For Option 2, we assume that NI delays the project for a year, that is why under good conditions, the initial
investment comes at Year 1 instead of Year 0. Supposedly, the inflows will be received for 7 years from Year 2 to
Year 8, but the problem states that if it decides to wait, the subsequent cash flows will be received only for six
years, so that's why the inflows will run only from Year 2 to Year 7. Similar to Illustration one, NI will know for sure
one year from today whether its product will have become the industry standard. Surely, NI would not proceed at
all if the products do not become the industry standards. That is why NPV under bad conditions in Option 2 is 0.
Multiply each NPV by their respective probabilities and adding these products, we get a weighted average NPV if
NI delays worth 462,020.69

If NI chooses to wait, the increase in the project's expected NPV (or the option value) is 75,508.39.

Slide 9 - The second option that we will discuss in detail is the growth option. If the problem is silent, take note
that we expect that there is growth option only if the existing project is generating gains. If the existing project is
losing, then we won't expect to exercise the growth option. This is also logical for who would want to expand when
the existing project is suffering from losses?

The question to answer is does the investment pave the way from a new opportunity for the company to invest
and what is the value of that growth opportunity.

To answer the question, compare the NPV with the growth option and NPV without the growth option. Whichever
option gives you the higher positive NPV should be chosen. Don't forget that there is no negative option value and
the least amount of option value is zero.

Slide 10 - Factors to consider when dealing with projects that has growth options.

Slide 11 - Illustration 3: Growth Options (Cheung Kong Holdings Limited)

Slide 11B - We make two decision tree timelines. One to represent Option 1 if there is no growth option and the
other to represent Option 2 if there is a growth option.

We draw two branches per decision tree timeline. For option 1, there is a 55% chance that the project is hugely
successful and generate 6 million cash flows for 3 years while there is a 45% chance that the project is not hugely
successful wherein only 1 million is generate for 3 years. With an initial investment of 10 million, the NPV under
good conditions is 4,410,987.61 and NPV under bad conditions is (7,598,168.73). We multiply each NPV with their
respectively probabilities and add the products to get the weighted average NPV without the growth option worth
(993,132.74). This is the answer to the first requirement.

For Option 2, we assume that there is a growth option ONLY if the the product is hugely successful. If not, then
there is no growth option to speak of. That is why if the product is successful, we included the 9 million outflow at
year 2 and 20 million inflow at year 3 in the timeline. However, we don't include those cash flows if the product is
not successful. We then find the NPV under both good and bad conditions, computed as 11,471,847.67 and
(7,598,168.73), respectively. Multiply each NPV by their respective probabilities and adding these products, we get
a weighted average NPV with the option of 2,890,340.29. This is the answer to the second requirement.

The third requirement is to compute for the value of the option, the equation is NPV with option - NPV without
option. Value of the option is: 2,890,340.29 - - 993,132.74 = 3,883,473.03.

Slide 12 - Illustration 4: Growth Options (Diplomat Inc.)

Slide 12B - We have two options. Option 1 if there is no growth option and Option 2 if there is a growth option.

For Option 1, we don't need to make a decision tree timeline. An ordinary timeline will suffice since the
probabilities only presents itself at Year 5. Hence the NPV without the growth option is (1,104,606.62), computed
as the present value of the 500,000 inflow for 5 years less the initial investment of 3 million. This is the answer to
the first requirement.

For Option 2, we assume that there is a growth option at Year 5 which would be 6 million under good conditions
and (6 million) under bad conditions. Supposedly, there should have been a (6 million) under bad conditions, but
we added zero. Why? It's because of the statement "Diplomat does not have to decide today whether it wants to
pursue these additional opportunities. Instead, it can wait until after it finds out if its technology is successful. Thus
for Option 2, NPV under good conditions is 2,620,921.32 and NPV under bad conditions is (1,104,606.62). Multiply
each NPV by their respective probabilities and adding these products, we get a weighted average NPV with the
option of 199,328.16. This is the answer to the second requirement.

If the problem asks for the option value, it is computed as NPV with option - NPV without option. Value of the
option is: 199,328.16 - - 1,104,606.62 = 1,303,934.78

Slide 13 - The third option that we would want to look at in detail is the abandonment or shutdown option.
Sometimes it might be better to abandon a project if it does not give the company the cash inflows that it so
desires. The abandonment option may be complete abandonment or just temporary abandonment - the latter of
which is more common for companies that often experience seasonal fluctuations.

