CHAPTER 14: • The project’s NPV is $6,190.

Therefore, it
REAL OPTIONS & OTHER TOPICS IN CAPITAL appears that the company should go ahead with
BUDGETING the project.

• However, if the company waits a year they will

REAL OPTION ANALYSIS
Definition
• Options are rights but not the obligation to take
some future action
• 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.
Examples
• Investment timing options
• Abandonment/shutdown options
• Growth/expansion options
• Flexibility options
• Fundamental options
find out more information about market
conditions and the impact on the project’s
expected cash flows.
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?

INVESTMENT TIMING OPTION

INVESTMENT TIMING DECISION TREE
Definition

• Faced with uncertainty, it is the ability to

postpone rather than immediately implement
or reject a capital budgeting project, to
significantly increase a project's value.

Example
At WACC = 10%, the NPV at t = 1 is:
• Sales of low-fat ice cream are surging.
• $37,889, if CF’s are $43,500 per year, or
Operating at full capacity, the Healthy Cow
Creamery is considering whether to expand its
• -$25,508, if CF’s are $23,500 per year, in which
plant.
case the firm would not proceed with the
• Launching the expansion would require a big project.
up-front investment, and the company's Should we wait or proceed?
managers can't be sure that the sales boom will
• If we proceed today, NPV = $6,190 .
persist.
• If we wait one year,
• They have the option of delaying the
investment until they learn more about the Expected NPV at t = 1 is 0.5($37,889) + 0.5(0) =
strength of demand. It may be that the risk $18,944.57,
avoided by waiting to invest has a greater value
Expected NPV at t=0 = $18,944.57/1.10 =
than the sales that might be forfeited by
$17,222.34 (assuming a 10% WACC).
postponing construction.
• Therefore, it makes sense to wait.

INVESTMENT TIMING OPTION: AN EXAMPLE

CONSIDERATIONS IN INVESTMENT TIMING DECISIONS
Given
Issues to Consider
• Project X has an up-front cost of $100,000. The
project is expected to produce cash flows of • What is the appropriate discount rate?
$33,500 at the end of each of the next four
years • Note that increased volatility can make the
(t = 1, 2, 3, and 4). The project has a WACC = option to delay more attractive.
10%.
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
Factors to Consider in Deciding 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.
ABANDONMENT/SHUTDOWN OPTION
Definition
• An abandonment option is the ability to
withdraw from the project before it ends. It
adds value by giving the parties the ability to
end if conditions change that would make the
investment unprofitable.
Example
• Management may begin with a relatively small
trial investment and create an option to
abandon the project if results are
unsatisfactory.
• Management may include abandonment option
clauses if certain project milestones are not met
• Research and development spending is a good
example. A company's future investment in
product development often depends on specific
performance targets achieved in the lab. The
option to abandon research projects is valuable
because the company can make investments in
stages rather than all up-front.
ABANDONMENT/SHUTDOWN OPTION: AN EXAMPLE
Given
• 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?
• 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.
ABANDONMENT OPTION DECISION TREE
• 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
NPV WITH ABANDONMENT OPTION
• 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.
• 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
• Abandonment options reduce variation,
therefore risk
• Abandonment option WORKS!
Should an abandonment option affect a project’s
WACC?
• Yes an abandonment option should have an
effect on WACC
• The abandonment option reduces risk, and
therefore the WACC
FUNDAMENTAL OPTION (OPTION TO CONTRACT)

Definition

• It is the option to shut down a project at some

point in the future if conditions are unfavorable
and continue when they become favorable

Examples
At WACC = 12%,
• A multinational corporation can stop the
NPV of top branch (10% prob.) = $1,562,758.19
operations of its branches in a country with an
NPV of lower branch (90% prob.) = -$139,522.38
unstable political situation
• A real estate developer can stop construction
Why only -$139,522.38?
when conditions such as interest rates or cost of
materials go up
• A manufacturer who has an option with its toll
packer to adjust their orders depending on NPV WITH THE GROWTH OPTION: AN EXAMPLE
demand

GROWTH (EXPANSION) OPTION

Definition

• If an investment creates the opportunity to

make other potentially profitable investments • If the project’s future opportunities have a
that would not otherwise be possible, then the negative NPV, the company would choose not
investment contains growth (expansion) option to pursue them.

• If an initial investment works out well, then
management can exercise the option to expand
its commitment to the strategy.
Examples
• A company that enters a new geographic
market may build a distribution center that it
can expand easily if market demand
materializes.
• Amazon's substantial investment to develop its
customer base, brand name and information
infrastructure for its core book business created
a portfolio of real options to extend its
operations into a variety of new businesses (i.e.
Prime Video)
• R&D
GROWTH OPTION: AN EXAMPLE
Given
• 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.
• 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. It
doesn’t consider the -$1,000,000
• The expected NPV of this project is:
NPV = 0.1($1,562,758) + 0.9(-$139,522)
= $30,706.
GROWTH OPTION: AN EXAMPLE
Given
Wander Inc. is evaluating a new project that would cost
$9 million at t = 0. There is a 50% chance that the
project would be highly successful and generate annual
after-tax cash flows of $6 million during Years 1, 2, and
3. However, there is a 50% chance that it would be less
successful and would generate only $1 million for each
of the 3 years.
If the project is highly successful, it would open the
door for another investment of $10 million at the end of
Year 2, and this new investment could be sold for $20
million at the end of Year 3. Assuming a WACC of
10.0%, what is the project's expected NPV (in
thousands) after taking into account this growth option?

