CHAPTER 12

Other Topics in Capital Budgeting

 Evaluating projects with unequal lives

 Identifying embedded options
 Valuing real options in projects

12-1
Evaluating projects with
unequal lives
Projects S and L are mutually exclusive, and will
be repeated. If k = 10%, which is better?

Expected Net CFs

Year Project S Project L
0 ($100,000) ($100,000)
1 59,000 33,500
2 59,000 33,500
3 - 33,500
4 - 33,500
12-2
Solving for NPV,
with no repetition
 Enter CFs into calculator CFLO register for
both projects, and enter I/YR = 10%.
 NPV = $2,397
S
 NPVL = $6,190
 Is Project L better?
 Need replacement chain analysis.

12-3
 Replacement chain
 Use the replacement chain to calculate an
extended NPVS to a common life.
 Since Project S has a 2-year life and L has a
4-year life, the common life is 4 years.

0 1 2 3 4
10%

-100,000 59,000 59,000 59,000 59,000

-100,000
-41,000
NPVS = $4,377 (on extended basis)
12-4
What is real option analysis?
 Real options exist when managers can
influence the size and riskiness of a
project’s cash flows by taking different
actions during the project’s life.
 Real option analysis incorporates
typical NPV budgeting analysis with an
analysis for opportunities resulting
from managers’ decisions.
12-5
What are some examples of
real options?
 Investment timing options
 Abandonment/shutdown options
 Growth/expansion options
 Flexibility options

12-6
Illustrating an investment
timing option
 If we proceed with Project L, its annual cash
flows are $33,500, and its NPV is $6,190.
 However, if we wait one year, we will find out
some additional information regarding output
prices and the cash flows from Project L.
 If we wait, the up-front cost will remain at
$100,000 and there is a 50% chance the
subsequent CFs will be $43,500 a year, and a
50% chance the subsequent CFs will be
$23,500 a year.

12-7
 Investment timing decision tree
-$100,000 43,500 43,500 43,500 43,500
50% prob.

-$100,000 23,500 23,500 23,500 23,500

50% prob.
0 1 2 3 4 5
Years
 At k = 10%, the NPV at t = 1 is:
 $37,889, if CF’s are $43,500 per year, or
 -$25,508, if CF’s are $23,500 per year, in
which case the firm would not proceed with
the project.
12-8
Should we wait or proceed?
 If we proceed today, NPV = $6,190.
 If we wait one year, Expected NPV at t
= 1 is 0.5($37,889) + 0.5(0) =
$18,944.57, which is worth
$18,944.57 / (1.10) = $17,222.34 in
today’s dollars (assuming a 10%
discount rate).
 Therefore, it makes sense to wait.
12-9
Issues to consider with
investment timing options
 What’s the appropriate discount rate?
 Note that increased volatility makes the option to

delay more attractive.

 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:
0.5($69,588) + 0.5(0) = $34,794 > $18,944.57

12-10
Factors to consider when
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.
12-11
Abandonment/shutdown option
 Project Y has an initial, up-front cost of
$200,000, at t = 0. The project is
expected to produce after-tax net cash
flows of $80,000 for the next three years.
 At a 10% discount rate, what is Project Y’s
NPV?
0 1 2 3
k = 10%

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

NPV = -$1,051.84
12-12
Abandonment option
 Project Y’s A-T net cash flows depend
critically upon customer acceptance of
the product.
 There is a 60% probability that the
product will be wildly successful and
produce A-T net CFs of $150,000, and
a 40% chance it will produce annual
A-T net CFs of -$25,000.

12-13
 Abandonment decision tree
150,000 150,000 150,000
60% prob.
-$200,000
-25,000 -25,000 -25,000
40% prob.
0 1 2 3
Years
 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
12-14
Issues with abandonment options
 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.
12-15
 NPV with abandonment option
150,000 150,000 150,000
60% prob.
-$200,000
-25,000
40% prob.
0 1 2 3
Years
 If the customer uses the product,
NPV is $173,027.80.
 If the customer does not use the product,
NPV is -$222,727.27.
 E(NPV) = 0.6(173,027.8) + 0.4(-222,727.27)
= 14,725.77
12-16
Is it reasonable to assume that the
abandonment option does not affect
the cost of capital?
 No, it is not reasonable to assume
that the abandonment option has
no effect on the cost of capital.
 The abandonment option reduces
risk, and therefore reduces the cost
of capital.

12-17
Growth option
 Project Z has an initial up-front cost of
$500,000.
 The project is expected to produce A-T cash
inflows of $100,000 at the end of each of the
next five years. Since the project carries a 12%
cost of capital, it clearly has a negative NPV.
 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.

12-18
 NPV with the growth option
$3,000,000
100,000 100,000 100,000 100,000 100,000
10% prob.

-$500,000 -$1,000,000
100,000 100,000 100,000 100,000 100,000
90% prob.
0 1 2 3 4 5
Years

 At k = 12%,
 NPV of top branch (10% prob) = $1,562,758.19
 NPV of lower branch (90% prob) = -$139,522.38

12-19
 NPV with the growth option
 If it turns out that the project has future
opportunities with a negative NPV, the company
would choose not to pursue them.
 Therefore, the NPV of the bottom branch should
include only the -$500,000 initial outlay and the
$100,000 annual cash flows, which lead to an NPV
of -$139,522.38.
 Thus, the expected value of this project should be:
NPV = 0.1($1,562,758) + 0.9(-$139,522)
= $30,706.
12-20
Flexibility options
 Flexibility options exist when it’s
worth spending money today, which
enables you to maintain flexibility
down the road.

12-21