CHAPTER 14 Fin 13 |1

REAL OPTIONS & OTHER TOPICS IN CAPITAL

BUDGETING
LEARNING OBJECTIVES
• Explain what real options are, how they influence, how they influence capital budgeting
and how they can be analyzed
• Identify real options in projects
• Discuss how projects’ NPVs are affected by the size of the firm’s total capital budget,
the process involved in determining a firm’s capital budget, the analysis undertaken in
value maximizing projects
• Describe the post-audit which is an important part of the capital budgeting process and
discuss its relevance in capital budgeting decisions

REAL OPTION ANALYSIS

Definition
 Options are rights but not the obligation to take some future action
 Real options exist when managers can influence the size and riskiness of a project’s
cash flows by taking different actions during or at the end of a project’s life.
 Real option analysis incorporates typical NPV capital budgeting analysis with an
analysis of opportunities resulting from managers’ responses to changing
circumstances that can influence a project’s
outcome.

Examples
• Investment timing options
• Abandonment/shutdown options
• Growth/expansion options
• Flexibility options
• Fundamental options

POP-QUIZ #1
Statement 1: The option to abandon a project is a real option, but a call option on a stock is
not a real option.
Statement 2: Real options exist whenever managers have the opportunity, after a project
has been implemented, to make operating changes in response to changed conditions that
modify the project's cash flows
A. Both statements are true
B. Both statements are false
C. Only Statement 1 is true
D. Only Statement 2 is true
 CHAPTER 14 Fin 13 |2

INVESTMENT TIMING OPTION

Definition
 Faced with uncertainty, it is the ability to postpone
rather than immediately implement or reject a
capital budgeting project, to significantly increase
a project's value.

Example
 Sales of low-fat ice cream are surging. Operating
at full capacity, the Healthy Cow Creamery is
considering whether to expand its plant.
 Launching the expansion would require a big up-front investment, and the company's
managers can't be sure that the sales boom will persist.
 They have the option of delaying the investment until they learn more about the strength
of demand. It may be that the risk avoided by waiting to invest has a greater value than
the sales that might be forfeited by postponing construction.

INVESTMENT TIMING OPTION: AN EXAMPLE

 Project X has an up-front cost of $100,000. The project is expected to produce cash
flows of $33,500 at the end of each of the next four years
(t = 1, 2, 3, and 4). The project has a WACC = 10%.
 The project’s NPV is $6,190. Therefore, it appears that the company should go ahead
with the project.
 However, if the company waits a year they will find out more information about market
conditions and the impact on the project’s expected cash flows.

If they wait a year:

 There is a 50% chance the market will be strong and the expected cash flows will be
$43,500 a year for four years.
 There is a 50% chance the market will be weak and the expected cash flows will be
$23,500 a year for four years.
 The project’s initial cost will remain $100,000, but it will be incurred at t = 1 only if it
makes sense at that time to proceed with the project.
Should the company go ahead with the project today or wait for more information?

At WACC = 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.
 CHAPTER 14 Fin 13 |3

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,
Expected NPV at t=0 = $18,944.57/1.10 = $17,222.34 (assuming a 10% WACC).
 Therefore, it makes sense to wait.

CONSIDERATIONS IN INVESTMENT TIMING DECISIONS

Issues to Consider
 What is the appropriate discount rate?
 Note that increased volatility can make 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:
t = 1: 0.5($69,588) + 0.5(0) = $34,794 > $18,945
t = 0: $34,794/1.10 = $31,631 > $17,222

Factors to Consider in 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.

POP-QUIZ #2
Arista Inc. is deciding whether to invest in a project today or to postpone the decision
until next year. The project has a positive expected NPV, but its cash flows might turn out
to be lower than expected, in which case the NPV could be negative. No competitors are
likely to invest in a similar project if the firm decides to wait. Which of the following
statements best describes the issues that the firm faces when considering this investment
timing option?
A. The investment timing option would not affect the cash flows and therefore would
have no impact on the project's risk.
B. The more uncertainty about the future cash flows, the more logical it is to go ahead
with this project today.
C. Since the project has a positive expected NPV today, this means that it should be
accepted in order to lock in that NPV.
D. Waiting would probably reduce the project's risk.
 CHAPTER 14 Fin 13 |4

ABANDONMENT/SHUTDOWN OPTION
Definition
 An abandonment option is the ability to withdraw from the project before it ends. It adds
value by giving the parties the ability to end if conditions change that would make the
investment unprofitable.
Example
 Management may begin with a relatively small
trial investment and create an option to abandon
the project if results are unsatisfactory.
 Management may include abandonment option
clauses if certain project milestones are not met
 Research and development spending is a good
example. A company's future investment in
product development often depends on specific
performance targets achieved in the lab. The
option to abandon research projects is valuable
because the company can make investments in stages rather than all up-front.

