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FM11 CH 12 Mini Case
FM11 CH 12 Mini Case
Assume that you have just been hired as a financial analyst by Tropical Sweets Inc., a mid-sized California
company that specializes in creating exotic candies from tropical fruits such as mangoes, papayas, and dates.
The firm's CEO, George Yamaguchi, recently returned from an industry corporate executive conference in San
Francisco, and one of the sessions he attended was on real options. Since no one at Tropical Sweets is familiar
with the basics of real options, Yamaguchi has asked you to prepare a brief report that the firm's executives
could use to gain at least a cursory understanding of the topics.
a. What are some types of real options? Answer: See Chapter 12 Mini Case Show
b. What are the five steps for analyzing a real option? Answer: See Chapter 12 Mini Case Show
c. Tropical Sweets is considering a project that will cost $70 million and will generate expected cash flows of $30
per year for three years. The cost of capital for this type of project is 10 percent and the risk-free rate is 6
percent. After discussions with the marketing department, you learn that there is a 30 percent chance of high
demand, with future cash flows of $45 million per year. There is a 40 percent chance of average demand, with
cash flows of $30 million per year. If demand is low (a 30 percent chance), cash flows will be only $15 per year.
What is the expected NPV?
Cost= ($70)
WACC= 10%
Risk-free rate= 6%
Annual Prob. x
Demand Prob. Cash Flow (CF)
High 0.3 $45 $13.50
Average 0.4 $30 $12.00
Low 0.3 $15 $4.50
Expected CF= $30.00
NPV= $4.61
d. Now suppose this project has an investment timing option, since it can be delayed for a year. The cost will
still be $70 million at the end of the year, and the cash flows for the scenarios will still last three years. However,
Tropical Sweets will know the level of demand, and will implement the project only if it adds value to the
company. Perform a qualitative assessment of the investment timing option’s value. Answer: See Chapter 12
Mini Case Show
e. Use decision tree analysis to calculate the NPV of the project with the investment timing option.
Procedure 3: Decision Tree Analysis
Notes: a
Discount the cost of the project at the risk-free rate, since the cost is known. Discount
the operating cash flows at the WACC.
f. Use a financial option pricing model to estimate the value of the investment timing option.
The option to defer the project is like a call option. The company has until Year 1 to decide whether or not to
implement the project, so the time to maturity of the option is one year. If the company exercises the option, it
must pay an exercise price equal to the cost of implementing the project. If the company does implement the
project, it gains the value of the project. If you exercise a call option, you will own a stock that is worth whatever
its price is. If the company implements the project, it will gain a project, whose value is equal to the present
value of its cash flows. Therefore, the present value of a project's future cash flows is analogous to the current
value of a stock. The rate of return on the project is equal to its cost of capital. To find the value of a call option,
we need the standard deviation of its rate of return; to find the value of this real option, we need the standard
deviation of the projects expected rate of return.
The option to defer the project is like a call option. The company has until Year 1 to decide whether or not to
implement the project, so the time to maturity of the option is one year. If the company exercises the option, it
must pay an exercise price equal to the cost of implementing the project. If the company does implement the
project, it gains the value of the project. If you exercise a call option, you will own a stock that is worth whatever
its price is. If the company implements the project, it will gain a project, whose value is equal to the present
value of its cash flows. Therefore, the present value of a project's future cash flows is analogous to the current
value of a stock. The rate of return on the project is equal to its cost of capital. To find the value of a call option,
we need the standard deviation of its rate of return; to find the value of this real option, we need the standard
deviation of the projects expected rate of return.
The first step is to find the value of the project's future cash flows, as of the time the option must be exercised.
We also need the standard deviation of the project's value as of the date it must be exercised. Finally, we need
the present value of the project's future cash flows.
Find the Year 1 Value and Risk of Future Cash Flows If Project is Deferred
Find the current value of future cash flows if project is deferred (note: this is the estimate of P).
P= $67.82
Use the direct approach to estimate the variance of the project's rate of return.
Use the indirect approach to estimate the variance of the project's rate of return. Start by estimating the coefficient
of variation, CV, of the project's value at the time the option expires. This was done in an earlier step.
Now use the following formula to estimate the variance of the project's rate of return.
2
2 ln [CV 1]
σ =
t
t = time until the option expires = 1
Indirect estimate of σ = 2
14.2%
rRF = 6%
t= 1
X= $70.00
P= $67.82
σ2 = 14.2%
g. Now suppose the cost of the project is $75 million and the project cannot be delayed. But if Tropical Sweets
implements the project, then Tropical Sweets will have a growth option. It will have the opportunity to replicate the
original project at the end of its life. What is total expected NPV of the two projects if both are implemented?
g. Now suppose the cost of the project is $75 million and the project cannot be delayed. But if Tropical Sweets
implements the project, then Tropical Sweets will have a growth option. It will have the opportunity to replicate the
original project at the end of its life. What is total expected NPV of the two projects if both are implemented?
Cost= $75
WACC= 10%
Risk-free rate = 6%
Original Project
Cost Future Cash Flows NPV this Prob. Data for
Year 0 Prob. 1 2 3 Scenario x NPV Std Deviation
h. Tropical Sweets will replicate the original project only if demand is high. Using decision tree analysis,
estimate the value of the project with the growth option.
Expected NPV =
Standard Deviation=
Coefficient of Variation =
Notes: 1. The CF in Year 3 includes the cost to implement the second project if it is optimal to do so.
2. When finding the NPV, the cost to implement the second project is discounted at the risk-free rate; other cash
flows are discounted at the cost of capital.
i. Use a financial option model to estimate the value of the growth option.
Find the value and risk of the future cash flows as of the time the option expires.
Find the current value of future cash flows if project is deferred (note: this is the estimate of P).
P= $56.05
Use the direct approach to estimate the variance of the project's rate of return.
Use the indirect approach to estimate the variance of the project's rate of return. Start by estimating the coefficient
of variation, CV, of the project's value at the time the option expires. This was done in an earlier step.
Now use the following formula to estimate the variance of the project's rate of return.
ln [CV 2 1]
2
σ =
t
t = time until the option expires = 3
Indirect estimate of σ2 = 4.7%
j. What happens to the value of the growth option if the variance of the project’s return is 14.2 percent? What if
it is 50 percent? How might this explain the high valuations of many dot.com companies?
=Variance of PV
Std Deviation
=Variance of PV
Std Deviation
=Variance of PV
g the coefficient
p.
cal Sweets
to replicate the
emented?
Std Deviation
=Variance of PV
Data for
Prob. Std Deviation
x NPV
$17.40 1,010
-$0.16 0
-$11.31 -
$5.94
1,010 =Variance of PV
$31.78
5.35
Data for
Prob. Std Deviation
x NPV
$33.57 417
$29.84 -
$11.19 417
$74.61
835 =Variance of PV
$28.89
0.39
Std Deviation
1.0%
0.0%
1.3%
2.3% =Variance of PV
g the coefficient
p.