• 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.
 FLEXIBILITY OPTION: AN EXAMPLE

E(NPV) = 0.5(12,683) + 0.5(-6,513) = $3,085

FLEXIBILITY OPTION

Definition

• An option that permits operations to be altered

depending on how conditions change during a
project’s life

• Flexibility options exist when it’s worth

spending money today, which enables you to
maintain flexibility down the road.

Examples

• Power plants that can generate electricity from If E(NPV) without the option is negative, the project
multiple energy sources would not be undertaken, therefore NPV =0

• Ginebra bottling/manufacturing plants that can

switch from one product to another (gin to
rubbing alcohol)
Value of Flexibility Option
• Value of Flexibility option = Expected NPV with
the option – Expected NPV without the option
FLEXIBILITY OPTION: AN EXAMPLE
Given
• Project Delta has an initial cost of $5,000, including
the cost of machinery. WACC = 12%
• The project has a 50% probability to generate a
strong demand and net after-tax cashflows of
$2,500 annually for the next 3 years. There’s also a
50% probability to suffer a weak demand and
generate only $1,500 annually for the same period
• However, the firm has an option to pay an
additional $100 on t=0 for a better machine that
can allow them to produce other products. In the
event of weak demand, they can produce other
products that will provide them with annual net
after-tax cash flows of $2,250 for Years 2 and 3.
OPTIMAL CAPITAL BUDGET & CAPITAL RATIONING
Definitions
IRR Schedule
• A graph of the marginal rates of return of
investment at different levels of investment
ranked from highest to lowest
Marginal Cost of Capital
• The cost of each peso raised
Optimal Capital Budget
• The size of the capital budget where the rate of
return on the marginal project is equal to the
marginal cost of capital
Capital Rationing
• The situation in which a firm can raise only a
specified, limited amount of capital regardless
of how many good projects it has

• What is the NPV of the project with and without

the flexibility options, and what is the value of the
flexibility option?

Value of Flexibility Option

Value of Flexibility option = Expected NPV with the

option – Expected NPV without the option
Application
• If a firm can continually raise capital, it can
invest as long as the project IRR is > MCC
• If IRR= MCC then Optimal capital budget has
been reached
Statement 1: The option to abandon a project is a real
option, but a call option on a stock is not a real option.
Statement 2: Real options exist whenever managers
have the opportunity, after a project has been
implemented, to make operating changes in response
to changed conditions that modify the project's cash
flows

POST-AUDIT

Definition
• A comparison of actual versus expected results
for a given capital project
• Involves the development of project
performance reports comparing planned and
actual results
Purpose
Reports should be provided to those involved with the
proposal to:
Arista Inc. is deciding whether to invest in a project
today or to postpone the decision until next year. The
project has a positive expected NPV, but its cash flows
might turn out to be lower than expected, in which case
the NPV could be negative. No competitors are likely to
invest in a similar project if the firm decides to wait.
Which of the following statements best describes the
issues that the firm faces when considering this
investment timing option?

• Improve operations and keep the project on  

target a. The investment timing option would not affect the
• Identify the need to re-evaluate the project if cash flows and therefore would have no impact on the
necessary project's risk.
• Improve forecasts and investment proposal
quality b. The more uncertainty about the future cash flows,
• Help the approving committee better evaluate the more logical it is to go ahead with this project today.
proposals
c. Since the project has a positive expected NPV today,
this means that it should be accepted in order to lock in
Steps in Capital Budgeting that NPV.

d. Waiting would probably reduce the project's risk.

Statement 1: In general, investment timing options are

more valuable than abandonment options

Statement 2: It is not possible for abandonment

options to decrease a project's risk as measured by the
project's coefficient of variation

Which one of the following is an example of a

“flexibility” option?

 a. A company has an option to invest in a project today

or to wait for a year before making the commitment.

b. A company has an option to close down an operation

if it turns out to be unprofitable.

c. A company agrees to pay more to build a plant in

order to be able to change the plant's inputs and/or
outputs at a later date if conditions change.

d. A company invests in a project today to gain

knowledge that may enable it to expand into different
markets at a later date.
Statement 1: 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.

Statement 2: Capital rationing is the situation in which a

firm can raise only a specified, limited amount of capital
regardless of how many good projects it has.

Langston Labs has an overall (composite) WACC of 10%,

which reflects the cost of capital for its average asset.
Its assets vary widely in risk, and Langston evaluates
low-risk projects with a WACC of 8%, average-risk
projects at 10%, and high-risk projects at 12%. The
company is considering the following projects:

Project Risk Expected Return

A High 15%

B Average 12%

C High 11%

D Low 9%

E Low 6%

Which set of projects would maximize shareholder

wealth?

a. A and B.
b. A, B, and C.
c. A, B, and D.
d. A, B, C, and D.
e. A, B, C, D, and E.

Wahal Corporation uses the NPV method when

selecting projects, and it does a reasonably good job of
estimating projects' sales and costs. However, it never
considers any real options that might be associated with
projects. Which of the following statements is most
likely to describe its situation?

a. Its estimated capital budget is probably too small,

because projects' NPVs are often larger when real
options are taken into account.

b. Its estimated capital budget is probably too large due

to its failure to consider abandonment and growth
options.
c. Failing to consider abandonment and flexibility
options probably makes the optimal capital budget too
large, but failing to consider growth and timing options
probably makes the optimal capital budget too small, so
it is unclear what impact the failure to consider real
options has on the overall capital budget.
d. Failing to consider abandonment and flexibility
options probably makes the optimal capital budget too
small, but failing to consider growth and timing options
probably makes the optimal capital budget too large, so
it is unclear what impact not considering real options
has on the overall capital budget.