Business finance ch 12 other topics in capital budgeting

CHAPTER 12 Other Topics in Capital Budgeting    Evaluating projects with unequal lives Identifying embedded options Valuing real options in projects 12-1 Evaluating projects with unequal lives Projects S and L are mutually exclusive, and will be repeated If k = 10%, which is better? Expected Net CFs Year Project S Project L ($100,000) ($100,000) 59,000 33,500 59,000 33,500 33,500 33,500 12-2 Solving for NPV, with no repetition  Enter CFs into calculator CFLO register for both projects, and enter I/YR = 10%  NPV = $2,397 S   NPVL = $6,190 Is Project L better?  Need replacement chain analysis 12-3 Replacement chain  Use the replacement chain to calculate an extended NPVS to a common life  Since Project S has a 2-year life and L has a 4-year life, the common life is years 10% -100,000 59,000 59,000 59,000 -100,000 -41,000 NPVS = $4,377 (on extended basis) 59,000 12-4 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 the project’s life Real option analysis incorporates typical NPV budgeting analysis with an analysis for opportunities resulting from managers’ decisions 12-5 What are some examples of real options?     Investment timing options Abandonment/shutdown options Growth/expansion options Flexibility options 12-6 Illustrating an investment timing option    If we proceed with Project L, its annual cash flows are $33,500, and its NPV is $6,190 However, if we wait one year, we will find out some additional information regarding output prices and the cash flows from Project L If we wait, the up-front cost will remain at $100,000 and 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 12-7 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 k = 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 12-8 Should we wait or proceed?    If we proceed today, NPV = $6,190 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% discount rate) Therefore, it makes sense to wait 12-9 Issues to consider with investment timing options What’s 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  12-10 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 12-11 Abandonment/shutdown option   Project Y has an initial, up-front cost of $200,000, at t = 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 Y’s NPV? k = 10% -$200,000 80,000 80,000 80,000 NPV = -$1,051.84 12-12 Abandonment option   Project Y’s 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 CFs of $150,000, and a 40% chance it will produce annual A-T net CFs of $25,000 12-13 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 12-14 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 12-15 NPV with abandonment option 150,000 60% prob -$200,000 40% prob    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, NPV is -$222,727.27 E(NPV) = 0.6(173,027.8) + 0.4(-222,727.27) = 14,725.77 12-16 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 12-17 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 = 12-18 NPV with the growth option 100,000 10% prob -$500,000 90% prob  100,000 100,000 100,000 100,000 $3,000,000 100,000 100,000 100,000 -$1,000,000 100,000 100,000 Years At k = 12%,   NPV of top branch (10% prob) = $1,562,758.19 NPV of lower branch (90% prob) = $139,522.38 12-19 NPV with the growth option    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 Thus, the expected value of this project should be: NPV = 0.1($1,562,758) + 0.9(-$139,522) = $30,706 12-20 Flexibility options  Flexibility options exist when it’s worth spending money today, which enables you to maintain flexibility down the road 12-21 ... Project L better?  Need replacement chain analysis 12- 3 Replacement chain  Use the replacement chain to calculate an extended NPVS to a common life  Since Project S has a 2-year life and L... analysis incorporates typical NPV budgeting analysis with an analysis for opportunities resulting from managers’ decisions 12- 5 What are some examples of real options?     Investment timing options... $18,944.57, which is worth $18,944.57 / (1.10) = $17,222.34 in today’s dollars (assuming a 10% discount rate) Therefore, it makes sense to wait 12- 9 Issues to consider with investment timing options