Chapter 13

Real Options and Other

Topics in Capital
Budgeting

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 Valuing Real Options in Projects

• Timing Option
• Abandonment/Shutdown Option
• Growth Option
• Flexibility Option

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 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 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.

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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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 Investment Timing Option (1 of 2)

• Project X has an upfront after-tax cost of $100,000. The project is expected to

produce after-tax 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 after-tax cash
flows.

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 Investment Timing Option (2 of 2)

• If they wait a year:

• There is a 50% chance the market will be strong and the expected after-tax cash flows will
be $43,500 a year for four years.

• There is a 50% chance the market will be weak and the expected after-tax cash flows will be
$23,500 a year for four years.

• The project’s initial after-tax 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?
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 Investment Timing Decision Tree

• At WACC = 10%, the NPV at t = 1 is:

• $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.

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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) =

$18,944.57, which is worth $18,944.57/1.10 = $17,222.34 in today’s dollars
(assuming a 10% WACC).

• Therefore, it makes sense to wait.

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 Issues to Consider with Investment Timing
Options
• What is the appropriate discount rate?

• Note that increased volatility makes the option to delay more attractive.

• If instead, there was a 50% chance the subsequent after-tax CFs will be $53,500 a year, and
a 50% chance the subsequent after-tax 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

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 Factors to Consider In Decision of 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.

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 Abandonment/Shutdown Option

• Project Y has an initial, upfront after-tax cost of $200,000, at t = 0. The project

is expected to produce after-tax cash flows of $80,000 for the next three years.
• At a 10% WACC, what is Project Y’s NPV?

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 Abandonment Option

• 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 annual after-tax CFs of $150,000, and a 40% chance it will produce
annual after-tax CFs of −$25,000.

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 Abandonment Decision Tree

• 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
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 Key Assumptions

• 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.

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 NPV with Abandonment Option

• 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
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 Should an abandonment option affect a
project’s WACC?
• Yes, an abandonment option should have an effect on the WACC.

• The abandonment option reduces risk, and therefore reduces the WACC.

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 Growth Option

• Project Z has an initial after-tax cost of $500,000.

• The project is expected to produce after-tax 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.

• 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.

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NPV with the Growth Option (1 of 3)

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 NPV with the Growth Option (2 of 3)

• Since the NPV of first 5 years of after-tax CFs for this outcome has a negative
NPV, then second phase with a negative NPV will not be done.
• At WACC = 12%,
• NPV of top branch (10% prob.) = $1,562,758.19
• NPV of lower branch (90% prob.) = −$139,522.38

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 NPV with the Growth Option (3 of 3)

• 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 after-tax outlay and the
$100,000 annual after-tax cash flows, which lead to an NPV of −$139,522.

• The expected NPV of this project is:

NPV = 0.1($1,562,758) + 0.9(−$139,522)

= $30,706.

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 Flexibility Options

• Flexibility options exist when it’s worth spending money today, which enables
you to maintain flexibility down the road.

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