The document discusses different types of real options that can be embedded in investment projects: 1) Growth options provide flexibility to invest further if initial projects are successful. 2) Abandonment options allow projects to be terminated if outcomes are poor, limiting downside losses. 3) Timing options give the flexibility to delay investments until more information is known. 4) Switching options permit changing project scope in response to new opportunities or conditions. Real options add value over traditional DCF analysis by accounting for management's ability to adapt plans based on future uncertainties and information. Properly identifying and valuing these options leads to more accurate investment evaluations.

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.