Chapter 13

Real Options and Other Topics in Capital Budgeting

Learning Objectives

After reading this chapter, the student should be able to:

Explain why conventional NPV analysis may not capture a projects impact on the firms opportunities.

Identify five different types of real options.

Explain what an abandonment/shutdown option is, give an example of a project that includes this type
of option, and explain what an option value is.

Explain what a decision tree is and provide an example of one.

Explain what an investment timing option is, and give an example of a project that includes one.

Explain what a growth option is, and give an example of a project that includes one.

Explain what a flexibility option is, and give an example of a project that includes one.

Use the replacement chain and equivalent annual annuity methods to compare projects with unequal
lives, and explain when you might use one method over the other.

List the steps a firm goes through when establishing its optimal capital budget in practice.

Chapter 13: Real Options Learning Objectives 341

 Lecture Suggestions

This chapter covers some important but relatively technical topics. Note too that this chapter is more
modular than most, i.e., the major sections are discrete, hence they can be omitted without loss of
continuity. Therefore, if you are experiencing a time crunch, you could skip sections or even the entire
chapter.
What we cover, and the way we cover it, can be seen by scanning the slides and Integrated Case
solution for Chapter 13, which appears at the end of this chapter solution. For other suggestions about the
lecture, please see the Lecture Suggestions in Chapter 2, where we describe how we conduct our classes.

DAYS ON CHAPTER: 2 OF 58 DAYS (50-MINUTE PERIODS)

342 Lecture Suggestions Chapter 13: Real Options

 Answers to End-of-Chapter Questions

13-1 a. An abandonment option is the option to abandoning a project if operating cash flows turn out
to be lower than expected. This option can both raise expected profitability and lower project
risk, because in the case of poor cash flows, the project can be ended and rather than continue
realizing negative cash flows, fixed assets are sold and some cash is recovered.

b. An investment timing option occurs when a firm has the option of delaying the start of a
project until additional information can be obtained. After the delay, if conditions for the
project look unfavorable, the project will not be undertaken, while if conditions are favorable
then the project proceeds as usual. However, there are some drawbacks to relying on
investment timing options. First, the timing option should raise NPV because the probability of
bad returns is less, but that NPV needs to be discounted back one additional year. Second,
there might be valuable first mover advantages to a project that will be lost if the project is
delayed a year.

c. Growth options exist if an investment creates the opportunity to make other potentially
profitable investments that would not otherwise be possible. A common example of a growth
option occurs when a firm starts a project in a new country or market. While the project is
hoped to add value from its cash flows, it also has value because it opens the door to the firm
to operate in the new country/market.

d. Flexibility options permit the firm to alter operations depending on how conditions change
during the projects life. Typically, inputs, outputs, or both can be changed easily to respond to
market demands. For example, instead of building an auto factory that builds a specific type of
car (compact, SUV, etc.), a manufacturer can build a factory that allows the building of many
types of cars. Therefore, as market demand and consumer tastes change the firm can rapidly
respond.

13-2 Failure to recognize a growth option implies that a project with a negative conventional NPV was
rejected despite have an embedded growth option whose consideration would cause the NPV to be
positive. As a result, failure to recognize the value of a growth option implies that the capital
budget is below the optimal level since a value-adding project (albeit because of a real option) has
been rejected. This argument holds when considering failure to recognize all real options.

13-3 It might be necessary for the firm to arrange things so that it has the possibility of abandonment
when it is making the initial decision. This might require contractual arrangements with suppliers,
customers, and its union, and there might be some costs to getting the advanced permissions. Any
such costs could be compared with the value of the option as we calculated it, and this could enter
into the initial decision. In the case of investment timing options, the initial investment might grow
if the project is delayed. For any type of options, these additional costs must be considered in the
analysis and the benefits of the real option must outweigh the associated costs.

13-4 The replacement chain approach is a method of comparing projects with unequal lives that
assumes that each project can be repeated as many times as necessary to reach a common life
span. As such, the NPVs over this life span are then compared, and the project with the higher
common-life NPV is chosen.

Chapter 13: Real Options Answers and Solutions 343

13-5 The equivalent annual annuity method calculates the annual payments a project would provide if it
were an annuity. When comparing projects of unequal lives, the one with the higher equivalent
annual annuity should be chosen.

13-6 Generally, the failure to employ replacement chain analysis or the equivalent annual annuity
approach in such situations will bias the NPV against the shorter project because it gets no credit
for profits beyond its initial life, even though it could possibly be renewed and thus provide
additional NPV.

