Chapter 14

Real Options and

Other Topics in Capital Budgeting
Learning Objectives
After reading this chapter, the student should be able to:
Explain what real options are, how they influence capital budgeting, and how they can be analyzed.
Discuss how projects N!s are affected by the size of the fir"s total capital budget and how to deal
with this situation.
Describe the post#audit, which is an i"portant part of the capital budgeting process, and discuss its
rele$ance in capital budgeting decisions.
Chapter 13: Real Options Learning Objectives 109
Lecture uggestions
%his chapter co$ers so"e i"portant but relati$ely technical topics. Note too that this chapter is "ore
"odular than "ost, i.e., the "ajor sections are discrete, hence they can be o"itted without loss of
continuity. %herefore, if you are experiencing a ti"e crunch, you could s&ip sections or e$en the entire
chapter.
'hat we co$er, and the way we co$er it, can be seen by scanning the slides and (ntegrated )ase
solution for )hapter *+, which appears at the end of this chapter solution. ,or other suggestions about the
lecture, please see the -.ecture /uggestions0 in )hapter 1, where we describe how we conduct our classes.
!"# O$ C%"&T'R: ( O) *+ !"# ,*0-./$0T' &'R/O!1
110 Lecture Suggestions Chapter 13: Real Options
"ns2ers to 'nd-o3-Chapter 4uestions
14-1 a5 An abandon"ent option is the option to abandoning a project if operating cash flows turn out to
be lower than expected. %his option can both raise expected profitability and lower project ris&,
because in the case of poor cash flows, the project can be ended and rather than continue
realizing negati$e cash flows, fixed assets are sold and so"e cash is reco$ered.
b5 An in$est"ent ti"ing option occurs when a fir" has the option of delaying the start of a project
until additional infor"ation can be obtained. After the delay, if conditions for the project loo&
unfa$orable, the project will not be underta&en, while if conditions are fa$orable then the project
proceeds as usual. 2owe$er, there are so"e drawbac&s to relying on in$est"ent ti"ing
options. ,irst, the ti"ing option should raise N! because the probability of bad returns is less,
but that N! needs to be discounted bac& one additional year. /econd, there "ight be
$aluable -first "o$er0 ad$antages to a project that will be lost if the project is delayed a year.
c5 3rowth options exist if an in$est"ent creates the opportunity to "a&e other potentially profitable
in$est"ents that would not otherwise be possible. A co""on exa"ple of a growth option
occurs when a fir" starts a project in a new country or "ar&et. 'hile the project is hoped to
add $alue fro" its cash flows, it also has $alue because it opens the door to the fir" to operate
in the new country4"ar&et.
d5 A contraction option has the flexibility of being able to reduce production output or to contract
the scale and scope of a project when conditions are not as good as expected. Exercising
contraction will reduce the $alue of the project, but at the sa"e ti"e creating so"e cost
sa$ings.
e5 ,lexibility options per"it the fir" to alter operations depending on how conditions change
during the projects life. %ypically, inputs, outputs, or both can be changed easily to respond to
"ar&et de"ands. ,or exa"ple, instead of building an auto factory that builds a specific type of
car 5co"pact, /6!, etc.7, a "anufacturer can build a factory that allows the building of "any
types of cars. %herefore, as "ar&et de"and and consu"er tastes change the fir" can rapidly
respond.
14-( ,ailure to recognize a growth option i"plies that a project with a negati$e con$entional N! was
rejected despite ha$ing an e"bedded growth option whose consideration would cause the N! to
be positi$e. As a result, failure to recognize the $alue of a growth option i"plies that the capital
budget is below the opti"al le$el since a $alue#adding project 5albeit because of a real option7 has
been rejected. %his argu"ent holds when considering failure to recognize all real options.
14-3 (t "ight be necessary for the fir" to arrange things so that it has the possibility of abandon"ent
when it is "a&ing the initial decision. %his "ight re8uire contractual arrange"ents with suppliers,
custo"ers, and its union, and there "ight be so"e costs to getting the ad$anced per"issions. Any
such costs could be co"pared with the $alue of the option, and this could enter into the initial
decision. (n the case of in$est"ent ti"ing options, the initial in$est"ent "ight grow if the project is
delayed. ,or any type of options, these additional costs "ust be considered in the analysis and the
benefits of the -real option0 "ust outweigh the associated costs.
