KELOMPOK 8

ACCOUNTING AND FINANCE D’79

Sahat Tumpal Putra Sitorus (21/475667/NEK/25458)
Rizki Rafiandi (21/483999/NEK/25522)
Januar Bayu (21/485085/NEK/25605)

OTHER TOPICS IN CAPITAL BUDFETING 21st Century Educational Products (21st

Century) is a rapidly growing software company, and consistent with its growth, it has a
relatively large capital budget. Although most of the company’s project are fairly easy to
evaluate, a handful of projects involve more complex evaluations.
John Keller, a senior member of the company’s finance staff, coordinates the evaluation of
these more complex projects. His group brings their recommendations directly to the
company’s CFO and CEO, Kristin Riley and Bob Stevens. Respectively.
a. In recent months, Keller’s group has focused on real option analysis
1. What is real option analysis?
2. What are some examples of projects with real options?
ANSWER:
1. 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 options analysis includes in the typical NPV capital
budgeting analysis for opportunities for managers to respond to changing
circumstances because management’s actions can influence a project’s
outcome.
2. A project may contain one or more different types of embedded real options.
Examples include abandonment/shutdown options, investment timing options,
growth/expansion, and flexibility options.
b. Considering real options one of Keller’s colleagues, Barbara Hudson, has suggested that
instead of investing in project X today, it might make sense to wait 1 year because 21 st
Century would learn more about market conditions and would improve its forecast of
the project’s cash flows. Right now 21st Century forecast that Project X will generate
expected cash flows of $33,500 for 4 years. However, if the company waits 1 year, it
will learn more about market conditions. There is a 50% chance that the market will be
strong and a 50% chance that it will be weak. If the market is strong, the annual cash
 flows will be $43,500. If the market is weak, the annual cash flows will be only $23,500.
If 21st Century choose to wait 1 year the initial investment will remain $100,000 and
cash flows will continue for 4 years after the initial investment is made. Assume that all
cash flows are discounted at 10%. Should 21st Century invest in Project X today, or
should it wait a year before deciding whether to invest in the project?
ANSWER:
WACC = 10%
End of time period Scenario NPV
0 1 2 3 4 5 at t=1
50% ($100,000) $43,500 $43,500 $43,500 $43,500 $37,889.15
50
50% ($100,000) $23,500 $23,500 $23,500 $23,500 ($25,508.16)

Perusahaan tidak akan mengambil Proyek X pada saat pasar lemah, dikarenakan
NPV < 0 yang bermakna proyek tersebut tidak layak untuk dijalankan, sehingga,
NPV yang diharapkan dari menunggu 1 tahun adalah (0,50)$0 + (0,50)$34,444 =
$17,222. Nilai sekarang dari menunggu 1 tahun adalah $17,222/1.10 = $15,656.
Karenanya, perusahaan harus menunggu untuk mendapatkan informasi lebih
terkait pasar daripada mengambil Proyek X hari ini, karena NPV dari menunggu
1 tahun $15,656 lebih besar dari NPV Proyek X aopabila diambil saat ini.

c. Now assume that there is more uncertainly about the future cash flows. More
specifically, assume that the annual cash flows are $53,500 if the market is strong and
$13,500 if the market is weak. Assume that the upfront cost is still $100,000 and that
the WACC is still 10%. Will this increased uncertainly make the firm more or less
willing to invest in the project today? Explain.
ANSWER:
WACC = 10%
End of time period Scenario NPV
0 1 2 3 4 5 at t=1
50% ($100,000) $53,500 $53,500 $53,500 $53,500 $69,587.80
50
50% ($100,000) $13,500 $13,500 $13,500 $13,500 ($57,206.82)

Again, the firm will not choose to pursue Project L. in the weak market. The NPV
of the project at t = 1 then equals $34,793.90 and $31,630.82 at t = 0.
 The more variable the cash flows (the more uncertainly) the less willing the firm
will be to invest in project today.
Factors the firm should consider when deciding when to invest:
a. Delaying the project means that cash flows come later rather than sooner.
b. It might make sense to proceed today if there are important advantages to being
the first competitor to enter a market.
c. Waiting may allow you to take advantage of changing conditions.
NPV of Project L @ t = 1 = $34,794
NPV of Project L = $31,631
Value of Option = $25,440

