Real Options in Project Evaluation: Project Timing Stephen Gray Campbell R. Harvey

NPV and Real Options n NPV: –Often misapplied –Ignores strategic values if misapplied n Real Option Valuation: –Values contingencies in project outcomes (i.e., alternative future uses of the asset).

Project Timing Example n A company has the opportunity to build a new power project in a foreign country. n Net cash flows are $100mm in the first year of operation.

Project Timing Example n Net cash flows in the second year of operation depend upon whether the government sponsors a link to bypass a transmission “bottleneck”. n This is an example of political risk.

Project Timing Example n If the link goes ahead, demand for power from the new plant will be low and net cash flow will be $80 mm. n If the link does not go ahead, demand for power from the new plant will be high and net cash flow will be $125 mm. n Similar uncertainty surrounds Year 3 net cash flows. n Cash flows beyond Year 3 are perpetual.

Expected Net Cash Flow

Expected Net Cash Flow...

Case 1 n Now or never. n Cost to build is 1,100. n NPV=1, ,100 = -56. n Negative NPV. n Reject the project.

Case 2 n Now or never. n Cost to build is 1,000. n NPV=1, ,000 = +44. n Positive NPV. n Accept the project.

Case 3 n Option to delay for one year. n During this one-year delay, the generator learns whether or not the new entrepreneurial link will proceed. n Based on this additional information, a “smarter” decision can be made. n Cost to build is 1,100.

Expected Net Cash Flow in “up” state Expected Net Cash Flow in “down” state... “up” state “down” state 0.5

Expected Net Cash Flow in “up” state...

Expected Net Cash Flow in “down” state...

Case 3 (con’t) n Option to delay for one year. n Cost to build is 1,100. n Wait one year: –proceed if “up state”, NPV=177. –reject if “down state”, NPV=0. n Expected NPV today is:

Case 4 n Option to delay for one year. n Cost to build is 1,000. n If we build now, NPV 0 = 44. n What if we wait one year?

Case 4 n Wait one year: –proceed if “up state”, NPV=277. –reject if “down state”, NPV=0. n Expected NPV today is:

Conclusions n The option to delay can be valuable, even if the project has positive NPV if started immediately. n The value of these options is ignored by standard DCF techniques. n Proper analysis of these options is needed not just for project valuation, but also for project timing.

Case 5 - Abandonment n Plant can be abandoned at any time for 800. n This option will be exercised whenever the PV of future cash flows falls below 800. n This only happens at the lowest node, where perpetual cash flows are 64.

Yearly Cash Flows One-time Liquidation Value

Case 5 (con’t) n When the abandonment option is incorporated, the NPV of building the project now is +77. n The NPV of waiting for one year is n It is still optimal to delay for one year in this case, although the incremental value of delaying has decreased. n The value of the option to delay is lower if it is easy to exit a bad investment.