CHAPTER 12

Other Topics in Capital

Budgeting

 Evaluating projects with unequal

lives
 Identifying embedded options
 Valuing real options in projects
12-1
Evaluating projects with
unequal lives
Projects S and L are mutually exclusive, and
will be repeated. If k = 10%, which is better?

Expected Net CFs

Year Project S Project L
0 ($100,000) ($100,000)
1 59,000 33,500
2 59,000 33,500
3 - 33,500
4 - 33,500

12-2
Solving for NPV,
with no repetition
 Enter CFs into calculator CFLO register
for both projects, and enter I/YR =
10%.
 NPV = $2,397
S

 NPVL = $6,190
 Is Project L better?
 Need replacement chain analysis.

12-3
 Replacement chain
 Use the replacement chain to calculate an extended
NPVS to a common life.
 Since Project S has a 2-year life and L has a
4-year life, the common life is 4 years.

0 1 2 3 4
10%

-100,000 59,000 59,000 59,000 59,000

-100,000
-41,000
NPVS = $4,377 (on extended basis)
12-4
What is real option
analysis?
 Real options exist when managers can
influence the size and riskiness of a
project’s cash flows by taking different
actions during the project’s life.
 Real option analysis incorporates typical
NPV budgeting analysis with an analysis
for opportunities resulting from
managers’ decisions.

12-5
What are some examples
of
real options?
 Investment timing options
 Abandonment/shutdown
options
 Growth/expansion options
 Flexibility options

12-6
Illustrating an investment
timing option
 If we proceed with Project L, its annual cash
flows are $33,500, and its NPV is $6,190.
 However, if we wait one year, we will find out
some additional information regarding output
prices and the cash flows from Project L.
 If we wait, the up-front cost will remain at
$100,000 and there is a 50% chance the
subsequent CFs will be $43,500 a year, and a
50% chance the subsequent CFs will be $23,500
a year.

12-7
 Investment timing decision
tree
-$100,000 43,500 43,500 43,500 43,500
50% prob.

-$100,000 23,500 23,500 23,500 23,500

50% prob.
0 1 2 3 4 5
Years
 At k = 10%, the NPV at t = 1 is:
 $37,889, if CF’s are $43,500 per year, or
 -$25,508, if CF’s are $23,500 per year, in
which case the firm would not proceed with
the project.

12-8
Should we wait or
proceed?
 If we proceed today, NPV = $6,190.
 If we wait one year, Expected NPV
at t = 1 is 0.5($37,889) + 0.5(0) =
$18,944.57, which is worth
$18,944.57 / (1.10) = $17,222.34 in
today’s dollars (assuming a 10%
discount rate).
 Therefore, it makes sense to wait.

12-9
Issues to consider with
investment timing options
 What’s the appropriate discount rate?
 Note that increased volatility makes the

option to delay more attractive.

 If instead, there was a 50% chance the

subsequent CFs will be $53,500 a year,

and a 50% chance the subsequent CFs
will be $13,500 a year, expected NPV
next year (if we delay) would be:
0.5($69,588) + 0.5(0) = $34,794 >
$18,944.57
12-10
Factors to consider when
deciding when to invest
 Delaying the project means that cash
flows come later rather than sooner.
 It might make sense to proceed today
if there are important advantages to
being the first competitor to enter a
market.
 Waiting may allow you to take
advantage of changing conditions.

12-11
Abandonment/shutdown
option
 Project Y has an initial, up-front cost
of $200,000, at t = 0. The project is
expected to produce after-tax net
cash flows of $80,000 for the next
three years.
 At a 10% discount rate, what is
Project
0 Y’s NPV?
1 2 3
k = 10%

-$200,000 80,000 80,000 80,000

NPV = -$1,051.84
12-12
Abandonment option
 Project Y’s A-T net cash flows
depend critically upon customer
acceptance of the product.
 There is a 60% probability that
the product will be wildly
successful and produce A-T net
CFs of $150,000, and a 40%
chance it will produce annual A-T
net CFs of -$25,000.
12-13
 Abandonment decision
tree
150,000 150,000 150,000
60% prob.
-$200,000
-25,000 -25,000 -25,000
40% prob.
0 1 2 3
Years
 If the customer uses the product,
NPV is $173,027.80.
 If the customer does not use the product,
NPV is -$262,171.30.
 E(NPV) = 0.6(173,027.8) + 0.4(-262,171.3)
= -1,051.84
12-14
Issues with abandonment
options
 The company does not have the
option to delay the project.
 The company may abandon the
project after a year, if the customer
has not adopted the product.
 If the project is abandoned, there will
be no operating costs incurred nor
cash inflows received after the first
year.

12-15
 NPV with abandonment
option
150,000 150,000 150,000
60% prob.
-$200,000
-25,000
40% prob.
0 1 2 3
Years
 If the customer uses the product,
NPV is $173,027.80.
 If the customer does not use the product,
NPV is -$222,727.27.
 E(NPV) = 0.6(173,027.8) + 0.4(-222,727.27)
= 14,725.77
12-16
Is it reasonable to assume that
the abandonment option does not
affect the cost of capital?
 No, it is not reasonable to
assume that the abandonment
option has no effect on the
cost of capital.
 The abandonment option
reduces risk, and therefore
reduces the cost of capital.

12-17
Growth option
 Project Z has an initial up-front cost of
$500,000.
 The project is expected to produce A-T cash
inflows of $100,000 at the end of each of the
next five years. Since the project carries a 12%
cost of capital, it clearly has a negative NPV.
 There is a 10% chance the project will lead to
subsequent opportunities that have an NPV of
$3,000,000 at t = 5, and a 90% chance of an
NPV of -$1,000,000 at t = 5.

12-18
 NPV with the growth
option
$3,000,000
100,000 100,000 100,000 100,000 100,000
10% prob.

-$500,000 -$1,000,000
100,000 100,000 100,000 100,000 100,000
90% prob.
0 1 2 3 4 5
Years

 At k = 12%,
 NPV of top branch (10% prob) =
$1,562,758.19
 NPV of lower branch (90% prob) = -
$139,522.38 12-19
 NPV with the growth
option
 If it turns out that the project has future
opportunities with a negative NPV, the
company would choose not to pursue them.
 Therefore, the NPV of the bottom branch
should include only the -$500,000 initial
outlay and the $100,000 annual cash flows,
which lead to an NPV of -$139,522.38.
 Thus, the expected value of this project
should be:
NPV = 0.1($1,562,758) + 0.9(-$139,522)
= $30,706.
12-20
Flexibility options
 Flexibility options exist when it’s
worth spending money today,
which enables you to maintain
flexibility down the road.

12-21