Chapter 14: Real Options Answers and Solutions 111
14-4 %he co"pany can wait until additional infor"ation can be obtained. After waiting for * year, if
conditions for the project loo& unfa$orable, the project will not be underta&en, while if conditions are
fa$orable then the project proceeds as usual.
14-* ,or large, "ature fir"s with good trac& records we can assu"e that all of its profitable projects can
be financed, but this assu"ption is harder to "a&e for s"aller fir"s, new fir"s, and fir"s with
dubious trac& records "ay ha$e difficulties raising capital, e$en for projects that the fir" concludes
would ha$e positi$e N!s. (n such circu"stances, the size of the fir"s capital budget "ay be
constrained, a situation called capital rationing. (n such situations capital is li"ited, so it should be
used in the "ost efficient way possible. rocedures ha$e been explored for allocating capital so as
to "axi"ize the fir"s aggregate N! subject to the constraint that the capital rationing ceiling is
not exceeded. As a result the greater the capital budget, the greater the need for external
financing, which raises the 'A)).
14-6 %he post#audit is a co"parison of actual $ersus expected results for a gi$en capital project. %he
post#audit has two "ain purposes: 5*7 i"pro$e forecasts and 597 i"pro$e operations.
%he post#audit is not a si"ple, "echanical process. ,irst, we "ust recognize that each
ele"ent of the cash flow forecast is subject to uncertainty: so a percentage of all projects
underta&en by any reasonably aggressi$e fir" will necessarily go awry. %his fact "ust be
considered when the perfor"ances of the operating executi$es who sponsor projects are
appraised. /econd, projects so"eti"es fail to "eet expectations for reasons beyond the control of
their sponsors and for reasons that no one could be expected to anticipate. %hird, it is often difficult
to separate the operating results of one in$est"ent fro" those of a larger syste". ,ourth, it is often
difficult to hand out bla"e or praise because the executi$es who were responsible for launching a
gi$en in$est"ent ha$e "o$ed on by the ti"e the results are &nown.
11( Answers and Solutions Chapter 14: Real Options
olutions to 'nd-o3-Chapter &roble7s
14-1 a5 'A)) ; *9<: cash flows shown in "illions.
= * 9 > N! ? @r. =
11< rob. A A A
B B B C+.+*
#*=
A A A #D.B=
+1< rob. * * *
Expected N! ; =.115C+.+*7 E =.+15#CD.B=7 ; #C=.FF> "illion. %he project would not be done.
b5 (f the project is hugely successful, CF "illion will be spent at the end of @ear 9, and the new
$enture will be sold for C9= "illion at the end of @ear >.
= * 9 > N! ? @r. =
11< rob. A A A
B B B
#F E9= C**.+D
#*= #> 9B
A A A #D.B=
+1< rob. * * *
Expected N! ; =.115C**.+D7 E =.+15#CD.B=7 ; C9.GF= "illion.
c5 !alue of growth option:
N! with option C9.GF= "illion
N! without option # =. FF>
EC > .GG> "illion
14-( %he fir" should accept rojects A, H, ), and D. %he fir"s opti"al capital budget is C>,F==,=== at a
'A)) of *=.G< and it re8uires the fir" to issue new co""on stoc&.
14-3 )ash flows shown in "illions on ti"e line:
= * 9 >
A A A A
#9= D.1 D.1 D.1
N! ; #C*.>+F "illion.
Chapter 14: Real Options Answers and Solutions 113
*=<
'ait * year: cash flows shown in "illions on ti"e line:
= * 9 > + N! ? @r. =
/trong de"and A A A A A
1=< rob. = #9= *= *= *= C+.+9B
'ea& de"and A A A A A
1=< rob. = #9= 1 1 1 #B.GDG
2owe$er, if de"and is wea&, the projects N! is negati$e and therefore would not be underta&en.
%he $alue of this option of waiting one year is e$aluated as =.15C=7 E 5=.175C+.+9B7 ; C9.9*> "illion.
/ince the N! of waiting one year is greater than going ahead and proceeding with the project
today and greater than zero, it "a&es sense to wait.