One needs to answer whether a company should abandon its investments, and if so, at which time should that
investment be abandoned.
Slide 14 - One common error of students is that they would combine the principle of the option to delay with the
principle of the option to abandon. The option to delay often allows the company not to undertake the project at
all after it waits and finds out that the project is actually unprofitable. However, the option to abandon does not
give the company the chance to "wait and see". Therefore, there is often no "zero" cash flows when constructing
the decision tree timeline.

When we were studying capital budgeting and the computation for NPV, we include all the cash flows during the
life of the project. But in the option to abandon, we assume that we can abandon the project after a year or a
number of years before the project ends. When we abandon the project, we assume that there will no longer be
any cash inflows or outflows associated with the abandoned project after the said abandonment.

Slide 15 - The factors to consider for abandonment option is that when the value for continuing is less then value
of shutting down, then it would be wiser to shut down.

Second, options can only increase NPV (or the worst case scenario maintain the NPV) if there is no option. Thus, if
the option to abandon has a value, this would lower the worst case results, and lowers the risk of the project.
Lowering the risk should also lower the WACC used but take note that earlier in the discussion, we assume that
WACC will still be the same unless otherwise stated.

Slide 16 - Illustration 5: Abandonment Option (HCT Transportation Company)

Slide 16B - The first requirement asks whether the truck should be abandoned and what is its optimal economic
life. To answer this requirement, we will make 5 scenarios and find the NPV assuming that the truck is abandoned
at the end of Years 1, 2, 3, and 4, and if the truck is not abandoned at all. Depending on the year of abandonment,
we should also include the abandonment value and discount them as needed.

If the truck is abandoned at the end of Year 1, the NPV is (909.09).

If the truck is abandoned at the end of Year 2, the NPV is (82.64).
If the truck is abandoned at the end of Year 3, the NPV is 1,307.29
If the truck is abandoned at the end of Year 4, the NPV is 726.73.
If the truck is not abandoned, the NPV is 1,192.42

Notice that the NPV is highest if the truck is abandoned at Year 3. Therefore for the first requirement, the firm
should not operate the truck until the end of its 5 year physical life, and the truck's optimal economic life is 3 years.

For requirement 2, option is a choice. So if the option is undesirable, the manager can just walk out as if there is no
option and the NPV will just be maintained (not decrease). Thus abandonment option (and any other real option)
can only increase or maintain expected NPV and/or IRR of a project. It can never reduce a project's expected NPV
and/or IRR.

Slide 17 - Illustration 6: Abandonment Options (High Roller Properties)

Slide 17B - We make two decision tree timelines. One to represent Option 1 if there is no abandonment option and
the other to represent Option 2 if there is an abandonment option.

We draw two branches per decision tree timeline. For option 1, there is a 50% chance that the tax will pass (bad
conditions) and generate 1.875 million cash flows for 5 years while there is a 50% chance that the tax will not pass
(good conditions) and generate 3.75 million cash flows for 5 years. With an initial investment of 10 million, the NPV
under good conditions is 3,824,819.81 and NPV under bad conditions is (3,087,590.09). We multiply each NPV with
their respectively probabilities and add the products to get the weighted average NPV without the abandonment
option worth 368,614.86.

For Option 2, we assume that there is an abandonment option. Definitely, the company will decide to abandon
only when conditions are bad. That is why when we look at the decision tree timeline under Option 2, the cash
flows under good conditions is the same as that of Option 1, but when conditions are bad, the project is
abandoned after year 1. We have an inflow of 6.5 million as this is stated in the problem. And following the
assumption that no cash flows will be received or incurred after the project is abandoned, you can see that the
cash flows stopped after Year 1. We then find the NPV under both good and bad conditions, computed as
3,824,819,81 and (2,461,746.18), respectively. Multiply each NPV by their respective probabilities and adding
these products, we get a weighted average NPV with the option of 681,536.82.

We are required to look for the value of the option. The equation is NPV with option - NPV without option. Value
of the option is: 681,536.82 - 368,614.86 = 312,921.96.

Slide 18 - An example of flexibility options lies on machine and equipment that are so flexible that they can make
multiple projects or make the same products out of different raw materials.

