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REAL OPTIONS AND OTHER TOPICS

IN CAPITAL BUDGETING

Evaluating projects with unequal lives


Evaluating projects with embedded options

Valuing real options in projects


WHAT IS A REAL OPTION?
They are opportunities to respond to changing
circumstances.
They are called real options rather than financial options,
because they involve real, rather than financial assets.
They are also known as:
Managerial options, because they give managers the option to
influence the outcome of a project
Strategic options, because they are often associated with large,
strategic projects rather than routine maintenance projects.
WHAT IS REAL OPTION ANALYSIS?
In the real world, real options are often present. Real option is
the right, but not the obligation to take some future action.
Real option must be valuable (have a value), if it expands the
firms opportunities.
Option Value = NPV with the relevant option NPV without the
relevant option.
Real options exist when managers can influence the size and
riskiness of a projects cash flows by taking different actions
during the projects life.
Real option analysis incorporates typical NPV budgeting analysis
with an analysis for opportunities resulting from managers
decisions.
A simple yet important tool that can be used in real option
analysis is the decision tree analysis. The point where the
tree branches is called a node. A decision node is a point at
which management can respond to new information.
EXAMPLES OF REAL OPTIONS:

Investment timing options (Option to delay)


Growth/expansion options

Options to contract (opposite of growth option)

Options to extend

Options to switch

Abandonment/shutdown options

Other flexibility options


INVESTMENT TIMING OPTIONS:

They allow a manager to defer making a decision on whether or


not to accept a project.
They are valuable during periods of volatile interest rates, since
the ability to wait can allow firms to raise capital for projects when
interest rates are lower.
They are also valuable when demand is very uncertain, since
waiting might resolve this uncertainty.
The option to delay is valuable only if it more than offsets any
harm that might come from delaying.
Question to answer:
Should we proceed with the project today or should we wait?
How to answer:
Determine the expected NPV if we proceed today and the expected NPV if we
wait.
Your decision shall be based on which choice will give you the higher positive
NPV.
ISSUES TO CONSIDER:
Whats the appropriate discount rate?
Increased volatility makes the option to delay more
attractive.

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.
ILLUSTRATION 1:
INVESTMENT TIMING OPTIONS

HTC Corp. is considering production of a new cell


phone. The project will require an investment of $20
million. If the phone is well-received, the project will
produce cash flows of $10 million a year for 3 years;
but if the market does not like the product, the cash
flows will be only $5 million per year. There is a 50%
probability of both good and bad market conditions.
HTC can delay the project a year while it conducts a
test to determine whether demand will be strong or
weak. The delay will not affect the projects cost or its
cash flows. HTCs WACC is 10%. What action do you
recommend?
ILLUSTRATION 2:
INVESTMENT TIMING OPTIONS
Nebraska Instruments is considering a project that has an up-front cost of
$1,500,000. The projects subsequent cash flows critically depend on whether
its products become the industry standard. There is a 75% chance that the
products will become the industry standard, in which case the projects
expected cash flows will be $500,000 at the end of each of the next 7 years.
There is a 25% chance that the products will not become the industry
standard, in which case the expected cash flows from the project will be
$50,000 at the end of each of the next 7 years. NI will know for sure one year
from today whether its products will have become the industry standard. It
is considering whether to make the investment today or to wait a year until
after it finds out if the products have become the industry standard. If it
waits a year, the projects up-front cost will remain at $1,500,000. If it
chooses to wait, the subsequent cash flows will remain at $500,000 per year
if the product becomes the industry standard, and $50,000 per year if the
product does not become the industry standard. However, if it decides to
wait, the subsequent cash flows will be received only for six years. Assume
that all cash flows are discounted at 10%. If NI chooses to wait a year before
proceeding, how much will this increase or decrease the projects expected
NPV today relative to the projects NPV if it proceeds today?
GROWTH OPTIONS:
They allow a company to increase capacity to meet changing
market conditions.
A growth option exists when an investment creates the
opportunity to make other potentially profitable investments
that would not otherwise be possible.
Some projects give a company an option expand capacity of an
existing product line, to expand into a new geographical market,
and an option to add a new product. Companies may even
accept negative NPV projects if they have embedded in them
the option to add complementary projects, or successive
generations of the original product.
Questions to answer:
Does the investment present an opportunity for the company to invest in
other investments?
How much is the value of that opportunity?