13-7 For large, mature firms with good track records we can assume that all of its profitable projects can
be financed, but this assumption is harder to make for smaller firms, new firms, and firms with
dubious track records may have difficulties raising capital, even for projects that the firm concludes
would have positive NPVs. In such circumstances, the size of the firms capital budget may be
constrained, a situation called capital rationing. In such situations capital is limited, so it should be
used in the most efficient way possible. Procedures have been explored for allocating capital so as
to maximize the firms aggregate NPV 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 WACC.

13-8 Capital rationing is a situation where a firm can raise only a specified, limited amount of capital
regardless of how many good projects it has. As a result, the firm must find the most efficient way
of deploying that capital to its projects.

344 Answers and Solutions Chapter 13: Real Options

 Solutions to End-of-Chapter Problems

13-1 a. WACC = 11%; cash flows shown in millions.

0 1 2 3 NPV @ Yr. 0
50% Prob. | | |
6 6 6 $5.662
-9
| | | -6.556
50% Prob. 1 1 1

Expected NPV = 0.5($5.662) + 0.5(-$6.556) = -$0.447 million.

b. If the project is hugely successful, $10 million will be spent at the end of Year 2, and the new
venture will be sold for $20 million at the end of Year 3.

0 1 2 3 NPV @ Yr. 0
50% Prob. | | |
6 6 6
-10 +20 $12.170
-9 -4 26
| | | -6.556
50% Prob. 1 1 1

Expected NPV = 0.5($12.170) + 0.5(-$6.556) = $2.807 million.

c. Value of growth option:

NPV with option $2.807 million
NPV without option - 0.447 million
+$3.254 million

13-2 a. Project A: 0 1 2
10%
| | |
-10,000 6,000 8,000

Using a financial calculator, input the following data: CF0 = -10000, CF1 = 6000, CF2 = 8000,
I/YR = 10, and then solve for NPVA = $2,066.12.

Project B: 0 1 2 3 4
10%
| | | | |
-10,000 4,000 4,000 4,000 4,000

Using a financial calculator, input the following data: CF0 = -10000, CF1-4 = 4000, I/YR = 10,
and then solve for NPVB = $2,679.46.

Since neither project can be repeated, Project B should be selected because it has a higher NPV
than Project A.

Chapter 13: Real Options Answers and Solutions 345

 b. To determine the answer to part b, we use the replacement chain (common life) approach to
calculate the extended NPV for Project A. Project B already extends out to 4 years, so its NPV is
$2,679.46.

Project A: 0 1 2 3 4
10%
| | | | |
-10,000 6,000 8,000 6,000 8,000
-10,000
-2,000

Using a financial calculator, input the following data: CF0 = -10000, CF1 = 6000, CF2 = -2000,
CF3 = 6000, CF4 = 8000, I/YR = 10, and then solve for NPVA = $3,773.65.

Since Project As extended NPV = $3,773.65, it should be selected over Project B with an NPV
= $2,679.46.

c. From part a, NPVA = $2,066.12 and NPVB = $2,679.46. Solving for PMT determines the EAA:
Project A: N = 2, I/YR = 10, PV = -2066.12, FV = 0; solve for PMT = $1,190.48.

Project B: N = 4, I/YR = 10, PV = -2679.46, FV = 0; solve for PMT = $845.29.

Project A should be selected.

13-3 0 1 2 3
14%
| | | |
-190,000 87,000 87,000 87,000

Using a financial calculator, input the following data: CF0 = -190000; CF1-3 = 87000; I/YR = 14;
and solve for NPV190-3 = $11,982 (for 3 years).

Extended NPV190-3 = $11,982 + $11,982/(1.14)3 = $20,070.

0 1 2 3 4 5 6
14%
| | | | | | |
-360,000 98,300 98,300 98,300 98,300 98,300 98,300

Using a financial calculator, input the following data: CF0 = -360000; CF1-6 = 98300; I/YR = 14;
and solve for NPV360-6 = $22,256 (for 6 years).

Both new machines have positive NPVs; hence the old machine should be replaced. Further, since
its NPV is greater, choose Model 360-6.

13-4 First, solve for each projects NPV.

Project A: CF0 = -20000, CF1 = 6000, Nj = 6, I/YR = 10; solve for NPV = $6,131.56.

Project B: CF0 = -12000, CF1 = 6000, Nj = 3, I/YR = 10; solve for NPV = $2,921.11.

The appropriate EAAs are:

Project A: N = 6, I/YR = 10, PV = -6131.56, FV = 0; solve for PMT = $1,407.85.