14-4 a5 N! of abandon"ent after @ear t:
6sing a financial calculator, input the following: ),= ; #991==, ),* ; 9>D1=, and (4@I ; *= to
sol$e for N!* ; #CF=F.=F #CF=F.
6sing a financial calculator, input the following: ),= ; #991==, ),* ; B91=, ),9 ; 9=91=, and
(4@I ; *= to sol$e for N!9 ; #CG9.B+ #CG>.
6sing a financial calculator, input the following: ),= ; #991==, ),* ; B91=, Nj ; 9, ),> ; *D91=,
and (4@I ; *= to sol$e for N!> ; C*,>=D.9F C*,>=D.
6sing a financial calculator, input the following: ),= ; #991==, ),* ; B91=, Nj ; >, ),+ ; **91=,
and (4@I ; *= to sol$e for N!+ ; CD9B.D> CD9D.
6sing a financial calculator, input the following: ),= ; #991==, ),* ; B91=, Nj ; 1, and (4@I ;
*= to sol$e for N!1 ; C*,*F9.+9 C*,*F9.
%he fir" should operate the truc& for > years, N!> ; C*,>=D.
b5 No. Abandon"ent possibilities could only raise N! and (II. %he $alue of the fir" is
"axi"ized by abandoning the project after @ear >.
14-* a5 'A))* ; *9<: 'A))9 ; *9.1<.
/ince each project is independent and of a$erage ris&, all projects whose (II J 'A)) will be
accepted. )onse8uently, rojects A, H, ), D, and E will be accepted and the opti"al capital budget
is C1,91=,===. After accepting projects A, H, and ), all of retained earnings will be used up and
additional e8uity will be raised to fund the re"aining projects, whose 'A))s all exceed *9.1<.
b5 (f rojects ) and D are "utually exclusi$e, the fir" will select roject D, because its N! is
greater than roject )s N!. /o, the opti"al capital budget is C+ "illion, and consists of
rojects A, H, D, and E.
c5 %he appropriate costs of capital are *=.1< for low#ris& projects, *9.1< for a$erage#ris& projects,
and *+.1< for high#ris& projects. /ince roject A is high ris&, it will be rejected 5*+< K *+.1<7.
rojects H, ), D, and E are all a$erage ris& and will be accepted since their returns exceed
*9.1<. rojects , and 3 are low ris& and will both be accepted since their returns exceed
*=.1<. %herefore, the opti"al capital budget is CB "illion and consists of rojects H, ), D, E,
,, and 3.
114 Answers and Solutions Chapter 14: Real Options
*=<
14-6 a5 = * 9 > +
A A A A
A
#G + + + +
N! ; C+.BDF1 "illion.
b5 'ait 9 years:
= * 9 > + 1 B N! ? @r. =
A A A A A A A
*=< rob. = = #F 9.9 9.9 9.9 9.9 #C*.BD+B
A A A A A A A
F=< rob. = = #F +.9 +.9 +.9 +.9 >.1B+G
(f the cash flows are only C9.9 "illion, the N! of the project is negati$e and, thus, would not be
underta&en. %he $alue of the option of waiting two years is e$aluated as =.*=5C=7 E
=.F=5C>.1B+G7 ; C>.9=G> "illion.
/ince the N! of waiting two years is less than going ahead and proceeding with the project
today, it "a&es sense to drill today.
c5 %he in$est"ent ti"ing option has a $alue of C=. /ince the difference between the project with
the option and the project without the option is negati$e, C>.9=G> "illion L C+.BDF1 "illion ;
#C*.+D*9 "illion, the option will not be exercised. (n other words, the costs of delaying the
project outweigh the benefits gained by delaying and gathering "ore infor"ation.
d5 %here is a danger that oil prices will decline causing the co"pany to recei$e less re$enue for
the oil it extracts, and there is a danger that the co"pany will lose "ar&et share or the chance
to co"pete for new contracts as a result of waiting.
