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In this model we examine four types of real options: Growth, Abandonment, Timing, and Flexibility. We
also analyze a procedure for determining the optimal size of the capital budget.
Part III. Value of the Option NPV considering the growth option $1,503
NPV not considering the growth option $122
Value of the option: If NPV without option is negative, value of option = NPV with option.
Otherwise, value of option = NPV with option – NPV without option: $1,381
Figure 13-2. Abandonment Option (Dollars in Thousands) 1/06/09
Value of the option: If NPV without option is negative, value of option = NPV
with option. Otherwise, value of option = NPV with option - NPV without option. $200
Figure 13-3. Analysis of a Timing Option (Dollars in Thousands) 1/06/09
Part II. Delay the Decision Until We Know the Market Conditions
Cash Flow At End of Period NPV@
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 NPV considering the growth option $170
NPV not considering the growth option -$58
Value of the option: If NPV without option is negative, value of option = NPV with option.
Otherwise, value of option = NPV with option - NPV without 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 t = 0 NPV. However, if we let PV = -3000, PMT
= 2000, N = 2, and I = 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 and get the correct answer.
Figure 13-4. Flexibility Option (Dollars in Thousands) 1/06/09
Part I. Project without the Flexibility Option Cash Flow at End of Period NPV@
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@
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 NPV with the option $270
NPV without the option -$196
Value of the option: If NPV without option is negative, value of option = NPV with option.
Otherwise, value of option = NPV with option – NPV without option. $270
Figure 13-5. Optimal Capital Budget: Marginal IRR = Marginal WACC 1/06/09
WACC
30%& IRR
25%
20% WACC
15%
10%
IRR
5%
0%
$100 $600 $1,100 $1,600 $2,100
Capital Budget
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?