346 Answers and Solutions Chapter 13: Real Options

 Project B: N = 3, I/YR = 10, PV = -2921.11, FV = 0; solve for PMT = $1,174.62.

Choose Project A, whose EAA = $1,407.85

13-5 The firm should accept Projects A, B, C, and D. The firms optimal capital budget is $3,900,000 at a
WACC of 10.8% and it requires the firm to issue new common stock.

13-6 Since Plane As renewal investment changes the EAA method cannot be used, so the replacement
chain method must be used.
Plane A: Expected life = 5 years; cost = $100 million; NCF = $30 million; WACC = 12%; cost of
renewing Plane A = $105 million.

A: 0 1 2 3 4 5 6 7 8 9 10
12%
| | | | | | | | | | |
-100 30 30 30 30 30 30 30 30 30 30
-105
-75

Enter these values into the cash flow register: CF0 = -100; CF1-4 = 30; CF5 = -75; CF6-10 = 30.
Then enter I/YR = 12, and press the NPV key to get NPVA = $9.93 million.

Plane B: Expected life = 10 years; cost = $132 million; NCF = $25 million; WACC = 12%.

B: 0 1 2 3 4 5 6 7 8 9 10
12%
| | | | | | | | | | |
-132 25 25 25 25 25 25 25 25 25 25

Enter these cash flows into the cash flow register, along with the interest rate, and press the NPV key
to get NPVB = $9.256 $9.26 million.

Project A is the better project and will increase the company's value by $9.93 million.

13-7 A: 0 10% 1 2 3 4 5 6 7 8
| | | | | | | | |
-10 4 4 4 4 4.2 4.2 4.2 4.2
-12
-8

Since Machine As renewal investment and cash flows change the EAA method cannot be used, so
the replacement chain method must be used. Machine As simple NPV is calculated as follows:
Enter CF0 = -10 and CF1-4 = 4. Then enter I/YR = 10, and press the NPV key to get NPVA = $2.679
million. However, this does not consider the fact that the project can be repeated again. Enter
these values into the cash flow register: CF0 = -10; CF1-3 = 4; CF4 = -8; CF5-8 = 4.2. Then enter
I/YR = 10, and press the NPV key to get extended NPVA = $3.58 million.

B: 0 10% 1 2 3 4 5 6 7 8
| | | | | | | | |
-15 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5

Chapter 13: Real Options Answers and Solutions 347

 Enter these cash flows into the cash flow register, along with the interest rate, and press the NPV
key to get NPVB = $3.672 $3.67 million.

Machine B is the better project and will increase the company's value by $3.67 million, rather than
the $3.58 million created by Machine A.

13-8 First, solve for each projects NPV.

Project X: CF0 = -100000, CF1 = 30000, CF2 = 50000, CF3 = 70000, I/YR = 12; solve for NPV =
$16,470.0255.

Project Y: CF0 = -70000, CF1 = 30000, Nj = 4, CF2 = 10000, I/YR = 12; solve for NPV =
$26,794.749.

The appropriate EAAs are:

Project X: N = 3, I/YR = 12, PV = -16470.0255, FV = 0; solve for PMT = $6,857.28.

Project Y: N = 5, I/YR = 12, PV = -26794.749, FV = 0; solve for PMT = $7,433.12.

Choose Project Y.

13-9 Cash flows shown in millions on time line:

0 1 2 3
10%
| | | |
-20 7.5 7.5 7.5

NPV = -$1.349 million.

Wait 1 year; cash flows shown in millions on time line:

0 1 2 3 4 NPV @ Yr. 0
10%
Strong demand | | | | |
50% Prob. 0 -20 10 10 10 $4.426

Weak demand | | | | |
50% Prob. 0 -20 5 5 5 -6.878

However, if demand is weak, the projects NPV is negative and therefore would not be undertaken.
The value of this option of waiting one year is evaluated as 0.5($0) + (0.5)($4.426) = $2.213
million. Since the NPV of waiting one year is greater than going ahead and proceeding with the
project today and greater than zero, it makes sense to wait.

13-10 a. NPV of abandonment after Year t:

Using a financial calculator, input the following: CF0 = -22500, CF1 = 23750, and I/YR = 10 to
solve for NPV1 = -$909.09 -$909.

Using a financial calculator, input the following: CF0 = -22500, CF1 = 6250, CF2 = 20250, and
I/YR = 10 to solve for NPV2 = -$82.64 -$83.

