Chapter 13.

Real Options and Other Topics in Capital Budgeting 1/06/09

In this model we examine four types of real options: Growth, Abandonment, Timing, and Flexibility. We
also analyze a procedure for determining the optimal size of the capital budget.

Figure 13-1. Analysis of a Growth Option (Dollars in Thousands)

Part I. Project without the Growth Option

Cash Flow At End of Period NPV@
Outcome Prob. 0 1 2 3 12%
Good 50% -$3,000 $1,500 $1,500 $1,500 $603
Bad 50% -$3,000 $1,100 $1,100 $1,100 -$358
Expected NPV $122
Standard Deviation (σ) $480
Coefficient of Variation = CV = σ / Expected NPV 3.93

Part II. Project with the Growth Option:

Cash Flow At End of Period NPV@
0 1 2 3 12%
Cash flows, initial investment -$3,100 $1,500 $1,500 $1,500
Cash flows, growth investment -$1,000 $5,000
Good 50% -$3,000 $1,500 $500 $6,500 $3,364
Bad 50% -$3,000 $1,100 $1,100 $1,100 -$358
Expected NPV $1,503
Standard Deviation (σ) $1,861
Coefficient of Variation = CV = σ / Expected NPV 1.24

Part III. Value of the Option NPV considering the growth option $1,503
NPV not considering the growth option $122

Value of the option: If NPV without option is negative, value of option = NPV with option.
Otherwise, value of option = NPV with option – NPV without option: $1,381
Figure 13-2. Abandonment Option (Dollars in Thousands) 1/06/09

Part I. Cannot Abandon

Cash Flow At End of Period NPV @
Prob. 0 1 2 3 4 10%
Best Case 25% -$1,000 $400 $600 $800 $1,300 $1,348
Base Case 50% -$1,000 $200 $400 $500 $600 $298
Worst Case 25% -$1,000 -$280 -$280 -$280 -$280 -$1,888
Expected NPV $14
Standard Deviation (σ) $1,179
Coefficient of Variation = CV = σ / Expected NPV 83.3

Part II. Can Abandon

Cash Flow At End of Period NPV @
Prob. 0 1 2 3 4 10%
Best Case 25% -$1,000 $400 $600 $800 $1,300 $1,348
Base Case 50% -$1,000 $200 $400 $500 $600 $298
Worst #1 0% -$1,000 -$280 -$280 -$280 -$280 -$1,888 Don't Use
Worst #2 25% -$1,000 -$280 $200 $0 $0 -$1,089 Use
Expected NPV $214
Standard Deviation (σ) $866
Coefficient of Variation = CV = σ / Expected NPV 4.1

Part III. Value of the Option

NPV considering the abandonment option $214
NPV not considering the abandonment option $14

Value of the option: If NPV without option is negative, value of option = NPV
with option. Otherwise, value of option = NPV with option - NPV without option. $200
Figure 13-3. Analysis of a Timing Option (Dollars in Thousands) 1/06/09

Part I. Project without the Timing Option

Cash Flow At End of Period NPV@
Outcome Prob. 0 1 2 3 12%
Good 50% -$3,000 $2,000 $2,000 $2,000 $1,804
Bad 50% -$3,000 $450 $450 $450 -$1,919
Expected NPV -$58
Standard Deviation (σ) $1,861
Coefficient of Variation = CV = σ / Expected NPV -32.23

Part II. Delay the Decision Until We Know the Market Conditions
Cash Flow At End of Period NPV@
0 1 2 3 12%
Good 50% $0 -$3,000 $2,000 $2,000 $339
Bad 50% $0 $0 $0 $0 $0
Expected NPV $170
Standard Deviation (σ) $170
Coefficient of Variation = CV = σ / Expected NPV 1.00

Part III. Value of the Option NPV considering the growth option $170
NPV not considering the growth option -$58
Value of the option: If NPV without option is negative, value of option = NPV with option.
Otherwise, value of option = NPV with option - NPV without option. $170

Note: Under the Delay situation, we must find the NPV as of t = 0. If we set the cash flow for t = 0 at $0,
then using a calculator or Excel we automatically find the t = 0 NPV. However, if we let PV = -3000, PMT
= 2000, N = 2, and I = 12, we get an NPV = $380 under the Good outcome and an expected NPV of $190.
Note, though, that these NPVs are as of t = 1, so we must discount them back one year at 12% to
achieve comparability and get the correct answer.
Figure 13-4. Flexibility Option (Dollars in Thousands) 1/06/09

Part I. Project without the Flexibility Option Cash Flow at End of Period NPV@
0 1 2 3 12%
Strong demand 50% -$5,000 $2,500 $2,500 $2,500 $1,005
Weak demand 50% -$5,000 $1,500 $1,500 $1,500 -$1,397
Expected NPV -$196

Part II. Project with the Flexibility Option Cash Flow at End of Period NPV@
0 1 2 3 12%
Strong demand 50% -$5,100 $2,500 $2,500 $2,500 $905
Weak demand Switch products 50% -$5,100 $1,500 $2,250 $2,250 -$366
Expected NPV $270

Part III. Value of the Option NPV with the option $270
NPV without the option -$196
Value of the option: If NPV without option is negative, value of option = NPV with option.
Otherwise, value of option = NPV with option – NPV without option. $270
Figure 13-5. Optimal Capital Budget: Marginal IRR = Marginal WACC 1/06/09

WACC
30%& IRR

25%

20% WACC

15%

10%

IRR
5%

0%
$100 $600 $1,100 $1,600 $2,100
Capital Budget

Project: Cost Cum Cost WACC IRR:

1 $100 $100 10.0% 25.0%
2 $100 $200 10.0% 24.0%
3 $100 $300 10.0% 23.0%
4 $100 $400 10.0% 22.0%
5 $100 $500 10.0% 21.0%
6 $100 $600 10.0% 20.0%
7 $100 $700 10.5% 19.0%
8 $100 $800 11.0% 18.0%
9 $100 $900 11.5% 17.0%
10 $100 $1,000 12.0% 16.0%
11 $100 $1,100 12.5% 15.0%
12 $100 $1,200 13.0% 14.0%
13 $100 $1,300 13.5% 13.0%
14 $100 $1,400 14.0% 12.0%
15 $100 $1,500 14.5% 11.0%
16 $100 $1,600 15.0% 10.0%
17 $100 $1,700 15.5% 9.0%
18 $100 $1,800 16.0% 8.0%
19 $100 $1,900 16.5% 7.0%
20 $100 $2,000 17.0% 6.0%
21 $100 $2,100 17.5% 5.0%
22 $100 $2,200 18.0% 4.0%
23 $100 $2,300 18.5% 3.0%
SECTION 13-3
SOLUTIONS TO SELF-TEST QUESTIONS

2. Suppose a project's expected "cannot abandon" NPV is -$14 and its "can
abandon" expected NPV is $214. How much is the abandonment option worth?

"Cannot abandon" NPV -$14

"Can abandon" NPV $214

Value of abandonment option $214