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CHAPTER 13
Other Topics in Capital Budgeting Evaluating projects with unequal lives Evaluating projects with embedded options Valuing real options in projects
Copyright 2001 by Harcourt, Inc. All rights reserved.
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S and L are mutually exclusive and will be repeated. k = 10%. Which is better? Expected Net CFs Year 0 1 2 3 4
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Note that Project S could be repeated after 2 years to generate additional profits.
Use replacement chain to calculate extended NPVS to a common life. Since S has a 2-year life and L has a 4-year life, the common life is 4 years.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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L:
10%
-100,000
33,500
33,500
33,500
33,500
S:
10%
-100,000
59,000 59,000 59,000 -100,000 -41,000 NPVS = $4,377 (on extended basis)
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59,000
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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.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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What are some examples of real options? Investment timing options Abandonment/shutdown options Growth/expansion options Flexibility options
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An Illustration of Investment Timing Options If we proceed with Project L, its NPV is $6,190. (Recall the up-front cost was $100,000 and the subsequent CFs were $33,500 a year for four years). However, if we wait one year, we will find out some additional information regarding output prices and the cash flows from Project L.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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If we wait, 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. If we wait, the up-front cost will remain at $100,000.
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Years
$37,889, if CFs are $43,500 per year, or -$25,508, if CFs are $23,500 per year, in which case the firm would not proceed with the project.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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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) = $18,944.58, which is worth $18,944.58/(1.10) = $17,222.34 in todays dollars (assuming a 10% discount rate). Therefore, it makes sense to wait.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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Issues to Consider
Whats 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.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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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.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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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 Ys NPV?
0 k = 10% 1 2 3
-$200,000
80,000
80,000
80,000
(More)
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NPV = -$1,051.84
Copyright 2001 by Harcourt, Inc.
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Abandonment/Shutdown (continued) Project Ys 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 cash flows of $150,000, and a 40% chance it will produce annual A-T cash flow of -$25,000.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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150,000 -25,000 2
150,000 -25,000 3
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) + 0.4(-262,171) = -1,051.84.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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Abandonment/Shutdown (continued) Company does not have the option to delay the project. 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.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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150,000
150,000
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) + 0.4(-222,727) = 14,725.77.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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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.
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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.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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100,000
100,000
100,000
2
Years
At k = 12%, NPV of top branch (w / 10% prob.) NPV of bottom branch (w / 90% prob.)
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= $1,562,758.19.
= -$ 139,522.38.
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NPV with the Growth Option (contd) 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.
Copyright 2001 by Harcourt, Inc. All rights reserved.
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NPV with the Growth Option (contd) Thus, the expected value of this project should be:
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Flexibility Options Flexibility options exist when its worth spending money today, which enables you to maintain flexibility down the road.