Let me give an example. Suppose you have a machine that can make necklaces out of different materials, say
plastic beads or precious stones. Supposing that the economy is good, the demand for precious stonenecklaces
would be high, so the company can program the computer to make more precious stone necklaces. However if the
economy is not good, the company can program the computer to make plastic bead necklaces instead.

This kind of machine would be desirable because it gives you the flexibility to produce whatever product that suits
the needs of the company. Even if it is expensive, but in the long run it may be worth it.

Slide 19 - Similar to what we have learned in the previous topic, WACC must be adjusted depending on the risk and
capital structure of the project. If the project is high risk, we add a risk premium, but if it is low risk we can reduce
the WACC to fit the project in question.

Doing this will reduce the chances of incorrect acceptance and incorrect rejection.

Slide 20 - The optimal capital budget is the size of the capital budget where the rate of return on the marginal
project is equal to the marginal cost of capital. When we say marginal return, it is the additional return resulting
from a one unit increase in marginal cost. As long as marginal return is greater than marginal cost, we can afford to
invest in more. It is only when these two equalize when you have already obtained that optimal capital budget.

In this slide, the optimal capital budget is 5.4 million. As you can see IRR is greater than WACC if the capital budget
is less than 5.4 million, but WACC is greater than IRR if the capital budget is more than 5.4 million. So the
maximum optimal amount that you can invest is 5.4 million.

Slide 21 - In computing for optimal capital budget, one must also consider one's resources and see if one has the
capacity to invest in all desirable projects. Priorities have to be made in cases of constraints which results to capital
rationing. Such will ensure the most efficient use of resources.

Slide 22 - Illustration 7: Optimal Capital Budget (Gibson Inc.)

Slide 22B - For this problem, let us first compute for two WACCs - one is assuming that we use rs to represent
common equity and the other is if we assume that re represents common equity.
The WACC using rs is computed to be 11.9543% and the WACC using re is computed to be 12.24%.

The next step is to compute for the retained earnings breakpoint. 600k/60% = 1 million.

Then we are going to list all the projects, their costs and respective IRRs. We know that we will accept projects only
if IRR > WACC. Notice further that both Projects D and E have IRRs that are lower than both WACCs computed
above. Therefore, we would reject them immediately by putting a X mark.

Further, looking at Projects A and B we notice that both of their IRRS are greater than any of the two WACCs so we
immediately accept them. We then assign priorities based on which project has the highest IRR.

Notice that Project C's IRR is 12% which is between the two WACCs of 11.9543% and 12.24%. So we have to
determine if we should accept Project C or not. Earlier, we computed REBP to be 1 million, deduct the costs of
Projects A and B, we only have 200,000 left to invest in Project C. The cost of Project C is 400,000. So, 200,000 out
of 400,000 should be discounted by WACC using rs and 200,000 out of 400,000 should be discounted by WACC
using re. The adjusted WACC is therefore 12.0972%.

Since the IRR of C is 12% which is less than the adjusted WACC of 12.0972%, we should reject Project C. Hence the
optimal capital budget of Gibson is the combined costs of Projects A and B, which is 800,000.

Slide 23 - So to remind ourselves regarding real options...

The more volatile is the real option, the more valuable it is.
The longer the time for the option to be exercised, the more valuable it is.
The higher is the current value of the underlying project compared with the cost to exercise the real option, the
more valuable it is.
The higher the interest rate, the more valuable it is.

Slide 24 - Like capital budgeting, it is essential to do post-audits to improve forecasts and thereby improve
business operations. It will also help a company manage its resources more effectively and efficiently.

However, the post-audit process has its problems. Remember, we are just estimating the cash flows so there is a
lot of uncertainty involved. If a firm is aggressive and leaves little margin for error, they might accept projects that
are too risky, and having too little margin for error, the company might end have accepting highly risky projects
resulting to negative NPVs.

Secondly, fortuitous events may occur so cash inflow expectations may not materialize.

Thirdly, to correctly and objectively assess a project, one must include all operating returns and operating costs
associated with the project. But there are many costs that are joint with other projects and it would be difficult to
assign such costs properly to a specific project.

Lastly, capital budgeting deals with long-term projects. Sometimes, we can only see the effects of the projects
after a long time so those who were responsible for such decisions may not be with the company anymore when
the effects reveal themselves. Thus to blame or praise those responsible may be difficult.