348 Answers and Solutions Chapter 13: Real Options

 Using a financial calculator, input the following: CF0 = -22500, CF1 = 6250, Nj = 2, CF3 =
17250, and I/YR = 10 to solve for NPV3 = $1,307.29 $1,307.

Using a financial calculator, input the following: CF0 = -22500, CF1 = 6250, Nj = 3, CF4 =
11250, and I/YR = 10 to solve for NPV4 = $726.73 $727.

Using a financial calculator, input the following: CF0 = -22500, CF1 = 6250, Nj = 5, and I/YR =
10 to solve for NPV5 = $1,192.42 $1,192.

The firm should operate the truck for 3 years, NPV3 = $1,307.

b. No. Abandonment possibilities could only raise NPV and IRR. The value of the firm is
maximized by abandoning the project after Year 3.

13-11 a. WACC1 = 12%; WACC2 = 12.5%.

Since each project is independent and of average risk, all projects whose IRR > WACC will be
accepted. Consequently, Projects A, B, C, D, and E will be accepted and the optimal capital budget
is $5,250,000. After accepting projects A, B, and C, all of retained earnings will be used up and
additional equity will be raised to fund the remaining projects, whose WACCs all exceed 12.5%.

b. If Projects C and D are mutually exclusive, the firm will select Project D, because its NPV is
greater than Project Cs NPV. So, the optimal capital budget is $4 million, and consists of
Projects A, B, D, and E.

c. The appropriate costs of capital are 10.5% for low-risk projects, 12.5% for average-risk
projects, and 14.5% for high-risk projects. Since Project A is high risk, it will be rejected (14%
< 14.5%). Projects B, C, D, and E are all average risk and will be accepted since their returns
exceed 12.5%. Projects F and G are low risk and will both be accepted since their returns
exceed 10.5%. Therefore, the optimal capital budget is $6 million and consists of Projects B,
C, D, E, F, and G.

13-12 a. 0 1 2 3 4
10%
| | | | |
-8 4 4 4 4

NPV = $4.6795 million.

b. Wait 2 years:
0 1 2 3 4 5 6 NPV @ Yr. 0
10%
| | | | | | |
10% Prob. 0 0 -9 2.2 2.2 2.2 2.2 -$1.6746

| | | | | | |
90% Prob. 0 0 -9 4.2 4.2 4.2 4.2 3.5648

If the cash flows are only $2.2 million, the NPV of the project is negative and, thus, would not
be undertaken. The value of the option of waiting two years is evaluated as 0.10($0) +
0.90($3.5648) = $3.2083 million.

Chapter 13: Real Options Answers and Solutions 349

 Since the NPV of waiting two years is less than going ahead and proceeding with the project
today, it makes sense to drill today.

c. The investment timing option has a value of $0. Since the difference between the project with
the option and the project without the option is negative, $3.2083 million $4.6795 million =
-$1.4712 million, the option will not be exercised. In other words, the costs of delaying the
project outweigh the benefits gained by delaying and gathering more information.

d. There is a danger that oil prices will decline causing the company to receive less revenue for
the oil it extracts, and there is a danger that the company will lose market share or the chance
to compete for new contracts as a result of waiting.

13-13 a. Cash flows if tax imposed:

0 1 14 15
12%
| | | |
-6,200,000 600,000 600,000 600,000

Using a financial calculator, input the following data: CF0 = -6200000; CF1-15 = 600000; I/YR = 12;
and then solve for NPV = -$2,113,481.31.

b. Cash flows if tax not imposed:

0 1 14 15
12%
| | | |
-6,200,000 1,200,000 1,200,000 1,200,000

Using a financial calculator, input the following data: CF0 = -6200000; CF1-15 = 1200000; I/YR
= 12; and then solve for NPV = $1,973,037.39.

c. If they proceed with the project today, the projects expected NPV = (0.5 -$2,113,481.31) +
(0.5 $1,973,037.39) = -$70,221.96. So, Nevada Enterprises would not do it.

d. Since the projects NPV with the tax is negative, if the tax were imposed the firm would
abandon the project. Thus, the decision tree looks like this:
0 1 2 15 NPV @ Yr. 0
12%
50% Prob. | | | |
Taxes -6,200,000 6,600,000 0 0 -$ 307,142.86

No Taxes | | | |
50% Prob. -6,200,000 1,200,000 1,200,000 1,200,000 1,973,037.39
Expected NPV $ 832,947.27

Yes, the existence of the abandonment option changes the expected NPV of the project from
negative to positive. Given this option the firm would take on the project because its expected
NPV is $832,947.27.

