Finance management cengage 2013 chapter 013

Chapter 13 Real Options and Other Topics in Capital Budgeting Identifying Embedded Options Valuing Real Options in Projects 13-1 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part 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 13-2 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What are some examples of real options? • • • • Growth/expansion options Abandonment/shutdown options Investment timing options Flexibility options 13-3 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Investment Timing Option • 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 13-4 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Investment Timing Option • 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 = 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? 13-5 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Investment Timing Decision Tree 50% prob 50% prob • -$100,000 43,500 43,500 43,500 43,500 -$100,000 23,500 23,500 23,500 23,500 Years At WACC = 10%, the NPV at t = 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 13-6 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Should we wait or proceed? • • If we proceed today, NPV = $6,190 • Therefore, it makes sense to wait If we wait one year, Expected NPV at t = 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) 13-7 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part 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 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 13-8 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part 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 13-9 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Abandonment/Shutdown Option • Project Y has an initial, up-front cost of $200,000, at t = The project is expected to produce cash flows of $80,000 for the next three years • At a 10% WACC, what is Project Y’s NPV? 10% -$200,000 80,000 80,000 80,000 NPV = -$1,051.84 13-10 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part 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 CFs of $150,000, and a 40% chance it will produce annual CFs of −$25,000 13-11 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Abandonment Decision Tree 60% prob -$200,000 40% prob • • 150,000 150,000 150,000 -25,000 -25,000 -25,000 Years 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 13-12 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Issues with Abandonment Options • 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 13-13 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part NPV with Abandonment Option 60% prob -$200,000 40% prob • • 150,000 150,000 150,000 -25,000 Years 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 13-14 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part 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 13-15 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Growth Option • • Project Z has an initial cost of $500,000 • 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 = 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 13-16 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part NPV with the Growth Option 100,000 100,000 10% prob -$500,000 90% prob • 100,000 100,000 100,000 $3,000,000 100,000 100,000 100,000 -$1,000,000 100,000 100,000 Years At WACC = 12%, – NPV of top branch (10% prob.) = $1,562,758.19 – NPV of lower branch (90% prob.) = -$139,522.38 13-17 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part NPV with the Growth Option • 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 • The expected NPV of this project is: NPV = 0.1($1,562,758) + 0.9(-$139,522) = $30,706 13-18 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Flexibility Options • Flexibility options exist when it’s worth spending money today, which enables you to maintain flexibility down the road 13-19 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part [...]... 0.4(−$222,727.27) = $14 ,725.77 13-14 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part 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 13-15 © 2013 Cengage Learning All Rights... 0.1($1,562,758) + 0.9(-$139,522) = $30,706 13-18 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Flexibility Options • Flexibility options exist when it’s worth spending money today, which enables you to maintain flexibility down the road 13-19 © 2013 Cengage Learning All Rights Reserved May not be... 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 13-13 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part NPV with Abandonment Option 60% prob -$200,000 40% prob... 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 13-11 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Abandonment Decision Tree 60% prob -$200,000 40% prob... chance of an NPV of -$1,000,000 at t = 5 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 13-16 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part NPV with the Growth Option 100,000 100,000 10% prob -$500,000... 100,000 $3,000,000 100,000 100,000 100,000 -$1,000,000 100,000 100,000 3 4 5 Years At WACC = 12%, – NPV of top branch (10% prob.) = $1,562,758.19 – NPV of lower branch (90% prob.) = -$139,522.38 13-17 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part NPV with the Growth Option • If the project’s future... -25,000 1 2 3 Years 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 13-12 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Issues with Abandonment Options • The company does not