A B C D E F G

1 Chapter 13. Real Options and Other Topics in Capital Budgeting

In this model we examine four types of real options: Growth, Abandonment, Timing, and Flexibility. We
2
also analyze a procedure for determining the optimal size of the capital budget.

3 Figure 13.1. Analysis of a Growth Option (Dollars in Thousands)

4
5 Part I. Project without the Growth Option
6 Cash Flow at End of Period
7 Outcome Prob. 0 1 2 3
8 Good 50% -$3,000 $1,500 $1,500 $1,500
9 Bad 50% -$3,000 $1,100 $1,100 $1,100
10 Expected NPV
11 Standard Deviation (σ)
12 Coefficient of Variation = CV = σ / Expected NPV
13
14 Part II. Project with the Growth Option
15 Cash Flow at End of Period
16 0 1 2 3
17 Cash flows, initial investment -$3,000 $1,500 $1,500 $1,500
18 Cash flows, growth investment -$1,000 $5,000
19 Good 50% -$3,000 $1,500 $500 $6,500
20 Bad 50% -$3,000 $1,100 $1,100 $1,100
21 Expected NPV
22 Standard Deviation (σ)
23 Coefficient of Variation = CV = σ / Expected NPV
24
25 Part III. Value of the Option
26 Expected NPV with the growth option
27 Expected NPV without the growth option

28 CASE 1: If the expected NPV without the growth option is positive, then

Expected NPV with the Expected NPV without

29 Value of the Option = ‒
growth option the growth option
30
31 CASE 2: If the expected NPV without the growth option is negative, then
Expected NPV with the
32 Value of the Option = ‒ 0
growth option
33
Note: If a negative NPV project does not have a growth option, then it would not be undertaken.
34
In these cases, the expected NPV without the growth option is zero.
35
36 VALUE OF OPTION =
 H
1 2/08/2018

nt, Timing, and Flexibility. We

2
dget.

ds) 3
4
5
6 NPV@
7 12%
8 $603
9 -$358
10 $122
11 $480
12 3.93
13
14
15 NPV@
16 12%
17
18
19 $3,364
20 -$358
21 $1,503
22 $1,861
23 1.24
24
25
26 $1,503
27 $122

28

29 $1,381

30
31

32 NA

33
uld not be undertaken.
34

35
36 $1,381
Figure 13.2. Analysis of an Abandonment Option (Dollars in Thousands) 2/08/2018

Part I. Cannot Abandon

Cash Flow at End of Period NPV @
Outcome Prob. 0 1 2 3 4 10%
Best Case 25% -$1,000 $400 $600 $800 $1,300 $1,348
Base Case 50% -$1,000 $200 $400 $500 $600 $298
Worst Case 25% -$1,000 -$280 -$280 -$280 -$280 -$1,888
Expected NPV $14
Standard Deviation (σ) $1,179
Coefficient of Variation = CV = σ / Expected NPV 83.25

Part II. Can Abandon

Cash Flow at End of Period NPV @
Outcome Prob. 0 1 2 3 4 10%
Best Case 25% -$1,000 $400 $600 $800 $1,300 $1,348
Base Case 50% -$1,000 $200 $400 $500 $600 $298
Worst #1 0% -$1,000 -$280 -$280 -$280 -$280 -$1,888 Don't Use
Worst #2 25% -$1,000 -$280 $200 $0 $0 -$1,089 Use
Expected NPV $214
Standard Deviation (σ) $866
Coefficient of Variation = CV = σ / Expected NPV 4.05

Part III. Value of the Option

Expected NPV with the abandonment option $214
Expected NPV without the abandonment option $14

CASE 1: If the expected NPV without the abandonment option is positive, then

Expected NPV with Expected NPV without

Value of the Option = the abandonment ‒ the abandonment
option option
$200

CASE 2: If the expected NPV without the abandonment option is negative, then

Expected NPV with

Value of the Option = the abandonment ‒ 0 NA
option

Note: If a negative NPV project does not have an abandonment option, then it would not be
undertaken. In these cases, the expected NPV without the abandonment option is zero.