ABANDONMENT/SHUTDOWN OPTION: AN EXAMPLE

 Project Y has an initial, up-front cost of $200,000, at t = 0. The project is expected to
produce cash flows of $80,000 for the next three years.

 Project Y’s cash flows depend critically upon customer acceptance of the product.
 There is a 60% probability that the product will be wildly successful and produce CFs of
$150,000, and a 40% chance it will produce annual CFs of $25,000.

 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
 CHAPTER 14 Fin 13 |5

NPV WITH ABANDONMENT OPTION

 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.

 If the customer uses the product, NPV is $173,027.80.

 If the customer does not use the product and it can be abandoned after Year 1, NPV is
-$222,727.27
 E(NPV) = 0.6(173,027.8) + 0.4 (-222,727.27) = $14,725.77
 Abandonment options reduce variation, therefore risk
 Abandonment option WORKS!

ABANDONMENT OPTION
Should an abandonment option affect a project’s WACC?
 Yes an abandonment option should have an effect on WACC
 The abandonment option reduces risk, and therefore the WACC

POP-QUIZ #3
Statement 1: In general, investment timing options are more valuable than abandonment
options
Statement 2: It is not possible for abandonment options to decrease a project's risk as
measured by the project's coefficient of variation
A. Both statements are true
B. Both statements are false
C. Only Statement 1 is true
D. Only Statement 2 is true

FUNDAMENTAL OPTION (OPTION TO CONTRACT)

Definition
 It is the option to shut down a project at some point in the future if
conditions are unfavorable and continue when they become
favorable

Examples
 A multinational corporation can stop the operations of its branches in
a country with an unstable political situation
 CHAPTER 14 Fin 13 |6

 A real estate developer can stop construction when conditions such as interest rates or
cost of materials go up
 A manufacturer who has an option with its toll packer to adjust their orders depending
on demand

GROWTH (EXPANSION) OPTION

Definition
 If an investment creates the opportunity to
make other potentially profitable
investments that would not otherwise be
possible, then the investment contains
growth (expansion) option
 If an initial investment works out well, then
management can exercise the option to
expand its commitment to the strategy.

Examples
 A company that enters a new geographic
market may build a distribution center that it
can expand easily if market demand materializes.
 Amazon's substantial investment to develop its customer base, brand name and
information infrastructure for its core book business created a portfolio of real options to
extend its operations into a variety of new businesses (i.e. Prime Video)
 R&D

GROWTH OPTION: AN EXAMPLE

 Project Z has an initial cost of $500,000.
 The project is expected to produce cash flows of $100,000 at the end of each of the
next five years, and has a WACC of 12%. It clearly has a negative NPV.

At WACC = 12%,
 NPV of top branch (10% prob.) = $1,562,758.19
 NPV of lower branch (90% prob.) = -$139,522.38
Why only -$139,522.38?
 CHAPTER 14 Fin 13 |7

 If the project’s future opportunities have a negative NPV, the company would choose
not to pursue them.
 The bottom branch only has the -$500,000 initial outlay and the $100,000 annual cash
flows, which lead to an NPV of -$139,522. It doesn’t consider the -$1,000,000
 The expected NPV of this project is:
NPV = 0.1($1,562,758) + 0.9(-$139,522)
= $30,706.

GROWTH OPTION: AN EXAMPLE

E(NPV) = 0.5(12,683) + 0.5(-6,513) = $3,085

FLEXIBILITY OPTION
Definition
 An option that permits operations to be altered depending
on how conditions change during a project’s life
 Flexibility options exist when it’s worth spending money
today, which enables you to maintain flexibility down the
road.

Examples
 Power plants that can generate electricity from multiple
energy sources
 Ginebra bottling/manufacturing plants that can switch from
one product to another (gin to rubbing alcohol).

Value of Flexibility Option

Value of Flexibility option = Expected NPV with the option – Expected NPV without the
option
 CHAPTER 14 Fin 13 |8

FLEXIBILITY OPTION: AN EXAMPLE

 Project Delta has an initial cost of $5,000, including the cost of machinery. WACC =
12%
 The project has a 50% probability to generate a strong demand and net after-tax
cashflows of $2,500 annually for the next 3 years. There’s also a 50% probability to
suffer a weak demand and generate only $1,500 annually for the same period
 However, the firm has an option to pay an additional $100 on t=0 for a better machine
that can allow them to produce other products. In the event of weak demand, they can
produce other products that will provide them with annual net after-tax cash flows of
$2,250 for Years 2 and 3.
 What is the NPV of the project with and without the flexibility options, and what is the
value of the flexibility option?