14-8 a5 )ash flows if tax i"posed:
= * *+ *1
A A A A
#B,9==,=== B==,=== B==,=== B==,===
6sing a financial calculator, input the following data: ),= ; #B9=====: ),*#*1 ; B=====: (4@I ; *9: and
then sol$e for N! ; #C9,**>,+G*.>*.
b5 )ash flows if tax not i"posed:
= * *+ *1
A A A A
#B,9==,=== *,9==,=== *,9==,=== *,9==,===
6sing a financial calculator, input the following data: ),= ; #B9=====: ),*#*1 ; *9=====: (4@I ;
*9: and then sol$e for N! ; C*,FD>,=>D.>F.
c5 (f they proceed with the project today, the projects expected N! ; 5=.1 #C9,**>,+G*.>*7 E
5=.1 C*,FD>,=>D.>F7 ; #CD=,99*.FB. /o, Applied De$elop"ent 2oldings .td. would not do it.
Chapter 14: Real Options Answers and Solutions 11*
*=<
*=<
*9<
*9<
d5 /ince the projects N! with the tax is negati$e, if the tax were i"posed the fir" would
abandon the project. %hus, the decision tree loo&s li&e this:
= * 9 *1 N! ? @r. =
1=< rob. A A A A
%axes #B,9==,=== B,B==,=== = = #C >=D,*+9.GB
No %axes A A A A
1=< rob. #B,9==,=== *,9==,=== *,9==,=== *,9==,=== *,FD>,=>D .>F
Expected N! C G>9,F+D .9D
@es, the existence of the abandon"ent option changes the expected N! of the project fro"
negati$e to positi$e. 3i$en this option the fir" would ta&e on the project because its expected
N! is CG>9,F+D.9D.
e5 = * N! ? @r. =
1=< rob. A A
%axes N! ; M #*,1==,=== wouldnt do C =.==
E>==,=== ; N! ? t ; *
No %axes A A
1=< rob. N! ; M #*,1==,=== 9,9>9,*+9 .GB
E+,===,=== ; N! ? t ; * Expected N! C*,**B,=D* .+>
(f the fir" pays C*,**B,=D*.+> for the option to purchase the land, then the N! of the project is
exactly e8ual to zero. /o the fir" would not pay any "ore than this for the option.
116 Answers and Solutions Chapter 14: Real Options
*9<
*9<
Co7prehensive9preadsheet &roble7s
Note to Instructors:
%he solutions to these proble"s are not pro$ided to students at the bac& of their text. (nstructors can
access the Excel files on the textboo&s web site or the (nstructors Iesource )D.
14-+ /ee roble" *+#D on the preceding two pages.
14-9 a5 'ithout abandon"ent 5)ost ? t ; = ; #C*= "illion7:
* 9 > N! ? @r. =
>=< rob. A A A
3ood F.= F.= F.= C**.B9
+=< rob. A A A
A$erage +.1 +.1 +.1 =.G*
>=< rob. A A
Had #*.1 #*.1 #*.1 #*>.B=
Expected N! ; =.>5C**.B97 E =.+5C=.G*7 E =.>5#C*>.B=7 ; #C=.9D "illion.
/tandard de$iation ; CF.G* "illion.
'ith abandon"ent 5)ost ? t ; = ; #C*= "illion7:
After the first year, the fixed assets will be depreciated by *4> of their $alue, "eaning they are
worth CB.BD "illion and can be retired4sold for CB.== "illion. %he cash flow in the abandon"ent
branch reflects the #C*.1 "illion operating cash flow plus the retire"ent of fixed assets 5#C*.1
"illion E CB "illion7.
* 9 > N! ? @r. =
>=< rob. A A A
3ood F.= F.= F.= C**.B9
+=< rob. A A A
A$erage +.1 +.1 +.1 =.G*
>=< rob. A A A
Had +.1 #1.FG
Expected N! ; =.>5C**.B97 E =.+5C=.G*7 E =.>5#C1.FG7 ; C9.=* "illion.
/tandard de$iation ; CB.GF "illion.
'hen the abandon"ent option is factored in, the $ery large negati$e N! under bad conditions
is reduced, and the expected N! beco"es positi$e. Also, the standard de$iation and )!
decline, indicating that the abandon"ent option lowers the projects ris&.
b5 N! declines as the 'A)) increases, and it increases as the percentage of boo& value at which
the asset can be sold increases. 2owe$er, if the 'A)) is reasonably close to the esti"ated
*9<, and the sale percentage is close to the esti"ated F=<, then the N! will be co"fortably
positi$e.