d. 21st century is considering another project, Project Y. Project Y has an up-front cost of
$200,000 and an economic life of 3 years. If the company develops the project, its after-
tax operating costs will be $100,000 a year; however, the project is expected to produce
after-tax inflows of $180,000 a year. Thus, the project’s estimated cash flows are as
follows:
Year Cash Outflows Cash Inflows Estimated Project
Cash Flows
0 ($200,000) $0 ($200,000)
1 (100,000) 180,000 80,000
2 (100,000) 180,000 80,000
3 (100,000) 180,000 80,000
1. The project has an estimated WACC of 10%. What is the project’s expected NPV?
2. Although the Project’s operating costs are fairly certain at $100,000 per year, the
estimated cash inflows depend critically on whether 21st Century’s largest customer
uses the product. Keller estimates that there is a 60% chance that the customer will
use the product, in which case the project will produce after-tax cash inflows of
$250,000. Thus, its estimated project cash flows will be $150,000 per year.
However, there is a 40% chance that the customer will not use the product, in which
case the project will produce after-tax cash inflows of only $75,000. Thus, its
estimated project cash flows will be -$25,000. Write out the estimated cash flows,
and calculate the project’s expected NPV under each of the two scenarios.
3. Although 21st Century does not have the option to delay the project, it will know 1
year from now whether the key customer has selected the product. If the customer
chooses not to adopt the product, 21st Century has the option to abandon the project.
If 21st Century abandons the project, it will not receive any cash flows after year 1,
and it will not incur any operating costs after year 1. Thus, if the company chooses
to abandon the project, its estimated cash flows will be as follows:

0 1 2 3
60%
probability
-200,000 150,000 150,000 150,000

40%
probability
-200,000 25,000

Again, assuming a WACC of 10%, what is the project’s expected NPV if it

abandons the project? Should 21st Century invest in Project Y today, realizing it has
the option to abandon the project at t = 1?
4. Up until now, we have assumed that the abandonment option has not affected the
project’s WACC. Is this assumption reasonable? How might the abandonment
option affect the WACC?
ANSWER:
1. The Project has an estimated WACC of 10%.
NPV = (-$200,000) + ($80,000/(1,1)1) + ($80,000/(1,1)2) + ($80,000/(1,1)3)
= (-$200,000) + $72,727 + $66,116 + $60,105
= - $1,052 didalam penulisan tabel dituliskan dengan “($1,052)”
2. WACC = 10%
End of Time Period
0 1 2 3 Scenario NPV ExpectedProject
NPV
60% ($200,000) $150,000 $150,000 $150,000 $173,028 ($1,052)
40% ($200,000) ($25,000) ($25,000) ($25,000) ($262,171)
a. Probabilitas Pembeli Menggunakan Produk Tersebut adalah 60%
NPV = (-$200,000) + ($150,000/(1,1)1 + ($150,000/(1,1)2) + ($150,000/(1,1)3)
= (-$200,000) + $136,364 + $123,967 + $112,697
 = $173,028
b. Probabilitas Pembeli Yang “Tidak” Menggunakan Produk Tersebut
adalah 40%.
NPV = (-$200,000) + (-$25,000/(1,1)1) + (-$25,000/(1,1)2) + (-$25,000/(1,1)3)
= (-$200,000) - $22,727 - $20,661 - $18,783
= - $262,171 ditabel dituliskan dengan menggunakan “($262,171)”
3. WACC = 10%
End of Time Period
0 1 2 3 Scenario NPV Expected Project
NPV
60% ($200,000) $150,000 $150,000 $150,000 $173,028 $14,726
40% ($200,000) ($25,000) $0 $0 ($222,727)
Value of Abandonment Option = $15,778
4. WACC (Weighted Average Cost of Capital) adalah rata-rata tertimbang biaya
modal. WACC terdiri atas ekuitas dan hutang. Opsi abandonment merupakan
pilihan untuk menghentikan proyek yang dijalankan ketika operating cash
flow leboh rendah dari yang diharapkan. “it is not reasonable to assume that the
abandonment option has no effect on the cost of capital. Having the ability to
abandon a project reduces risk, reducing its cost of capital”.
e. Finally, 21st Century is also considering Project Z. Project Z has an up-front cost of
$500,000 and its expected to produce cash flows of $100,000 at the end of each the next
5 years (t = 1,2,3,4, and). Because Project Z has a WACC of 12%, it clearly has a
negative NPV. However, Keller and his group recognize that if 21st Century goes ahead
with Project Z today, there is a 10% chance that this will lead to subsequent opportunities
that have an expected net present value at t = 5 equal to $3,000,000. At the same time,
there is a 90% chance that the subsequent opportunities will have an expected negative
net present value (-$1,000,000) at t = 5. On the basis of their knowledge of real options,
Keller and his group understand that the company will choose to develop these
subsequent opportunities only if they appear to be profitable at t = 5. Given this
information, should 21st Century invest in Project Z today? Explain your answer.
ANSWER:
WACC = 12%
End of Time Period
 0 1 2 3 4 5

