Chapter 13 Real Options and Other Topics in Capital Budgeting Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1 Valuing Real Options in Projects • Timing Option • Abandonment/Shutdown Option • Growth Option • Flexibility Option Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2 What 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 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. Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 3 What are some examples of real options? • Investment timing options • Abandonment/shutdown options • Growth/expansion options • Flexibility options Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 4 Investment Timing Option (1 of 2) • Project X has an upfront after-tax cost of $100,000. The project is expected to produce after-tax 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 after-tax cash flows. Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 5 Investment Timing Option (2 of 2) • If they wait a year: • There is a 50% chance the market will be strong and the expected after-tax cash flows will be $43,500 a year for four years. • There is a 50% chance the market will be weak and the expected after-tax cash flows will be $23,500 a year for four years. • The project’s initial after-tax 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? Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 6 Investment Timing Decision Tree • At WACC = 10%, the NPV at t = 1 is: • $37,889, if CFs are $43,500 per year, or • −$25,508, if CFs are $23,500 per year, in which case the firm would not proceed with the project. Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 7 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. Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 8 Issues to Consider with Investment Timing Options • What is the appropriate discount rate? • Note that increased volatility makes the option to delay more attractive. • If instead, there was a 50% chance the subsequent after-tax CFs will be $53,500 a year, and a 50% chance the subsequent after-tax 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 Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 9 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. Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10 Abandonment/Shutdown Option • Project Y has an initial, upfront after-tax cost of $200,000, at t = 0. The project is expected to produce after-tax cash flows of $80,000 for the next three years. • At a 10% WACC, what is Project Y’s NPV? Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 11 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 annual after-tax CFs of $150,000, and a 40% chance it will produce annual after-tax CFs of −$25,000. Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 12 Abandonment Decision Tree • If 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 Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 13 Key Assumptions • 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. Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 14 NPV with Abandonment Option • 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. E(NPV) 0.6($173,027.8) 0.4( $222,727.27) $14,725.77 Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 15 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. Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 16 Growth Option • Project Z has an initial after-tax cost of $500,000. • The project is expected to produce after-tax 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. Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 17 NPV with the Growth Option (1 of 3) Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 18 NPV with the Growth Option (2 of 3) • Since the NPV of first 5 years of after-tax CFs for this outcome has a negative NPV, then second phase with a negative NPV will not be done. • At WACC = 12%, • NPV of top branch (10% prob.) = $1,562,758.19 • NPV of lower branch (90% prob.) = −$139,522.38 Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 19 NPV with the Growth Option (3 of 3) • 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 after-tax outlay and the $100,000 annual after-tax 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. Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 20 Flexibility Options • Flexibility options exist when it’s worth spending money today, which enables you to maintain flexibility down the road. Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 21
