Yoran Yacht Company

1. Yoran Yacht Company Applying Real Options in Capital Budgeting Decision-making

2. Yoran Yacht Company • The Yoran Yacht Company (YYC), a prominent sailboat builder in Newport, may design a new 30-foot sailboat based on the “winged” keels first introduced on the 12-meter yachts that raced for the America’s Cup. • Project is being considered in stages: model testing, prototyping and production • Stage 1 Model testing • Initial cost = $10,000 (t=0) • Probability of success = 60% • Salvage value = $0

3. Yoran Yacht Company • Stage 2: Two Prototype Boats • Costs = $500,000 (t=1) • Probability of success = 80% • Salvage value if unsuccessful = $100,000 (t=2) • Stage 3: Production • Costs = $1,000,000 (t=2) • Expected cash flows • If economy is strong, $3,000,000 for two years (t=3 & 4) • If economy is weak, $500,000 for two years (t=3 & 4) • Equal probability of strong or weak economy (50% chance) • Cost of capital is 12%

4. Traditional capital budgeting • Calculate the expected value of the cash flows in years 3 and 4 • Calculate the NPV of the project, based on the assumption that you do all stages. • Should the project be accepted?

5. Decision tree method • Draw the tree • Calculate the joint probabilities and NPV for each alternative branch of the decision tree. • How can this method be used to assess option value? • How can this method be used to assess risk?

6. Calculating joint probabilities • Multiply the probabilities together as you move out a specific branch of the decision tree. • Sum of the joint probabilities = 1.0

7. Complete the decision tree

8. Calculating Expected NPV • Multiply joint probability times NPV of specific branch • Sum the weighted average NPVs for all branches • Is there a benefit to “staging” the project?

9. Valuing a delay option • Suppose Yoran Yacht decided to wait one year between prototyping and full production. Is there a value in this delay option? • Should the modeling stage and prototype stage cash flows be considered?

10. Valuing the delay option • By delaying production, Yoran Yacht can assess economic conditions. • If the economy is strong, build the boats • If the economy is weak, do not. • What is the value of the delay option? • Are there business risks associated with the delay?