CHAPTER 12 Other Topics in Capital BudgetingEvaluating projects with unequal livesSolving for NPV, with no repetitionReplacement chainWhat is real option analysis?What are some examples of real options?Illustrating an investment timing optionInvestment timing decision treeShould we wait or proceed?Issues to consider with investment timing optionsFactors to consider when deciding when to investAbandonment/shutdown optionAbandonment optionAbandonment decision treeIssues with abandonment optionsNPV with abandonment optionIs it reasonable to assume that the abandonment option does not affect the cost of capital?Growth optionNPV with the growth optionSlide 20Flexibility options12-1CHAPTER 12Other Topics in Capital BudgetingEvaluating projects with unequal livesIdentifying embedded optionsValuing real options in projects12-2Evaluating projects with unequal livesProjects S and L are mutually exclusive, and will be repeated. If k = 10%, which is better? Expected Net CFsYear Project S Project L 0 ($100,000) ($100,000) 1 59,000 33,500 2 59,000 33,500 3 - 33,500 4 - 33,50012-3Solving for NPV, with no repetitionEnter CFs into calculator CFLO register for both projects, and enter I/YR = 10%.NPVS = $2,397NPVL = $6,190Is Project L better?Need replacement chain analysis.12-4-100,000 59,000 59,000 59,000 59,000 -100,000 -41,000Replacement chainUse 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 4 years.0 1 2 310%4NPVS = $4,377 (on extended basis)12-5What 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.12-6What are some examples of real options?Investment timing optionsAbandonment/shutdown optionsGrowth/expansion optionsFlexibility options12-7Illustrating an investment timing optionIf 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.12-8Investment timing decision treeAt k = 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.50% prob.50% prob.0 1 2 3 4 5Years -$100,000 43,500 43,500 43,500 43,500-$100,000 23,500 23,500 23,500 23,50012-9Should 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% discount rate).Therefore, it makes sense to wait.12-10Issues to consider with investment timing optionsWhat’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 > $18,944.5712-11Factors to consider when deciding when to investDelaying 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.12-12Abandonment/shutdown optionProject 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 Y’s NPV?0 1 2 3-$200,000 80,000 80,000 80,000k = 10%NPV = -$1,051.8412-13Abandonment optionProject 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 -$25,000.12-14Abandonment decision treeIf 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-$200,00060% prob.40% prob.1 2 3Years0 150,000 150,000 150,000-25,000 -25,000 -25,00012-15Issues with abandonment optionsThe 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.12-16NPV with abandonment optionIf 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-$200,00060% prob.40% prob.1 2 3Years0 150,000 150,000 150,000-25,00012-17Is 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.12-18Growth optionProject 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 = 5.12-19NPV with the growth option100,000 100,000 100,000 100,000 100,000-$500,00010% prob.90% prob.1 2 3 4 5Years0100,000 100,000
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