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- 1. Options
- 2. Real Options • Managers have options to adapt and revise decisions. • Flexibility is valuable. • Value of flexibility should be accounted for.
- 3. Real Options and Financial Options • Option Definition – the right (but not the obligation) , to buy/sell an underlying asset at a price (the exercise price) that maybe different than the market price. Real Options Vs. Financial Options Not traded on an exchange. The underlying asset is something other than a security Options on stocks, stock indices, foreign exchange, gold, silver, wheat, etc.
- 4. Real Options • Identification – Are there real options imbedded in this project? – What type of options? • Valuation – How do we value options? – How do we value different types of options? – Can’t we just use NPV?
- 5. Identifying Real Options • Value • Almost always exist • Art: – Identify options that are “significant” – Ignore options that are not • Identifying real options takes practice, and some times “vision”.
- 6. Identifying Real Options • 4 types 1. Growth 2. Abandon 3. Investment Timing 4. Switch • Key elements – Information will arrive in the future – Decisions can be made after the information
- 7. Options vs. DCF • DCF method: – “expected scenario” of cash flows – Discount the expected cash flows • DCF is fine – as long as – – Expected cash flows are estimated properly – Discount rates are estimated properly • Complex options make it difficult to estimate
- 8. Start with “Static” DCF Analysis • Begin by valuing project with no options – Pretend the investment decision must be taken immediately. • This benchmark constitutes a lower bound for the project’s value. – NPV < 0 – Does not mean: • – NPV > 0 – Does not mean: • •
- 9. Growth Option (1) • A company is considering a project that 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 5 years, and has a WACC of 12%. • Should they take the project?
- 10. Growth Option (1) • 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.
- 11. NPV with the Growth Option • At WACC = 12%, – – • Project NPV – 100,000 100,000 100,000 100,000 100,000 -$500,000 10% prob. 90% prob. 1 2 3 4 5 Years0 100,000 100,000 100,000 100,000 100,000 -$1,000,000 $3,000,000
- 12. Growth Option (2) • Suppose GRE Inc is considering a $3M investment. There is a 50% probability of success in which case they will earn 1.5M for 3 years. And, there is a 50% probability of poor results in which case they will earn only $1.1 for 3 years. It is considered to be a relatively risky investment with a WACC of 12%. What is the NPV of this project?
- 13. Growth Option (2) • However, if the plan is successful at the end of the first year, then GRE Inc could invest another $1M at the end of the first year. This additional investment is expected to yield an additional cash flow of $5 the following year. What is the value of the growth option?
- 14. Part I - Project without the Growth Option Outcome Prob. 0 1 2 3 NPV Good 50% -3 1.5 1.5 1.5 $0.603 Bad 50% -3 1.1 1.1 1.1 ($0.358) Expected NPV $0.122 Part II - Project with the Growth Option Initial Investmet -3 1.5 1.5 1.5 Growth Option -1 5 Good 50% -3 1.5 0.5 6.5 $3.364 Bad 50% -3 1.1 1.1 1.1 ($0.358) Expected NPV $1.503 • The value of the option: $
- 15. Abandonment Option • A project has an initial, up-front cost of $200,000. The project is expected to produce cash flows of $80,000 for the next three years. • At a 10% WACC, should we take the project? – The NPV is -1051.84. – No, don’t take the project.
- 16. Abandonment Option • The project’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. Abandonment Decision Tree • If the customer uses the product NPV = $173,027.80. • If the customer does not use the product, NPV is -$262,171.30. • Overall, -$200,000 60% prob. 40% prob. 1 2 3 Years0 150,000 150,000 150,000 -25,000 -25,000 -25,000
- 18. 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. NPV with Abandonment Option • If the customer uses the product, NPV is still $173,027.80. • If the customer does not use the product and it can be abandoned after Year 1, NPV is $222,727.27. • Overall, -$200,000 60% prob. 40% prob. 1 2 3 Years0 150,000 150,000 150,000 -25,000
- 20. Should an abandonment option affect a project’s WACC?
- 21. Investment Timing Option • A company is considering a project that has an up-front 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. The project has a WACC = 10%. • Should they take the project now? • However, if the company waits a year they will find out more information.
- 22. 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?
- 23. Investment Timing Decision Tree • 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. 50% prob. 50% prob. 0 1 2 3 4 5 Years -$100,000 43,500 43,500 43,500 43,500 -$100,000 23,500 23,500 23,500 23,500
- 24. Should we wait or proceed?
- 25. 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.

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