Group 4

Real Options and Other Topics in Capital Budgeting

Introduction to Real Options

 DCF techniques were originally developed to value securities such as stocks and
bonds. Those securities are passive investments—once they have been
purchased, most investors have no influence over the cash flows they produce.3
However, real assets are not passive investments—managers can often take
actions to alter the cash flow stream. Such opportunities are called real options—
“real” to distinguish them from financial options like an option to buy shares of GE
stock, and options because they provide the right but not the obligation to take
some future action that can increase cash flows.
 Real options are valuable, and as this value is not captured by conventional NPV
analysis, it must be considered separately.

Several Types of Real Options

 Growth/expansion options
 where the project can be expanded if demand turns out to be stronger
than expected
 Abandonment/shutdown options
 where the project can be shut down if its cash flows are low
 Investment timing options
 where a project can be delayed until more information about demand
and/or costs can be obtained
 Flexibility options
 where the input/output used can be changed if availability or market
conditions change
Abandonment/Shutdown Option

 where the project can be shut down if its cash flows are low
 If the firm has the option to abandon a project during its operating life, this can
lower its risk and increase its expected profitability.

Illustration:

 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?

Year Flow Present value Computation

0 $(200,000) $(200,000)

1 80,000 72,727.27 80,000/(1.10)^1

2 80,000 66,115.70 80,000/(1.10)^2

3 80,000 60,105.18 80,000/(1.10)^3

NPV =$(200,000) + 72,727.27 + 66,115.70 + 60,105.18= $(1,051.85)

Should the abandonment affect the project’s WACC?
 Yes, the abandonment option should have an effect on the WACC.
 The abandonment option reduces risk, and therefore reduces the WACC.