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Real Options: Timing, Abandonment, Growth, Flexibility

Learn about real option analysis and how it incorporates NPV capital budgeting analysis with opportunities resulting from managers' responses to changing circumstances.

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Real Options: Timing, Abandonment, Growth, Flexibility

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  1. Valuing Real Options in Projects Timing Option Abandonment/Shutdown Option Growth Option Flexibility Option Chapter 13Real Options and Other Topics in Capital Budgeting

  2. INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY What is real option analysis? Real Option: The right 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.

  3. INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY What are some examples of real options? Investment timing options Abandonment/shutdown options Growth/expansion options Flexibility options

  4. Real options can affect the size of a project's expected NPV but not project's risk as measured by the standard deviation or coefficient of variation of the NPV. a. True b. False

  5. INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY Investment Timing Option Project X has an upfront 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.

  6. INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY 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 = 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?

  7. INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY Investment Timing Decision Tree -$100,000 43,500 43,500 43,500 43,500 50% prob. -$100,000 23,500 23,500 23,500 23,500 50% prob. Years 0 1 2 3 4 5 • 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.

  8. INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY 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.

  9. INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY What is the value of this option? then Option value=zero

  10. INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY Issues to Consider with Investment Timing Options • 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

  11. INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY 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.

  12. 13-6

  13. Which one of the following is NOT a real option? a. The option to expand production if the product is successful. b. The option to buy shares of stock if its price is expected to increase. c. The option to expand into a new geographic region. d. The option to abandon a project if cash flows turn out to be lower than expected. e. The option to switch the type of fuel used in an industrial furnace to lower the cost of production.

  14. INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY Abandonment/Shutdown Option If the firm’s project has an abandonment option that allows the project to be stopped before the end of its physical life, this can increase expected profitability and lower risk.

  15. INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY Abandonment/Shutdown Option 0 1 2 3 10% -$200,000 80,000 80,000 80,000 NPV = -$1,051.84 Project Y has an initial, upfront cost of $200,000, at t = 0. 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?

  16. INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY 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.

  17. INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY Abandonment Decision Tree -$200,000 150,000 150,000 150,000 60% prob. -$200,000 -25,000 -25,000 -25,000 40% prob. 0 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.

  18. INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY 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.

  19. INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY NPV with Abandonment Option -$200,000 150,000 150,000 150,000 60% prob. -$200,000 -25,000 0 0 40% prob. 0 1 2 3 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.

  20. INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY 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.

  21. 13-4

  22. INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY Growth Option 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. 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.

  23. INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY NPV with the Growth Option -$500,000 $3,000,000 100,000 100,000 100,000 100,000 100,000 10% prob. -$1,000,000 -$500,000 100,000 100,000 100,000 100,000 100,000 90% prob. 0 1 2 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

  24. INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY 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.

  25. Abandonment option problem: Tamdeen is considering building a new mall at a cost of $10 million at t = 0. The after-tax cash flows the mall generates will depend on whether the state imposes a new income tax, and there is a 50-50 chance the tax will pass. If it passes, after-tax cash flows will be $1.875 million per year for the next 5 years. If it doesn't pass, the after-tax cash flows will be $3.75 million per year for the next 5 years. The project's WACC is 11.0%. If the tax is passed, the firm will have the option to abandon the project 1 year from now, in which case the property could be sold to net $6.5 million after tax at t = 1. What is the value (in thousands) of this abandonment option?

  26. Growth option problem 1: Tutor.com is considering a plan to develop an online finance tutoring package that has the cost and revenue projections shown below. One of Tutor's larger competitors, Online Professor (OP), is expected to do one of two things in Year 5: (1) develop its own competing program, which will put Tutor's program out of business, or (2) offer to buy Tutor's program if it decides that this would be less expensive than developing its own program. Tutor thinks there is a 35% probability that its program will be purchased for $6 million and a 65% probability that it won't be bought, and thus the program will simply be closed down with no salvage value. What is the estimated net present value of the project (in thousands) at a WACC = 10%, giving consideration to the potential future purchase?

  27. Growth option problem 2: Chrustuba Inc. is evaluating a new project that would cost $9 million at t = 0. There is a 50% chance that the project would be highly successful and generate annual after-tax cash flows of $6 million during Years 1, 2, and 3. However, there is a 50% chance that it would be less successful and would generate only $1 million for each of the 3 years. If the project is highly successful, it would open the door for another investment that will cost $10 million at the end of Year 2, and this new investment could be sold for $20 million at the end of Year 3. Assuming a WACC of 10.0%, what is the project's expected NPV (in thousands) after taking into account this growth option?

  28. INTRO REAL OPTIONS TIMING ABANDONMENT GROWTH FLEXIBILITY Flexibility Options Flexibility options exist when it’s worth spending money today, which enables you to maintain flexibility down the road.

  29. Examples • BMW’s South Carolina auto assembly plant: • It was planned to produce only sports coupes • BMW decided to spend additional money to construct a more flexible plant • Later, demand for coupes dropped, while the demand for convertibles soared • Power companies began to build higher-cost but more flexible plants to permit switching from oil to gas and back again depending on relative fuel prices. • Flexibility options do have costs, but those costs can be compared with the calculated values of the options.

  30. Post-Audit • Post-audit is: • Comparing actual results versus those forecasted for the project • Explaining any possible differences • Benefits: • Improve forecasts • Improve operations

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