How to answer:
Determine the expected NPV without the opportunity to expand and the
expected NPV with the opportunity to expand.
FACTORS TO CONSIDER WHEN DECIDING ON
INVESTMENTS THAT HAVE GROWTH OPTIONS

Technical and market uncertainties of the


opportunities.
Costs and benefits of the growth opportunities.
Qualitative factors such as political and economic
risks that may affect the secondary investment must
be considered.
When the growth option has no value, or if it results
to a negative value, after taking all quantitative and
qualitative factors into account, it may make sense
not to proceed with the investment at all.
ILLUSTRATION 3:
GROWTH OPTIONS
Cheung Kong (Holdings) Limited is deciding whether to proceed
with Project A. The cost would be $10 million in Year 0. There is a
55% chance that A would be hugely successful and would generate
annual after-tax cash flows of $6 million per year during Years 1, 2,
and 3. However, there is a 45% chance that A would be less
successful and would generate only $1 million per year for the 3
years. If Project A is hugely successful, it would open the door to
another investment, Project B, which would require an outlay of $9
million at the end of Year 2. Project B would then be sold to
another company at a price of $20 million at the end of Year 3.
Cheung Kongs WACC is 12%.
Requirements:
If the company does not consider real options, what is Project As NPV?
What is project As NPV considering the growth option?
How valuable is the growth option?
ILLUSTRATION 4:
GROWTH OPTIONS
Diplomat Inc. is considering a project that has an up-front cost of $3 million
and produces an expected cash flow of $500,000 at the end of each of the next 5
years. The projects cost of capital is 10%. If Diplomat goes ahead with this
project today, the project will create additional opportunities five years from
now. The company can decide at t = 5 whether or not it wants to pursue these
additional opportunities. Based on the best information that is available
today, the company estimates that there is a 35% chance that its technology
will be successful, in which case the future investment opportunities will have
a net present value of $6 million at t = 5. There is a 65% chance that its
technology will not succeed, in which case the future investment opportunities
will have a net present value of -$6 million at t = 5. Diplomat does not have to
decide today whether it wants to pursue these additional opportunities.
Instead, it can wait until after it finds out if its technology is successful.
However, Diplomat cannot pursue these additional opportunities in the future
unless it makes the initial investment today.
Requirements:
What is the projects NPV?
What is the estimated net present value of the project, after taking into
account the future opportunities?
ABANDONMENT/SHUTDOWN OPTIONS:

An abandonment option is the option of discontinuing a


project if operating cash flows turn out to be lower than
expected. Common in capital intensive industries, this
option can raise expected profitability and lower project risk.
Some options allow a company to reduce capacity or
temporarily suspend operations, rather than completely
abandon them.
Questions to answer:
When should a company to abandon or shutdown its investment?
How to answer:
Determine at which year the investment can attain the least
negative NPV.
The value of the abandonment option = NPV with the
abandonment option NPV without abandonment option.
ASSUMPTIONS FOR
ABANDONMENT/SHUTDOWN OPTIONS

Unless otherwise stated, when a company has the


abandonment option, assume that the company does
not have the option to delay the project.
The company may abandon the project after a year
or a number of years.
If the project is abandoned, there will be no
operating costs incurred nor cash inflows
received after the project is abandoned.
FACTORS TO CONSIDER FOR
ABANDONMENT/SHUTDOWN OPTIONS

Firms should abandon projects at any moment


when they consider the value of continuing
operations is smaller than the value of shutting
down operations.
The option to abandon greatly lowers the worst-
case results and this will lower the risk of the
project.
Because the abandonment option reduces risk, it
therefore reduces the cost of capital.
ILLUSTRATION 5:
ABANDONMENT OPTIONS

HCT Transportation Company recently purchased a new delivery truck. The


new truck costs $22,500, and it is expected to generate after-tax cash flows,
including depreciation of $6,250 per year. The truck has a 5-year expected
life. The expected year-end abandonment values (Salvage values after tax
adjustments) for the truck are given here. The companys WACC is 10%.
Year Annual After-Tax Cash Flow Abandonment Value
0 ($22,500) $0
1 6,250 17,500
2 6,250 14,000
3 6,250 11,000
4 6,250 5,000
5 6,250 0

