Professional Documents
Culture Documents
Chapter 13. Real Options and Other Topics in Capital Budgeting
Chapter 13. Real Options and Other Topics in Capital Budgeting
In this model we examine four types of real options: Growth, Abandonment, Timing, and Flexibility. We
also analyze a procedure for determining the optimal size of the capital budget.
Part III. Value of the Option NPV considering the growth option $1,503
NPV not considering the growth option $122
Value of the option: If NPV without option is negative, value of option = NPV with option.
Otherwise, value of option = NPV with option – NPV without option: $1,381
Figure 13-2. Abandonment Option (Dollars in Thousands) 1/06/09
Value of the option: If NPV without option is negative, value of option = NPV
with option. Otherwise, value of option = NPV with option - NPV without option. $200
Figure 13-3. Analysis of a Timing Option (Dollars in Thousands) 1/06/09
Part II. Delay the Decision Until We Know the Market Conditions
Cash Flow At End of Period NPV@
0 1 2 3 12%
Good 50% $0 -$3,000 $2,000 $2,000 $339
Bad 50% $0 $0 $0 $0 $0
Expected NPV $170
Standard Deviation (σ) $170
Coefficient of Variation = CV = σ / Expected NPV 1.00
Part III. Value of the Option NPV considering the growth option $170
NPV not considering the growth option -$58
Value of the option: If NPV without option is negative, value of option = NPV with option.
Otherwise, value of option = NPV with option - NPV without option. $170
Note: Under the Delay situation, we must find the NPV as of t = 0. If we set the cash flow for t = 0 at $0,
then using a calculator or Excel we automatically find the t = 0 NPV. However, if we let PV = -3000, PMT
= 2000, N = 2, and I = 12, we get an NPV = $380 under the Good outcome and an expected NPV of $190.
Note, though, that these NPVs are as of t = 1, so we must discount them back one year at 12% to
achieve comparability and get the correct answer.
Figure 13-4. Flexibility Option (Dollars in Thousands) 1/06/09
Part I. Project without the Flexibility Option Cash Flow at End of Period NPV@
0 1 2 3 12%
Strong demand 50% -$5,000 $2,500 $2,500 $2,500 $1,005
Weak demand 50% -$5,000 $1,500 $1,500 $1,500 -$1,397
Expected NPV -$196
Part II. Project with the Flexibility Option Cash Flow at End of Period NPV@
0 1 2 3 12%
Strong demand 50% -$5,100 $2,500 $2,500 $2,500 $905
Weak demand Switch products 50% -$5,100 $1,500 $2,250 $2,250 -$366
Expected NPV $270
Part III. Value of the Option NPV with the option $270
NPV without the option -$196
Value of the option: If NPV without option is negative, value of option = NPV with option.
Otherwise, value of option = NPV with option – NPV without option. $270
Figure 13-5. Optimal Capital Budget: Marginal IRR = Marginal WACC 1/06/09
WACC
30%& IRR
25%
20% WACC
15%
10%
IRR
5%
0%
$100 $600 $1,100 $1,600 $2,100
Capital Budget
2. Suppose a project's expected "cannot abandon" NPV is -$14 and its "can
abandon" expected NPV is $214. How much is the abandonment option worth?