FM‐Fall 2021 11/16/2021

Dr. N Amin

Valuing Real Options in Projects

Real Options and Other
Topics in Capital Budgeting
Timing Options
Chapter 13
Abandonment/Shutdown Option

Growth Option

Flexibility Option

© 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

1 2

What is real option analysis? What are some examples of real options?

 Real options exist when managers can influence  Investment timing options
the size and riskiness of a project’s cash flows
by taking different actions during or at the end  Abandonment/shutdown options
of a project’s life.  Growth/expansion options
 Real option analysis incorporates typical NPV  Flexibility options
capital budgeting analysis with an analysis of
opportunities resulting from managers’
responses to changing circumstances that can
influence a project’s outcome.

© 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

3 4

Investment Timing Option Investment Timing Option

 Project X has an upfront cost of $100,000. The  If they wait a year:

project is expected to produce cash flows of • There is a 50% chance the market will be strong
$33,500 at the end of each of the next four and the expected cash flows will be $43,500 a
years (t = 1, 2, 3, and 4). The project has a year for four years.
WACC = 10%. • There is a 50% chance the market will be weak
and the expected cash flows will be $23,500 a
 The project’s NPV is $6,190. Therefore, it year for four years.
appears that the company should go ahead with • The project’s initial cost will remain $100,000,
the project. but it will be incurred at t = 1 only if it makes
 However, if the company waits a year they will sense at that time to proceed with the project.
find out more information about market  Should the company go ahead with the project
conditions and the impact on the project’s today or wait for more information?
expected cash flows.

© 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

5 6

1
FM‐Fall 2021 11/16/2021
Dr. N Amin

Investment Timing Decision Tree Should we wait or proceed?

-$100,000 43,500 43,500 43,500 43,500  If we proceed today, NPV = $6,190.

50% prob.
 If we wait one year, Expected NPV at t = 1 is
-$100,000 23,500 23,500 23,500 23,500 0.5($37,889) + 0.5(0) = $18,944.57, which is
50% prob. worth $18,944.57/1.10 = $17,222.34 in today’s
0 1 2 3 4 5 Years dollars (assuming a 10% WACC).
 Therefore, it makes sense to wait.
 At WACC = 10%, the NPV at t = 1 is:
• $37,889, if CFs are $43,500 per year, or
• -$25,508, if CFs are $23,500 per year, in which
case the firm would not proceed with the project.

© 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

7 8

Issues to Consider with Investment Timing Options Factors to Consider In Decision of When to Invest

 What is the appropriate discount rate?  Delaying the project means that cash flows
come later rather than sooner.
 Note that increased volatility makes the option
to delay more attractive.  It might make sense to proceed today if there
• If instead, there was a 50% chance the are important advantages to being the first
subsequent CFs will be $53,500 a year, and a competitor to enter a market.
50% chance the subsequent CFs will be $13,500
a year, expected NPV next year (if we delay)
 Waiting may allow you to take advantage of
would be: changing conditions.

t = 1: 0.5($69,588) + 0.5(0) = $34,794 >

$18,945
t = 0: $34,794/1.10 = $31,631 > $17,222

© 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

9 10

Abandonment/Shutdown Option Abandonment Option

 Project Y has an initial, upfront cost of  Project Y’s cash flows depend critically upon
$200,000, at t = 0. The project is expected to customer acceptance of the product.
produce cash flows of $80,000 for the next
three years.  There is a 60% probability that the product will
be wildly successful and produce CFs of
 At a 10% WACC, what is Project Y’s NPV? $150,000, and a 40% chance it will produce
annual CFs of $25,000.
0 10%
1 2 3

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

NPV = -$1,051.84

© 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

11 12

2
FM‐Fall 2021 11/16/2021
Dr. N Amin

Abandonment Decision Tree Key Assumptions

150,000 150,000 150,000

60% prob.
 The company does not have the option to delay
-$200,000
the project.
-25,000 -25,000 -25,000
40% prob.
0 1 2 3 Years
 The company may abandon the project after a
year, if the customer has not adopted the
product.
 If the customer uses the product, NPV is
$173,027.80.  If the project is abandoned, there will be no
operating costs incurred nor cash inflows
 If the customer does not use the product, NPV is received after the first year.
-$262,171.30.

E(NPV )  0.6($173,027.8)  0.4( $262,171.3)

 $1,051.84

© 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

13 14

Should an abandonment option affect a project’s

NPV with Abandonment Option WACC?

150,000 150,000 150,000

60% prob.  Yes, an abandonment option should have an
-$200,000 -25,000
effect on the WACC.
40% prob.
0 1 2 3 Years  The abandonment option reduces risk, and
therefore reduces the WACC.
 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

© 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

15 16

Growth Option NPV with the Growth Option

 Project Z has an initial cost of $500,000.

 The project is expected to produce cash flows of $3,000,000
$100,000 at the end of each of the next five 100,000 100,000 100,000 100,000 100,000
10% prob.
years, and has a WACC of 12%. It clearly has a
-$1,000,000
negative NPV. -$500,000
100,000 100,000 100,000 100,000 100,000
90% prob.
 There is a 10% chance the project will lead to 0 1 2 3 4 5 Years
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.

© 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

17 18

3
FM‐Fall 2021 11/16/2021
Dr. N Amin

NPV with the Growth Option NPV with the Growth Option

$3,000,000
100,000 100,000 100,000 100,000 100,000
 If the project’s future opportunities have a
10% prob. negative NPV, the company would choose not to
pursue them.
-$500,000
100,000 100,000 100,000 100,000 100,000
90% prob.  The bottom branch only has the -$500,000
0 1 2 3 4 5 Years initial outlay and the $100,000 annual cash
flows, which lead to an NPV of -$139,522.
 Since the NPV of first 5 years of CFs for this
outcome has a negative NPV, then second phase  The expected NPV of this project is:
with a negative NPV will not be done.
NPV = 0.1($1,562,758) + 0.9(-$139,522)
 At WACC = 12%,
= $30,706.
• NPV of top branch (10% prob.) = $1,562,758.19
• NPV of lower branch (90% prob.) = -$139,522.38
© 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

19 20

Flexibility Options
End of Chapter 13
 Flexibility options exist when it’s worth spending
money today, which enables you to maintain
flexibility down the road.

© 2019 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website or school-approved learning management system for classroom use.
© 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Cover image attribution: “Finance District” by Joan Campderrós-i-Canas (adapted) https://flic.kr/p/6iVMd5

21 22