Chapter 14: Real Options Comprehensive/Spreadsheet Problems 118
*9<
*9<
$2.01 63% 72% 81% 90% 99% 108% 117%
8.4% $2.26 $2.43 $2.59 $2.76 $2.93 $3.09 $3.26
9.6% $2.01 $2.17 $2.34 $2.50 $2.67 $2.83 $2.99
10.8% $1.77 $1.93 $2.09 $2.25 $2.42 $2.58 $2.74
12.0% $1.53 $1.69 $1.85 $2.01 $2.17 $2.34 $2.50
13.2% $1.30 $1.46 $1.62 $1.78 $1.94 $2.10 $2.26
14.4% $1.09 $1.24 $1.40 $1.56 $1.72 $1.87 $2.03
15.6% $0.87 $1.03 $1.19 $1.34 $1.50 $1.65 $1.81
W
A
C
C
% of Book Value the Assets are sold at
)onclusion: 'hen abandon"ent is recognized, the project is acceptable.
c5 'ithout abandon"ent, with growth 5)ost ? t ; = ; #C*= "illion7
* 9 > N! ? @r. =
>=< rob. A A A
3ood F.= F.= 9=.B C*F.GG
+=< rob. A A A
A$erage +.1 +.1 +.1 =.G*
>=< rob. A A
Had #*.1 #*.1 #*.1 #*>.B=
Expected N! ; =.>5C*F.GG7 E =.+5C=.G*7 E =.>5#C*>.B=7 ; C9.9* "illion.
/tandard de$iation ; C*>.=9 "illion.
%his growth option "a&es the projects N! positi$e, too. 6sing a spreadsheet, the 'A)) at
which N! e8uals zero in this case is 9>.**<. /o, we can be safe in saying that this projects
N! is robust to changes in the 'A)).
d5 'ithout abandon"ent, with in$est"ent ti"ing 5)ost ? t ; = ; #C*= "illion7
9 > + N! ?@r. *
>=< rob. A A A
3ood F.= F.= F.= C**.B9
+=< rob. A A A
A$erage +.1 +.1 +.1 =.G*
>=< rob. A A
Had = = = =
Expected N! ? @ear * ; =.>5C**.B97 E =.+5C=.G*7 E =.>5=7 ; C>.G* "illion.
Expected N! today ; C>.G*4*.*9 ; C>.+= "illion.
%he option $alue is calculated as follows:
N! without abandon"ent but with ti"ing option: C>.+=
N! without abandon"ent and ti"ing option: C=.==
Nption $alue C>.+=
11+ Comprehensive/Spreadsheet Problems Chapter 14: Real Options
*9<
*9<
/ntegrated Case
14-10
7arTone-:oda3one
Other opics in Capital !udgeting
/"ar%one#!odafone currently owns a radio spectru" in the *G== O2z bandwidth.
/"ar%one#!odafone is a teleco""unications co"pany in 2ong Pong that pro$ides $oice,
"ulti"edia, and broadband ser$ices in the "obile and fixed#line "ar&ets through its
ubi8uitous 3/O4>342/AE networ&s. As of Qune >=, 9==F, /"ar%one#!odafone was
ser$ing a total of *,*B+,=== custo"ers in 2ong Pong. /"ar%one#!odafone is growing
rapidly: and consistent with its growth, it has a relati$ely large capital budget. 'hile "ost of
the co"panys projects are fairly easy to e$aluate, a handful of projects in$ol$e "ore
co"plex e$aluations.
(n Qanuary 9==F, /"ar%one#!odafone considered bidding for another *G== O2z
spectru". Aubrey 'ang, a senior "e"ber of the co"panys finance staff, coordinates the
e$aluation of these "ore co"plex projects. 2er group pro$ides their reco""endations
directly to the co"panys ),N and )EN, Ann Rin and 2erbert %sai, respecti$ely.
"5 /n recent 7onths; "ubre<=s group has begun to 3ocus on real option
anal<sis5
,11 >hat is real option anal<sis?
Answer: S/how /*+#* and /*+#9 here.T Ieal options exist when "anagers can influence
the size and ris&iness of a projects cash flows by ta&ing different actions during
or at the end of a projects life.
Ieal option analysis includes in the typical N! capital budgeting analysis
an analysis of opportunities for "anagers to respond to changing circu"stances
because "anage"ents actions can influence a projects outco"e.