VALUE OF OPTION = $200

Figure 13.3. Analysis of a Timing Option (Dollars in Thousands) 2/08/2018

Part I. Project without the Timing Option

Cash Flow at End of Period NPV@
Outcome Prob. 0 1 2 3 12%
Good 50% -$3,000 $2,000 $2,000 $2,000 $1,804
Bad 50% -$3,000 $450 $450 $450 -$1,919
Expected NPV -$58
Standard Deviation (σ) $1,861
Coefficient of Variation = CV = σ / Expected NPV -32.23

Part II. Delay the Decision Until We Know the Market Conditions
Cash Flow at End of Period NPV@
Outcome Prob. 0 1 2 3 12%
Good 50% $0 -$3,000 $2,000 $2,000 $339
Bad 50% $0 $0 $0 $0 $0
Expected NPV $170
Standard Deviation (σ) $170
Coefficient of Variation = CV = σ / Expected NPV 1.00

Part III. Value of the Option

Expected NPV with the timing option $170
Expected NPV without the timing option -$58

CASE 1: If the expected NPV without the timing option is positive, then

Expected NPV with the Expected NPV without

Value of the Option = ‒
timing option the timing option
NA

CASE 2: If the expected NPV without the timing option is negative, then
Expected NPV with the
Value of the Option = ‒ 0 $170
timing option

Note: If a negative NPV project does not have a timing option, then it would not be undertaken. In these
cases, the expected NPV without the timing option is zero.

VALUE OF OPTION = $170

Note: Under the Delay situation, we must find the NPV as of t = 0. If we set the cash flow for t = 0 at $0,
then using a calculator or Excel we automatically find the NPV at t = 0. However, if we let
CF0 = -3000, CFj = 2000, Nj = 2, and I/YR = 12, we get an NPV = $380 under the Good outcome and an
expected NPV of $190. Note, though, that these NPVs are as of t = 1, so we must discount them back
one year at 12% to achieve comparability with the NPV calculated for not delaying the project and arrive
at the correct answer.
Figure 13.4. Analysis of a Flexibility Option (Dollars in Thousands) 2/08/2018

Part I. Project without the Flexibility Option Cash Flow at End of Period NPV@
Outcome Prob. 0 1 2 3 12%
Strong demand 50% -$5,000 $2,500 $2,500 $2,500 $1,005
Weak demand 50% -$5,000 $1,500 $1,500 $1,500 -$1,397
Expected NPV -$196

Part II. Project with the Flexibility Option Cash Flow at End of Period NPV@
Outcome Prob. 0 1 2 3 12%
Strong demand 50% -$5,100 $2,500 $2,500 $2,500 $905
Weak demand Switch products 50% -$5,100 $1,500 $2,250 $2,250 -$366
Expected NPV $270

Part III. Value of the Option

Expected NPV with the flexibility option $270

Expected NPV without the flexibility option -$196

CASE 1: If the expected NPV without the flexibility option is positive, then

Expected NPV
Value of the Expected NPV with
‒ without the flexibility NA
Option = the flexibility option
option

CASE 2: If the expected NPV without the flexibility option is negative, then

Value of the Expected NPV with

‒ 0 $270
Option = the flexibility option

Note: If a negative NPV project does not have a flexibility option, then it would not be undertaken. In
these cases, the expected NPV without the flexibility option is zero.

VALUE OF OPTION = $270

Figure 13.5. Optimal Capital Budget: Marginal IRR = Marginal WACC 2/08/2018
WACC & IRR
30%

25%

20%
WACC

15%

10%

IRR
5%

0%
$100 $600 $1,100 $1,600 $2,100

Capital Budget

Project: Cost Cum Cost WACC IRR:

1 $100 $100 10.0% 25.0%
2 $100 $200 10.0% 24.0%
3 $100 $300 10.0% 23.0%
4 $100 $400 10.0% 22.0%
5 $100 $500 10.0% 21.0%
6 $100 $600 10.0% 20.0%
7 $100 $700 10.5% 19.0%
8 $100 $800 11.0% 18.0%
9 $100 $900 11.5% 17.0%
10 $100 $1,000 12.0% 16.0%
11 $100 $1,100 12.5% 15.0%
12 $100 $1,200 13.0% 14.0%
13 $100 $1,300 13.5% 13.0%
14 $100 $1,400 14.0% 12.0%
15 $100 $1,500 14.5% 11.0%
16 $100 $1,600 15.0% 10.0%
17 $100 $1,700 15.5% 9.0%
18 $100 $1,800 16.0% 8.0%
19 $100 $1,900 16.5% 7.0%
20 $100 $2,000 17.0% 6.0%
21 $100 $2,100 17.5% 5.0%
22 $100 $2,200 18.0% 4.0%
23 $100 $2,300 18.5% 3.0%
SECTION 13-3 2/08/2018
SOLUTIONS TO SELF-TEST QUESTIONS

2. Suppose a project's expected "cannot abandon" NPV is -$14 and its "can
abandon" expected NPV is $214. How much is the abandonment option worth?

"Cannot abandon" NPV -$14

"Can abandon" NPV $214

Value of abandonment option $214