Value of Flexibility Option

Value of Flexibility option = Expected NPV with the option – Expected NPV without the
option

FLEXIBILITY OPTION: AN EXAMPLE

If E(NPV) without the option is negative, the project

would not be undertaken, therefore NPV =0
 CHAPTER 14 Fin 13 |9

POP-QUIZ #4
Which one of the following is an example of a “flexibility” option?
A. A company has an option to invest in a project today or to wait for a year before
making the commitment.
B. A company has an option to close down an operation if it turns out to be
unprofitable.
C. A company agrees to pay more to build a plant in order to be able to change
the plant's inputs and/or outputs at a later date if conditions change.
D. A company invests in a project today to gain knowledge that may enable it to expand
into different markets at a later date.

OPTIMAL CAPITAL BUDGET & CAPITAL RATIONING

Definitions
IRR Schedule
 A graph of the marginal rates of return of investment at different levels of investment
ranked from highest to lowest
Marginal Cost of Capital
 The cost of each peso raised
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
Capital Rationing
 The situation in which a firm can raise only a specified, limited amount of capital
regardless of how many good projects it has

Application
 If a firm can continually raise capital, it can invest as long as the project IRR is > MCC
 If IRR= MCC then Optimal capital budget has been reached
 CHAPTER 14 F i n 1 3 | 10

POP-QUIZ #5
Statement 1: The optimal capital budget is the size of the capital budget where the rate of
return on the marginal project is equal to the marginal cost of capital.
Statement 2: Capital rationing is the situation in which a firm can raise only a specified,
limited amount of capital regardless of how many good projects it has.
A. Both statements are true
B. Both statements are false
C. Only Statement 1 is true
D. Only Statement 2 is true

POST-AUDIT
Definition
 A comparison of actual versus expected results for a
given capital project
 Involves the development of project performance reports
comparing planned and actual results
Purpose
 Reports should be provided to those involved with the
proposal to:
 Improve operations and keep the project on target
 Identify the need to re-evaluate the project if necessary
 Improve forecasts and investment proposal quality
 Help the approving committee better evaluate proposals

POP-QUIZ #6
Langston Labs has an overall (composite) WACC of 10%, which reflects the cost of capital
for its average asset. Its assets vary widely in risk, and Langston evaluates low-risk
projects with a WACC of 8%, average-risk projects at 10%, and high-risk projects at 12%.
The company is considering the following projects:
Project Risk Expected Return
A High 15%
B Average 12%
C High 11%
D Low 9%
E Low 6%
Which set of projects would maximize shareholder wealth?
A. A and B.
B. A, B, and C.
C. A, B, and D.
D. A, B, C, and D.
E. A, B, C, D, and E.
 CHAPTER 14 F i n 1 3 | 11

POP-QUIZ #7
Wahal Corporation uses the NPV method when selecting projects, and it does a reasonably
good job of estimating projects' sales and costs. However, it never considers any real
options that might be associated with projects. Which of the following statements is most
likely to describe its situation?
A. Its estimated capital budget is probably too small, because projects' NPVs are
often larger when real options are taken into account.
B. Its estimated capital budget is probably too large due to its failure to consider
abandonment and growth options.
C. Failing to consider abandonment and flexibility options probably makes the optimal
capital budget too large, but failing to consider growth and timing options probably
makes the optimal capital budget too small, so it is unclear what impact the failure to
consider real options has on the overall capital budget.
D. Failing to consider abandonment and flexibility options probably makes the optimal
capital budget too small, but failing to consider growth and timing options probably
makes the optimal capital budget too large, so it is unclear what impact not
considering real options has on the overall capital budget.

MONTE CARLO SIMULATION

Definition
 Monte Carlo Simulation is a statistical method applied in financial modeling. ... The
simulation relies on the repetition of random samples to achieve numerical results. It
can be used to understand the effect of uncertainty and randomness in forecasting
models.

Application
 The method can also be used in capital budgeting, where the project manager tries to
establish its financial viability. Profits and costs are likely to be affected by numerous
underlying variables, which may include interest rate movements, exchange rate
fluctuations, technological changes, labor supply costs, among others. Monte Carlo
simulation can incorporate all the variables into a model that can be iterated to highlight
all the possible future outcomes of the project. The outcomes are then summarized in
terms of probabilities. The least likely outcome and the most likely one can then be
deduced.

Limitations
It only provides us with statistical estimates of results, not exact figures.
It is fairly complex and can only be carried out using specially designed software that may
be expensive.
The complexity of the process may cause errors leading to wrong results that can be
potentially misleading.
 CHAPTER 14 F i n 1 3 | 12

WHAT WE HAVE LEARNED SO FAR?

 A real option gives a firm's management the right, but not the obligation to undertake
certain business opportunities or investments.
 Real option refer to projects involving tangible assets versus financial instruments.
 Real options can include the decision to expand, defer or wait, or abandon a project
entirely.
 Real options are most valuable when uncertainty is high; management has significant
flexibility to change the course of the project in a favorable direction and is willing to
exercise the options.
 Real options have economic value and often minimize risk