"5 ,(1 >hat are so7e e@a7ples o3 projects 2ith real options?
Chapter 14: Real Options Integrated Case 119
Answer: S/how /*+#> here.T A project "ay contain one or "ore different types of real
options. Exa"ples include abandon"ent4shutdown options, in$est"ent ti"ing
options, growth4expansion options, and flexibility options.
B5 Considering real options; one o3 "ubre<=s colleagues; To7 Aang; has
suggested that instead o3 acBuiring another 1+00 .%C spectru7 toda<; it
7ight 7aDe sense to 2ait a <ear because the technolog< 2ould be 7ore
7ature and the de7and 3or the spectru7 2ill be clearer5 7arTone-
:oda3one 2ould then be better able to 3orecast the projectEs cash 3lo2s5
Currentl<; 7arTone-:oda3one 3orecasts that the additional 1+00 .%C
spectru7 2ill generate e@pected annual net cash 3lo2s o3 F33;*00 3or 4
<ears5 %o2ever; i3 the co7pan< 2aits a <ear; it 2ill learn 7ore about
7arDet conditions5 There is a 60G chance that the 7arDet 2ill be strong
and a 40G chance that it 2ill be 2eaD5 /3 the 7arDet is strong; the annual
cash 3lo2s 2ill be F43;*005 /3 the 7arDet is 2eaD; the annual cash 3lo2s
2ill be onl< F(1;*005 /3 7arTone-:oda3one chooses to 2ait a <ear; the
initial invest7ent 2ill re7ain F100;000 and cash 3lo2s 2ill continue 3or 4
<ears a3ter the initial invest7ent is 7ade5 "ssu7e that all cash 3lo2s are
discounted at 10G5 hould 7arTone-:oda3one bid 3or another 1+00 .%C
spectru7 toda<; or should it 2ait a <ear be3ore deciding 2hether to bid?
Answer: S/how /*+#+ through /*+#D here.T
0 1 ( 3 4 * $&: H t I 1
60G &rob5 J J J J J J
trong .Dt5 0 -100;000 43;*00 43;*00 43;*00 43;*00 F38;++951*
>eaD .Dt5 J J J J J J
40G &rob5 0 -100;000 (1;*00 (1;*00 (1;*00 (1;*00 -(*;*0+516
Do it today,
Time 0 1 2 3 4
Cash flow -100,000 33,500 33,500 33,500 33,500
1(0 Integrated Case Chapter 14: Real Options
10G
NPV 6,190.49
2owe$er, in a wea& "ar&et the fir" will not bid for the *G== O2z spectru" since
its $&: K =. )onse8uently, the expected $&: of waiting one year is 5=.+7C= E
5=.B75C>D,GGF.*17 ; C99,D>>.+F. 2owe$er, this is the present $alue at @ear *,
so we "ust discount it bac& one year to find the $alue today of waiting to bid for
the *G== O2z spectru". /o, the $alue today of waiting is calculated as
C99,D>>.+F4*.*= ; C9=,BBB.G*. %herefore, the fir" should wait to obtain "ore
infor"ation about the "ar&et rather than bidding for the *G== O2z spectru"
today because the $&: is C9=,BBB.G* co"pared to CB,*F=.+F, the N! of
doing it today.
C5 $o2 assu7e that there is 7ore uncertaint< about the 3uture cash 3lo2s5
.ore speci3icall<; assu7e that the annual cash 3lo2s are F*3;*00 i3 the
7arDet is strong and F13;*00 i3 the 7arDet is 2eaD5 "ssu7e that the up-
3ront cost is still F100;000 and that the >"CC is still 10G5 >ill this
increased uncertaint< 7aDe the 3ir7 7ore or less 2illing to invest in the
project toda<? '@plain5
Answer: S/how /*+#G and /*+#F here.T
0 1 ( 3 4 * $&: H t I 1
60G &rob5 J J J J J J
trong .Dt5 0 -100;000 *3;*00 *3;*00 *3;*00 *3;*00 F69;*+85+0
>eaD .Dt5 J J J J J J
40G &rob5 0 -100;000 13;*00 13;*00 13;*00 13;*00 -*8;(065+(
(n a wea& "ar&et the fir" will not bid for the *G== O2z spectru" since its N!
