Real Options and

Other Topics in
Capital Budgeting
CHAPTER 13
What is real
option analysis?
Real Option Analysis

Real options exist when managers can influence the size and
riskiness of a projects cash flows by taking different actions during
the projects life.

Real option analysis incorporates typical NPV budgeting analysis

with an analysis for opportunities resulting from managers
decisions.
 Types of Real Options

Growth or
Investment
expansion Abandonment Flexibility
timing option
option option option
GROWTH OPTION

Next
ABANDONMENT
OPTION

Next
Allows the project to be stopped before the end of its
physical life, this can increase expected profitability
and lower risk. For example, suppose GRE is
considering another project, and it is negotiating with
a key supplier regarding the cost and availability of
electricity. Typically, the utility requires a guarantee
for the purchase of a minimum amount of power
before it will bring in the required power lines, because
it wants assurance that its investment will not be
stranded.
Given the option to abandon, GRE would never choose the Worst #1 case; if things turned out badly,
it would choose the Worst #2 case and abandon the project.
INVESTION TIMING
OPTION

Next
To illustrate an investment timing option, suppose GRE
Inc. is considering a 3-year project with the data
shown on an Excel spreadsheet in Figure 13.3. The
project has a relatively short life, because GRE
anticipates that after 3 years there will be significant
shifts in technology, which will require the company to
go in a different direction. The current project under
consideration requires an initial investment of $3
million at t 5 0. It will generate positive cash flows for 3
years, and it is considered to have above-average
risk, so, a 12% WACC is used. The size of the annual
cash flows depends on what happens to market
conditions in the future.
FLEXIBILITY
OPTION

Next
Many projects offer this option which permit the firm
to change either the inputs it uses or the output it
produces after operations have commenced.
This figure was created using Excel and illustrates the analysis for a flexibility option.
WHAT IS POST
AUDIT?
 POST AUDIT
Post audit is the one final aspect of the capital budgeting process
which involves (1) comparing actual results with those predicted by the
project’s sponsors and (2) explaining why any differences occurred.

Two types of post audit:

1. Improve forecasts
2. Improve operations
 TWO PURPOSES OF
POST AUDIT
improve forecasts
When decision makers are forced to compare
their projections with actual outcomes, there is
a tendency for estimates to improve. Conscious
or unconscious biases are observed and
eliminated, new forecasting methods are
sought as the need for them becomes
apparent, and people tend to do everything
better, including forecasting, if they know that
their actions are being monitored.
improve operations
Businesses are run by people, and people can
perform at higher or lower levels of efficiency.
When a divisional team has made a forecast
about an investment, the team members are, in
a sense, putting their reputations on the line.
Accordingly, if costs are above and sales are
below predicted levels, executives in production,
marketing, and other areas will strive to
improve operations and to bring results in line
with forecasts.
Thank you!
Reported by: Florence M. De Castro