10% ($500,000) $100,000 $100,000 $100,000 $100,000 $100,000

$3,000,000
90% ($500,000) $100,000 $100,000 $100,000 $100,000 $100,000
($1,000,000)
SCENARIO NPV is $1,562,758 for 10% and ($139,522) for 90%.
PROJECT NPV is $30,706.
NPV at 10% chance (WACC = 12%)

𝟏 𝐂𝐅 𝟐 𝐂𝐅 𝟑 𝐂𝐅 𝐍 𝐂𝐅
NPV = CF0 + (𝟏+𝐖𝐀𝐂𝐂)𝟏 + (𝟏+𝐖𝐀𝐂𝐂)𝟐 + (𝟏+𝐖𝐀𝐂𝐂)𝟑 + . . . + (𝟏+𝐖𝐀𝐂𝐂)𝐍

$𝟏𝟎𝟎,𝟎𝟎𝟎 $𝟏𝟎𝟎,𝟎𝟎𝟎 $𝟏𝟎𝟎,𝟎𝟎𝟎 $𝟏𝟎𝟎,𝟎𝟎𝟎 $𝟑,𝟏𝟎𝟎,𝟎𝟎𝟎

NPV = -$500,000 + (𝟏+𝟎,𝟏𝟐)𝟏 + (𝟏+𝟎,𝟏𝟐)𝟐 + (𝟏+𝟎,𝟏𝟐)𝟑 + (𝟏+𝟎,𝟏𝟐)𝟒 + (𝟏+𝟎,𝟏𝟐)𝟓

NPV = -$500,000 + $89,285.71 + $79,719.39 + $71,178.02 + $63,551.81 +

$1,759,023.25

NPV = $1,562,758

NPV at 90% chance (WACC = 12%)

𝟏 𝐂𝐅 𝟐 𝐂𝐅 𝟑 𝐂𝐅 𝐍 𝐂𝐅
NPV = CF0 + (𝟏+𝐖𝐀𝐂𝐂)𝟏 + (𝟏+𝐖𝐀𝐂𝐂)𝟐 + (𝟏+𝐖𝐀𝐂𝐂)𝟑 + . . . + (𝟏+𝐖𝐀𝐂𝐂)𝐍

$𝟏𝟎𝟎,𝟎𝟎𝟎 $𝟏𝟎𝟎,𝟎𝟎𝟎 $𝟏𝟎𝟎,𝟎𝟎𝟎 $𝟏𝟎𝟎,𝟎𝟎𝟎 $𝟏𝟎𝟎,𝟎𝟎𝟎

NPV = -$500,000 + (𝟏+𝟎,𝟏𝟐)𝟏 + (𝟏+𝟎,𝟏𝟐)𝟐 + (𝟏+𝟎,𝟏𝟐)𝟑 + (𝟏+𝟎,𝟏𝟐)𝟒 + (𝟏+𝟎,𝟏𝟐)𝟓

NPV = -$500,000 + $89,285.71 + $79,719.39 + $71,178.02 + $63,551.81 + $56,742.69

NPV = -$139,522 penulisan ditabel menggunakan ($139,522)

Apabila proyek yang dijalankan selama 5 tahun ini menghasilkan nilai NPV
negatif, maka proyek tersebut tidak dapat dijalankan. Berdasarkan yang
diketahui pada proyek tersebut besar present value sebesar $500.000 dan cash flow
sebesar $100.000 untuk setiap tahunnya selama 5 tahun, NPV untuk proyek Z
dengan peluang sebesar 10% dan 90% adalah:

NPV = (10% × $1,562,758.18) + (90% × -$139,522.38)

NPV = $156,275.81 + (-$125,570.14)

NPV = $30,706
“Therefore, Project Z has a Positive NPV so the firm should invest in it today”.