K =. )onse8uently, the expected $&: of waiting one year is 5=.+7C= E 5=.B7
5CBF,1GD.G=7 ; C+*,D19.BG. 2owe$er, this is the present $alue at @ear *, so
we "ust discount it bac& one year to find the $alue today of waiting to bid for
the *G== O2z spectru". /o, the $alue today of waiting is calculated as
C+*,D19.BG4*.*= ; C>D,F1B.FG. %herefore, the fir" should wait to obtain "ore
infor"ation about the "ar&et rather than bidding for the *G== O2z spectru"
Chapter 14: Real Options Integrated Case 1(1
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today because the $&: is C>D,F1B.FG co"pared to CB,*F=.+F, the $&: of
doing it today.
%he "ore $ariable the cash flows 5the "ore uncertainty7 the less willing
the fir" will be to in$est in the project today.
,actors the fir" should consider when deciding when to in$est:
15 Delaying the project "eans that cash flows co"e later rather than
sooner.
(5 (t "ight "a&e sense to proceed today if there are i"portant ad$antages
to being the first co"petitor to enter a "ar&et.
35 'aiting "ay allow you to ta&e ad$antage of changing conditions.
!5 7arTone-:oda3one is considering another radio spectru7; (600 .%C5
The (600 .%C spectru7 has an up-3ront cost o3 F(00;000 and an
econo7ic li3e o3 3 <ears5 /3 the co7pan< bids 3or the spectru7; its a3ter-
ta@ operating costs 2ill be F100;000 a <earK ho2ever; the project is
e@pected to produce a3ter-ta@ cash in3lo2s o3 F1+0;000 a <ear5 Thus; the
project=s esti7ated cash 3lo2s are as 3ollo2s:
#ear Cash Out3lo2s Cash /n3lo2s $et Cash )lo2s
0 ,F(00;0001 F 0 ,F(00;0001
1 ,100;0001 1+0;000 +0;000
( ,100;0001 1+0;000 +0;000
3 ,100;0001 1+0;000 +0;000
,11 The project has an esti7ated >"CC o3 10G5 >hat is the project=s $&:?
Answer: S/how /*+#*= here.T
0 1 ( 3
J J J J
-(00;000 +0;000 +0;000 +0;000
6sing a financial calculator, input the following data: C)0 ; #9=====: C)1-3 ;
G====: /9#R ; *=: and then sol$e for $&: ; #C*,=1*.G+.
1(( Integrated Case Chapter 14: Real Options
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!5 ,(1 >hile the project=s operating costs are 3airl< certain at F100;000 per
<ear; the esti7ated cash in3lo2s depend criticall< on 2hether 7ost o3
7arTone-:oda3oneEs custo7ers accept the i7ple7entation o3 the 4L
LT' ,Long Ter7 'volution1 service on the (600 .%C spectru75 "ubre<
esti7ates that there is a 60G chance that the custo7ers 2ill use the
service; in 2hich case the project 2ill produce a3ter-ta@ cash in3lo2s o3
F(*0;0005 Thus; its net cash 3lo2s 2ould be F1*0;000 per <ear5
%o2ever; there is a 40G chance that the custo7ers 2ill not use the
service; in 2hich case the project 2ill produce a3ter-ta@ cash in3lo2s o3
onl< F8*;0005 Thus; its net cash 3lo2s 2ill be -F(*;0005 >rite out the
esti7ated cash 3lo2s and calculate the project=s $&: under each o3 the
t2o scenarios5
Answer: S/how /*+#** through /*+#*> here.T
)usto"er accept +3 .%E ser$ice 5B=< probability7
0 1 ( 3
J J J J
-(00;000 1*0;000 1*0;000 1*0;000
6sing a financial calculator, input the following data: C)0 ; #9=====: C)1-3 ;
*1====: /9#R ; *=: and then sol$e for $&: ; C*D>,=9D.G=.
)usto"er doesnt accept +3 .%E ser$ice 5+=< probability7
0 1 ( 3
J J J J
-(00;000 -(*;000 -(*;000 -(*;000
6sing a financial calculator, input the following data: C)0 ; #9=====: C)1-3 ;
#91===: /9#R ; *=: and then sol$e for $&: ; #C9B9,*D*.>=.