Should the firm operate the truck until the end of its 5-year physical life; if
not, what is the trucks optimal economic life?
Would the introduction of abandonment values, in addition to operating cash
flows, ever reduce the expected NPV and/or IRR of a project? Explain.
ILLUSTRATION 6:
ABANDONMENT OPTIONS

High Roller Properties is considering building a new casino at


a cost of $10 million. The after-tax cash flows the casino
generates will depend on whether the state imposes a new
income tax, and there is a 50-50 chance the tax will pass. If it
passes, after-tax cash flows will be $1.875 million per year for
the next 5 years. If it doesnt pass, the after-tax cash flows will
be $3.75 million per year for the next 5 years. The projects
WACC is 11.1%. If the tax is passed, the firm will have the
option to abandon the project 1 year from now, in which case,
the property could be sold to net $6.5 million after tax at Year
1. What is the value of this abandonment option?
FLEXIBILITY OPTIONS

They allow managers to switch inputs or outputs in a


manufacturing process.
An option that permits operations to be altered
depending on how conditions changes during a
projects life, especially the type of output produced
or inputs used.
Flexibility options exist when its worth spending
money today which enables you to maintain
flexibility down the road.
STEPS IN DETERMINING THE OPTIMAL CAPITAL BUDGET

1. Estimate the overall composite WACC (based on market


conditions, capital structure, and asset riskiness).
2. Scale corporate WACC up or down depending on the
divisions capital structure and risk characteristics (eg.
Stable low risk = 0.9; exotic high risk = 1.1)
3. Estimate relevant cash flows and risks of each potential
project and consider real options embedded + opportunity to
repeat the project later. Adjust divisional WACC using the
same factors (0.9 and 1.1)
4. Determine each projects NPV using the risk-adjusted WACC.
If independent, accept all projects with + NPV. If mutually
exclusive, accept the project with the highest NPV.
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.
IRR, WACC (%)
A
13.0
C
12.0

11.39
D WACC
11.2
11.02
B
10.7
10.58 IRR
10.22
9.86

New
Capital
3,200,000 4,950,000 5,400,000 6,700,000
3,000,000 4,725,000 5,225,000 6,000,000
OPTIMAL CAPITAL BUDGET

Capital constraint will lead to Capital


Rationing. Since resources are scarce. It
is of utmost importance that resources
must be used in the most efficient way.
ILLUSTRATION 7:
OPTIMAL CAPITAL BUDGET
Gibson Inc. is considering the following five independent projects:

Project Cost IRR


A $200,000 20%
B $600,000 15%
C $400,000 12%
D $400,000 11%
E $400,000 10%

The company has a target capital structure that consists of 40% debt
and 60% common equity. The company can issue bonds with a YTM
of 11%. The company has $600,000 in retained earnings, and the
current stock price is $42 per share. The flotation costs associated
with issuing new equity are $2 per share. Gibsons earnings are
expected to continue to grow at 6% per year. Next years dividend is
forecasted to be $4. The firm faces a 40% tax rate. What is the size
of Gibsons optimal capital budget?
QUALITATIVE ASSESSMENT OF A REAL OPTIONS
VALUE:

Real options are more valuable if the project is very


volatile.
Real options are more valuable if there is a long time
until the option must be exercised.
Real options are more valuable when the current value of
the underlying project is relatively high compared with
the cost to exercise the real option.
Real options are more valuable when interest rates are
high.
POST-AUDIT

Post-audit is a comparison of actual versus expected results for a


given capital project.
Purposes:
To improve forecast
To improve operations
Factors that complicate the post-audit process:
Each element of the cash flow forecast is subject to uncertainty and a
reasonably aggressive firm may find that a percentage of its projects may go
awry.
Projects sometimes fail to meet expectations for reasons beyond the control of
their sponsors and for reasons that no one could be expected to anticipate.
It is often difficult to separate the operating results of one investment from
those of a larger system. Cost savings from assets such as new computers,
for example, may be hard to measure.
It is often difficult to hand out blame or praise because the executives who
were responsible for launching a given investment have moved on by the
time the results are known.

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