Question

An online DVD and CD retailer is considering investing $2m on improving its customer information and online
systems. The expectation is that this will enable the company to expand by extending its range of products. A de
will be made on the expansion in 1 years' time, when the directors have had chance to analyse customer behavi
competitors businesses in more detail, to assess whether the expansion is worthwhile.

Preliminary estimates of the expansion programme have found that an investment of $5m in 1 year's time will ge
net receipts with a present value of $4m in the years thereafter. The project's cash flows are expected to be quite
with a standard deviation of 40%.

The current risk free rate of interest is 5%.

Required:
Advise the firm whether the initial investment in updating the systems is worthwhile

Solution

Pa = Price of underlying asset 4 mn

Pe = Exercise price 5 mn
r = risk free rate 5% per annum
t = time to expiry in years 1 year
s = standard deviation 40% = 0.40

** The underlying asset is the one which is subject to volatility. It is because of the uncertainty associated with t
of this underlying asset that we face the need to have all these techniques like options, futures, etc.
In our case, it is the net receipts which are expected to be volatile, uncertain and we need to secure ourselves w.r
net receipts, that is our underlying asset

*** Exercise price, in case of a call option, is the amount that you have to pay to buy the product
In this case, the amount you have to pay is 5 mn
Company invests 2 mn today in improving the customer online ordering system
That means, there is an outflow of 2 mn at T0 and there are no specific inflows associated with this expenditure

Then, after 1 year, company has the option to invest 5 mn in the expansion program, which will lead to Net rece
of 4 mn in later years, and cashflows facing volatility with SD of 40%. The option / decision to invest a further 5
has to be made 1 year from today and the value of this option comes down to 0.38 mn

Strategic Net Present Value

PV of outflow at T0 (2.00)
Value of Option to invest 0.38

Strategic NPV (1.62)

er information and online ordering
s range of products. A decision
analyse customer behaviour and

5m in 1 year's time will generate

s are expected to be quite volatile,

ertainty associated with the value

futures, etc.
ed to secure ourselves w.r.t these
ed with this expenditure

hich will lead to Net receipts

cision to invest a further 5 mn
Illustration : 2

Shivam Ltd is a company which is evaluating a project with the following cash flows

T0 T1 T2 T3 T4
PV of cash flows (100) 12 15 30 35

NPV of the project (8)

Since NPV is negative, normally, we would end up rejecting the project

What if you were told that Shivam Ltd can exit the project after expiry of 2 years. When he exits the
project, the net assets of the project will be disposed of and Shivam Ltd will earn cash flows from such
disposal and PV of these cash flows will be 70.

Risk free rate is 5% and volatility ( i.e. Standard Deviation) is 20%

Will it be advisable to take up the project now and then abandon after 2 years ?

Solution

If we take up the project and there is no option to abandon, that means, we will have to continue with this
project till the end, it will give negative NPV of 8 mn and that would be an incorrect decision

There is however, an option to abandon the project after 2 years

When you abandon, you withdraw from the project by selling off the net assets. The proceeds of such sale
are given as 70 mn

Can I say : Option to abandon = Option to sell = Put Option

If I decide to abandon, i.e. decide to sell, I will get 70 mn [ Exercise price of Put Option ]

If I abandon the project after T2, I will not be able to get 30 mn in T3 and 35 mn in T4
If I abandon, that means, I will have to forego the opportunity to earn 30 mn and 35 mn

The underlying item, subject to volatility, is the projected cash flow of T3 and T4
So, value of my underlying asset / item = 30 ( + ) 35 = 65

Pa Value of underlying 65
Pe Exercise price 70
r Risk free rate 5%
s Standard Deviation 20%
t time to expiry in years 2

Strategic NPV

Base case NPV (8.00)

Value of Put Option 6.42

Startegic NPV (1.58)

Even after introducing an option to abandon after 2 years, the project is still not viable as strategic NPV is negat
hen he exits the
h flows from such

to continue with this

proceeds of such sale

e as strategic NPV is negative 1.58
Question

Moiz Ltd wants to start a new gym and the cash flows are expected as under

T0 T1 T2 T3 - T8
Free cash flows -500 120 -200 160

Discounting rate is 10%

What is the NPV ?