!5 ,31 >hile 7arTone-:oda3one does not have the option to dela< the project; it
2ill Dno2 one <ear 3ro7 no2 2hether custo7ers pre3er the ne2 service5 /3
custo7ers choose not to use the service; 7arTone-:oda3one has the
Chapter 14: Real Options Integrated Case 1(3
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option to trade the spectru75 /3 7arTone-:oda3one abandons the
project; it 2ill not receive an< cash 3lo2s a3ter #ear 1 and it 2ill not incur
an< operating costs a3ter #ear 15 Thus; i3 the co7pan< chooses to
abandon the project; its esti7ated cash 3lo2s 2ill be as 3ollo2s:
0 1 ( 3
J J J J
60G &rob5 -(00;000 1*0;000 1*0;000 1*0;000
J J J J
40G &rob5 -(00;000 -(*;000
"gain; assu7ing a >"CC o3 10G; 2hat is the project=s e@pected $&: i3 it
abandons the project? hould 7arTone-:oda3one invest in the (600
.%C spectru7 toda<; realiCing it has the option to abandon the project at t
I 1?
Answer: S/how /*+#*+ here.T
0 1 ( 3 $&: H t I 0
J J J J
60G &rob5 -(00;000 1*0;000 1*0;000 1*0;000 F183;0(85+0
J J J J
40G &rob5 -(00;000 -(*;000 -(((;8(85(8
E5N!7 ; =.B5C*D>,=9D.G=7 E =.+5#C999,D9D.9D7
; C*+,D91.DD.
!5 ,41 0p until no2; 2e have assu7ed that the abandon7ent option has not
a33ected the project=s >"CC5 /s this assu7ption reasonable? %o2
7ight the abandon7ent option a33ect the >"CC?
Answer: S/how /*+#*1 here.T (t is not reasonable to assu"e that the abandon"ent
option has no effect on the projects 'A)). 2a$ing the ability to abandon a
project reduces ris&: therefore, reducing its 'A)).
1(4 Integrated Case Chapter 14: Real Options
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'5 )inall<; 7arTone-:oda3one is also considering another 900 .%C
spectru75 This ne2 spectru7 has an up-3ront cost o3 F*00;000; and it is
e@pected to produce a3ter-ta@ cash in3lo2s o3 F100;000 at the end o3
each o3 the ne@t * <ears ,t I 1; (; 3; 4; and *15 Because the 900 .%C
spectru7 has a >"CC o3 1(G; it clearl< has a negative $&:5 %o2ever;
"ubre< and her group recogniCe that i3 7arTone-:oda3one goes ahead
2ith another 900 .%C spectru7 toda<; there is a 10G chance that this
2ill lead to subseBuent opportunities that have a net present value at t I
* eBual to F3;000;0005 "t the sa7e ti7e; there is a 90G chance that the
subseBuent opportunities 2ill have a negative net present value
,-F1;000;0001 at t I *5 On the basis o3 their Dno2ledge o3 real options;
"ubre< and her group understand that the co7pan< 2ill choose to
develop these subseBuent opportunities onl< i3 the< appear to be
pro3itable at t I *5 Liven this in3or7ation; should 7arTone-:oda3one
invest in another 900 .%C spectru7 toda<? '@plain <our ans2er5
Chapter 14: Real Options Integrated Case 1(*
Answer: S/how /*+#*B through /*+#*F here.T
10G 0 1 ( 3 4 * $&: H t I 0
&rob5 J J J J J J
-*00;000 100;000 100;000 100;000 100;000 100;000 F1;*6(;8*+519
3;000;000
3;100;000
90G J J J J J J
&rob5 -*00;000 100;000 100;000 100;000 100;000 100;000 -139;*((53+
-1;000;000 >ill not do
(f it turns out that the project at @ear 1 has a negati$e N! of future
opportunities, the fir" will not pursue the". %herefore, the cash flows for that
branch of the decision tree include only the C1==,=== outlay and the
C*==,=== inflows. %herefore, the expected N! of the F== O2z spectru" is
5=.*=75C*,1B9,D1G.*F7 E 5=.F75#C*>F,199.>G7 ; C>=,D=1.BG. %herefore, the
F== O2z spectru" has a positi$e N! so the fir" should in$est in it today.
1(6 Integrated Case Chapter 14: Real Options
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