350 Answers and Solutions Chapter 13: Real Options

 e. 0 1 NPV @ Yr. 0
12%
50% Prob. | |
Taxes NPV = ? -1,500,000 wouldnt do $ 0.00
+300,000 = NPV @ t = 1

No Taxes | |
50% Prob. NPV = ? -1,500,000 2,232,142.86
+4,000,000 = NPV @ t = 1 Expected NPV $1,116,071.43

If the firm pays $1,116,071.43 for the option to purchase the land, then the NPV of the project
is exactly equal to zero. So the firm would not pay any more than this for the option.

Chapter 13: Real Options Answers and Solutions 351

 Comprehensive/Spreadsheet Problems

Note to Instructors:
The solutions to these problems are not provided to students at the back of their text.
Instructors can access the Excel files on the textbooks Web site or the Instructors Resource
CD.

13-14 See Problem 13-13 on the preceding two pages.

13-15 a. Without abandonment (Cost @ t = 0 = -$10 million):

1 2 3 NPV @ Yr. 0
12%
30% Prob. | | |
Good 9.0 9.0 9.0 $11.62

40% Prob | | |
Average 4.5 4.5 4.5 0.81

30% Prob | |
Bad -1.5 -1.5 -1.5 -13.60

Exp NPV = 0.3($11.62) + 0.4($0.81) + 0.3(-$13.60) = -$0.27 million.

Standard deviation = $9.81 million.

With abandonment (Cost @ t = 0 = -$10 million):

After the first year, the fixed assets will be depreciated by 1/3 of their value, meaning they are
worth $6.67 million and can be retired/sold for $6.00 million. The cash flow in the
abandonment branch reflects the -$1.5 million operating cash flow plus the retirement of fixed
assets (-$1.5 million + $6 million).

1 2 3 NPV @ Yr. 0
12%
30% Prob. | | |
Good 9.0 9.0 9.0 $11.62

40% Prob | | |
Average 4.5 4.5 4.5 0.81

30% Prob | | |
Bad 4.5 -5.98

Exp NPV = 0.3($11.62) + 0.4($0.81) + 0.3(-$5.98) = $2.01 million.

Standard deviation = $6.89 million.

When the abandonment option is factored in, the very large negative NPV under bad conditions
is reduced, and the expected NPV becomes positive. Also, the standard deviation and CV
decline, indicating that the abandonment option lowers the projects risk.

352 Integrated Case Chapter 13: Real Options

 b. NPV declines as the WACC increases, and it increases as the percentage of book at which the
asset can be sold increases. However, if the WACC is reasonably close to the estimated 12%,
and the sale percentage is close to the estimated 90%, then the NPV will be comfortably positive.

% of Book Value the Assets are sold at

$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
W
10.8% $1.77 $1.93 $2.09 $2.25 $2.42 $2.58 $2.74
A
12.0% $1.53 $1.69 $1.85 $2.01 $2.17 $2.34 $2.50
C
13.2% $1.30 $1.46 $1.62 $1.78 $1.94 $2.10 $2.26
C
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

Conclusion: When abandonment is recognized, the project is acceptable.

c. Without abandonment, with growth (Cost @ t = 0 = -$10 million)

1 2 3 NPV @ Yr. 0
12%
30% Prob. | | |
Good 9.0 9.0 20.6 $19.88

40% Prob | | |
Average 4.5 4.5 4.5 0.81

30% Prob | |
Bad -1.5 -1.5 -1.5 -13.60

Exp NPV = 0.3($19.88) + 0.4($0.81) + 0.3(-$13.60) = $2.21 million.

Standard deviation = $13.02 million.

This growth option makes the projects NPV positive, too. Using a spreadsheet, the WACC at
which NPV equals zero in this case is 23.11%. So, we can be safe in saying that this projects
NPV is robust to changes in the WACC.

d. Without abandonment, with investment timing (Cost @ t = 0 = -$10 million)

2 3 4 NPV @Yr. 1
12%
30% Prob. | | |
Good 9.0 9.0 9.0 $11.62

40% Prob | | |
Average 4.5 4.5 4.5 0.81

30% Prob | |
Bad 0 0 0 0

Exp NPV @ Year 1 = 0.3($11.62) + 0.4($0.81) + 0.3(0) = $3.81 million.

Expected NPV today = $3.81/1.12 = $3.40 million.

Considering the project originally had a -$0.27 million NPV, the investment timing option adds
$3.67 million of value to the project.

Chapter 13: Real Options Integrated Case 353