Timing T0 T1 T2 T3 T4
Free cash flows (500.00) 120.00 (200.00) 160.00 160.00
DF @ 10% 1.000 0.909 0.826 0.751 0.683
DCF (500.00) 109.09 (165.29) 120.21 109.28

NPV 19.70

Decision : Accept the project

While the project gives a positive NPV, the amount of 19.70 mn NPV is far below expectations because there ha

** Smart Tip : minus 200 mn is net cash flow for T2

So, in T2, when we say that we want to avoid capex, that means there is no outflow for capex in that year
Minus 200 = Capex + Annual net cash flow
Minus 200 = Capex + 120
Capex = - 320

So, capex at end of year 2 is 320, cash inflow is 120

If we do that capex, cash flow from T3 bumps up to 160 instead of 120

The manager evaluates this project and realises that the outflow of 320 mn at the end of year 2, i.e. additional ca
The project can still be run without incurring an additional capex of 320 mn at end of year 2; the only drawback
at the end of year 2, then the year on year cash flow from T3 to T8 will be 120 mn as opposed to 160 mn

There are two alternatives that can be pursued

Alternative I : Do not incur capex of 320 mn at end of year 2, be ok with an inflow of 120 mn every year fr

NPV of alternative I

Timing T0 T1 T2 T3 T4
Free cash flows (500.00) 120.00 120.00 120.00 120.00
DF @ 10% 1.000 0.909 0.826 0.751 0.683
DCF (500.00) 109.09 99.17 90.16 81.96

Net Present Value 140.19

Alternative II : Incur capex of 320 mn at end of year 2 and get additional cash inflow of 40 mn (over and a

NPV of alternative II

Timing T0 T1 T2 T3 T4
Free cash flows (320.00) 40.00 40.00
DF @ 10% 0.826 0.751 0.683
DCF - - (264.46) 30.05 27.32

Additional NPV of alternative II (120.49)

What if you go ahead with alternative II ?

What NPV will you get for the entire project 19.70

If we are looking at this from an investment appraisal POV, opting for alternative II i.e. additional capex of 320
inflow of 40 mn every year from T3 to T8, the ultimate impact is to reduce the NPV generated by alternative I
You might want to reject the proposal

Option to invest after 2 years is a call option

When you invest, you will have to pay 320 mn i.e. Pe = Exercise price

Value of underlying item 143.98 Pa

[ PV of cashflows due to this decision to invest 320 mn ]

Say risk free rate 5%

Standard Deviation 50%

Value of option to invest 11.83

NPV that you would have received without the option to invest 320 mn is 140.19
And as per BSOP, the value [ NPV ] of option to invest is 11.83 mn

So, Strategic NPV = 140.19 ( + ) 11.83 = 152.03

 T5 T6 T7 T8
160.00 160.00 160.00 160.00
0.621 0.564 0.513 0.467
99.35 90.32 82.11 74.64

pectations because there has been a huge expenditure for the project

or capex in that year

of year 2, i.e. additional cash outflow is discretionary

year 2; the only drawback is that if the 320 mn capex is not done
opposed to 160 mn

w of 120 mn every year from T 1 to T 8

T5 T6 T7 T8
120.00 120.00 120.00 120.00
0.621 0.564 0.513 0.467
 74.51 67.74 61.58 55.98

nflow of 40 mn (over and above original 120) every year [ T3 to T8 ]

T5 T6 T7 T8
40.00 40.00 40.00 40.00
0.621 0.564 0.513 0.467
24.84 22.58 20.53 18.66

.e. additional capex of 320 mn at end of year 2 leading to additional cash

generated by alternative I

** the 40 that we use in regular NPV calculation is the 'mean' or 'average' cash flow
Normally, you use that and get NPV
But, in this case, the cash flows are volatile, that is they won't always be 40
They could go up [ upside ] or they could fall down [ downside ]
This volatility is measured by standard deviation
The SD here is 50%, that means cashflow figures are highly scattered
The upside, if it happens, will be huge as will the downside
When we use BSOP, and put in r, s, t, Pa and Pe, the value that BSOP gives us is the
PV of all cashflows, after considering the upside and downside movement
These could be a large number of values, and BSOP integrates all together to
give you 11.83

The SD of 50% means multiple values of cash flow are possible

When we do the working with -320 and 40 mn each year, these are discrete values
and hence you get a direct NPV

When you consider SD of 50%, you accept the fact that 40 is just the mean value
14.67, 38.9, 67.90, and so many values in between these and lesser and more than these
are possible values of cashflow
[ the three numbers are just any random values ] , in fact countless cash flow values are
possible.
If we have the time, we can calculate countless NPVs and then, when we take their
average, it will be 11.83
But, thanks to BSOP, it gives us that value directly