Copyright © 2001 by Harcourt, Inc.All rights reserved. CHAPTER 13 Other Topics in Capital Budgeting Evaluating projects with unequal lives Evaluating projects with embedded options Valuing real options in projects

Copyright © 2001 by Harcourt, Inc.All rights reserved. S and L are mutually exclusive and will be repeated. k = 10%. Which is better? Expected Net CFs YearProject SProject L 0($100,000) 1 59,000 33, ,000 33, , ,500

Copyright © 2001 by Harcourt, Inc.All rights reserved. SL CF ,000 CF 1 59,00033,500 NjNj 24 I10 NPV2,3976,190 Q. NPV L > NPV S. Is L better? A. Can’t say. Need replacement chain analysis.

Copyright © 2001 by Harcourt, Inc.All rights reserved. Note that Project S could be repeated after 2 years to generate additional profits. Use replacement chain to calculate extended NPV S to a common life. Since S has a 2-year life and L has a 4-year life, the common life is 4 years.

Copyright © 2001 by Harcourt, Inc.All rights reserved. L: S: % 33, % 59, , ,000 59, ,000 NPV L = $6,190 (already to Year 4) NPV S = $4,377 (on extended basis) -100, ,000

Copyright © 2001 by Harcourt, Inc.All rights reserved. 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 the project’s life. Real option analysis incorporates typical NPV budgeting analysis with an analysis for opportunities resulting from managers’ decisions.

Copyright © 2001 by Harcourt, Inc.All rights reserved. What are some examples of real options? Investment timing options Abandonment/shutdown options Growth/expansion options Flexibility options

Copyright © 2001 by Harcourt, Inc.All rights reserved. An Illustration of Investment Timing Options If we proceed with Project L, its NPV is $6,190. (Recall the up-front cost was $100,000 and the subsequent CFs were $33,500 a year for four years). However, if we wait one year, we will find out some additional information regarding output prices and the cash flows from Project L.

Copyright © 2001 by Harcourt, Inc.All rights reserved. Investment Timing (Continued) If we wait, 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. If we wait, the up-front cost will remain at $100,000.

Copyright © 2001 by Harcourt, Inc.All rights reserved. Investment Timing Decision Tree 50% prob Years -$100,000 43,500 43,500 43,500 43,500 -$100,000 23,500 23,500 23,500 23,500 At 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.

Copyright © 2001 by Harcourt, Inc.All rights reserved. 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) = $18,944.58, which is worth $18,944.58/(1.10) = $17, in today’s dollars (assuming a 10% discount rate). Therefore, it makes sense to wait.

Copyright © 2001 by Harcourt, Inc.All rights reserved. Issues to Consider What’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 subse- quent 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,

Copyright © 2001 by Harcourt, Inc.All rights reserved. Factors to Consider When Deciding 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.

Copyright © 2001 by Harcourt, Inc.All rights reserved. Abandonment/Shutdown Option Project 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? (More…) $200,000 80,00080,000 80,000 k = 10% NPV = -$1,051.84

Copyright © 2001 by Harcourt, Inc.All rights reserved. Abandonment/Shutdown (continued) Project 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 cash flows of $150,000, and a 40% chance it will produce annual A-T cash flow of -$25,000.

Copyright © 2001 by Harcourt, Inc.All rights reserved. -$200,000 Abandonment/Shutdown Decision Tree 60% prob. 40% prob Years 0 150, , , , , ,000 k = 10% If the customer uses the product, NPV is $173, If the customer does not use the product, NPV is -$262, E(NPV) = 0.6(173,027) + 0.4(-262,171) = -1,

Copyright © 2001 by Harcourt, Inc.All rights reserved. Abandonment/Shutdown (continued) Company does not have the option to delay the project. 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.

Copyright © 2001 by Harcourt, Inc.All rights reserved. NPV with the Abandonment Option If the customer uses the product, NPV is $173, If the customer does not use the product, NPV is -$222, E(NPV) = 0.6(173,027) + 0.4(-222,727) = 14, $200,000 60% prob. 40% prob Years 150, , , ,000 k = 10% 0

Copyright © 2001 by Harcourt, Inc.All rights reserved. Is 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.

Copyright © 2001 by Harcourt, Inc.All rights reserved. Growth Option Project 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.

Copyright © 2001 by Harcourt, Inc.All rights reserved. 100, , ,000100, ,000 NPV with the Growth Option -$500,000 10% prob. 90% prob Years 0 100, , , , ,000 -$1,000,000 $3,000,000 At k = 12%, NPV of top branch (w / 10% prob.)= $1,562, NPV of bottom branch (w / 90% prob.)= -$ 139,

Copyright © 2001 by Harcourt, Inc.All rights reserved. NPV with the Growth Option (cont’d) If it turns out that the project has future opportunities with a negative NPV, the company would choose not to pursue them. Therefore, the NPV of the bottom branch should include only the -$500,000 initial outlay and the $100,000 annual cash flows, which lead to an NPV of -$139,

Copyright © 2001 by Harcourt, Inc.All rights reserved. NPV with the Growth Option (cont’d) Thus, the expected value of this project should be: NPV= 0.1($1,562,758) + 0.9(-$139,522) = $30,706.

Copyright © 2001 by Harcourt, Inc.All rights reserved. Flexibility Options Flexibility options exist when it’s worth spending money today, which enables you to maintain flexibility down the road.