REAL OPTIONS & OTHER

TOPICS IN CAPITAL BUDGETING

RAFI DEVIANA

( 150810301045 )

CHETRIN DESTI E.

( 150810301128 )

I D AT U L F I T R I A

( 150810301129 )

VELIA MONICA

( 150810301148 )

WHAT IS REAL OPTION ANALYSIS?

Real options exist when managers can influence the size and
riskiness of a projects cash flows by taking different actions
during the projects life.
Real option analysis incorporates typical NPV budgeting analysis
with an analysis for opportunities resulting from managers
decisions.

WHAT ARE SOME EXAMPLES OF

REAL OPTIONS?

Investment timing options

Abandonment/shutdown options
Growth/expansion options
Flexibility options

INVESTMENT TIMING OPTIONS

ABANDONMENT/SHUTDOWN
OPTION
The option of stopping a project if operating cash
flows turn out to be lower that expected.

EXAMPLE
Suppose GRE is considering another project and it is negotiating with a key supplier regarding the
cost and availability of electricity. Typically, the utility requires a guarantee for the purchase of a
minimum amount of power before it will bring in the required lines because it wants assurance that
its investment will not be stranded. The result is that if GRE undertakes the project, GRE will be
forced to operate the project for its full 4-year life.
The initial investment would be $1 million at t = 0. Three possible outcomes are considered:
(1) A best-case outcome
(2) a base-case (or average) outcome with the cash flows
(3) a worst-case outcome with annual losses
There is a 50% probability of the base-case results and a 25% probability of both the best-case and
worst-case outcomes. Initially, the project was considered to have a relatively low risk, so its cost
of capital is 10%.

ABANDONMENT/SHUTDOWN OPTION
Project Y has an initial, up-front cost of $200,000, at t =
0.
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 Ys NPV?
0

k = 10%1

-$200,000

80,000

NPV = -$1,051.84

2
80,000

3
80,000

ABANDONMENT OPTION
Project Ys 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 net CFs of $150,000, and a 40% chance
it will produce annual net CFs of -$25,000.

ABANDONMENT OPTION
150,000
60% prob.
-$200,000
40% prob.
0

150,000

-25,000
1

-25,000
2
Years

o If the customer uses the product,

NPV = $173,027.80.
o If the customer does not use the product,
NPV = -$262,171.30.
o E(NPV) = 0.6(173,027.8) + 0.4(-262,171.3)
= -1,051.84

150,000
-25,000
3

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.

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.

GROWTH OPTION

Anheuser-Buschs investment strategy in

South America illustrates a growth option.
Another example is a strategic investment such
as a new process fordesalinating seawater.
Suppose GRE Inc. is considering the investment
shown in

Part I
looks at the investment without considering an
embedded real
option to expand the project. GRE would invest $3
million at Time 0.
Because this is considered a relatively risky
investment, a WACC of 12% is used. There is a
50% probability of success, in which case the
project will yield positive cash inflows of $1.5
million per year for 3 years.
There is also a 50% probability of poor results, in

Part II, where we recognize the existence of the

growth option. The firm would know if conditions are
good at the end of Year 1, so it would then invest
another $1 million to expand at Time 2. The expansion
would produce cash flows on out in future years; and
the present value of those flows, at the end of Year 3,
is estimated to be $5 million.

Part III shows the option value, which is the additional

value of the project if the option exists. If the
expected NPV of the project with and without the
option is positive, as it is in our example, the value of
the option will be the additional NPV resulting from
the option: Value of option Expected NPV with
option Expected NPV without option

NPV WITH THE GROWTH OPTION

Part I

1500,000

50% prob.

1100,000

50% prob.
0

1500,000

$3,000,000
1500,000

1100,000

-$3,000,000
1100,000

3
Years

At k = 12%,
NPV of top or good branch (50% prob) = $603.000
NPV of lower or bad branch (50% prob) = -$358.000

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.
Thus, the expected value of this project should be:
NPV = 0.5($3364) + 0.5(-$358)
= $1503

FLEXIBILITY OPTIONS
Flexibility options exist when its worth spending
money today, which enables you to maintain
flexibility down the road.

EVALUATING PROJECTS WITH UNEQUAL

LIVES

Part I shows a negative expected NPV if demand for the

productsay, sedansturns out to below. However, as we see
in

Part II, if the plant is sufficiently flexible to switch production

to another productsay, convertiblesthe expected NPV will
be positive. The setup would be similar if we were analyzing
input flexibilitysay, aswitch from oil to natural gas if oil
prices rose more than gas prices. Flexibility options do have
costs, but those costs can be compared with the calculated
values of the options.

EVALUATING PROJECTS WITH UNEQUAL

LIVES
Projects S and L are mutually exclusive, and will be repeated. If k
= 10%, which is better?

Year
0
1
2
3
4

Expected Net CFs

Project S
Project L
($100,000)
($100,000)
59,000
33,500
59,000
33,500
33,500
33,500s

SOLVING FOR NPV,

WITH NO REPETITION
Enter CFs into calculator CFLO register for both
projects, and enter I/YR = 10%.
NPVS = $2,397
NPVL = $6,190
Is Project L better?
Need replacement chain analysis.

SOLVING FOR NPV,

WITH NO REPETITION

REPLACEMENT CHAIN
o Use the replacement chain to calculate an extended
NPVS to a common life.
o Since Project S has a 2-year life and L has a
4-year life, the common life is 4 years.
0

10%

-100,000

59,000
59,000
-100,000
-41,000

3
59,000

NPVS = $4,377 (on extended basis)

4
59,000

THE OPTIMAL CAPITAL BUDGED

For planning
The treasures estimated the firms overall
composite WACC at diffe
purposes,
managers must
also forecast the
total capital
budget because
the amount of
capital raised
affects the
WACC

THE POST-AUDIT
(1)comparing actual results with those predicted by the
projects sponsors and
(2)explaining why any differences occurred
Main purpose of the post-audit :
1. Improve forecast
2. Improve operatons