Abandonment Option (contd..

• The project’s negative net present value is based on a cash flow analysis
that assumes that the lathe will produce the parts for the entire
economic life of the project. This cash flow analysis does not take into
consideration the option of the company to abandon the project and sell
the lathe in the active secondary market that exists for lathes and other
manufacturing equipment. Shutting down the project represents a put
option to sell the project for the salvage value of equipment. Or the
company could simply choose to switch from making the specific parts to
another potentially more profitable product. The abandonment option is
embedded in the project; its existence may limit the downside risk of
the project.
3. Shutdown Options

• A firm may have the option of temporarily shutting down a project

in order to avoid negative cash flows. Consider a mining or
manufacturing operation characterized by relatively high variable
costs. If output prices drop below variable costs, a business has
the option to shut down until output prices recover and rise above
variable costs. The shutdown option also reduces the downside
risk of a project.
4. Growth Options

• A firm may have an opportunity to undertake a research program,

build a small manufacturing facility to serve a new market, or
make a small strategic acquisition in a new line of business. Each
of these examples may be a negative net present value project,
but each project can be viewed as having generated a growth
option for the company which, if exercised, may lead ultimately
to a large positive net present value project.
Growth Options (contd..)

• To illustrate a growth option, suppose a company is considering a large

Internet investment project that has the potential for either failure,
i.e., large losses with a high probability of occurrence, or success, i.e.,
large profits with a low probability of occurrence. The investment
consists of two stages. The first stage (today) is an investment in a Web
site and the second stage (one year from today) is an investment in an
electronic commerce venture. The investment in the Web site has an
NPV of –10 million. Setting up the Web site (first stage) gives the
company the option, but not the obligation, to invest in the electronic
commerce business (second stage) one year from today. While the cash
flows are highly uncertain, ranging from large losses to substantial
profits, the best estimate today is that the electronic commerce
business has an NPV of –60 million.
Growth Options (contd..)

• Based on the NPV decision rule, the Internet investment project

would be unacceptable since it has an NPV of –70 million [–10
million + (–60 million)]. However, one year from today, the
company will have more information and be better able to
estimate whether the electronic commerce business (second
stage) is worth pursuing. At that time, suppose new information
about the cash flows of the electronic commerce venture shows
that it will be extremely profitable, yielding an overall NPV of 200
million for the Internet project.
Growth Options (contd..)

• Clearly, the project would be worth undertaking at that time.

Investing in the Web site today, even though it has a negative NPV,
preserves the company’s option to invest in a positive NPV project
in the future. By investing only in the Web site initially, the
company is able to limit its downside risk (–10 million NPV) while
preserving the upside potential (200 million NPV) for the Internet
investment project.
Other Real Options

Designed In Options
1) Input Flexibility Options
2) Output Flexibility Options
Moral of the Story

• Using conventional discounted cash flow analyses in capital

budgeting without considering real options often results in a
downward-biased estimate of the true value of a project’s net
present value. Some operating options, such as an option to
expand, may increase a project’s upside potential, while other
operating options, such as an option to abandon, may reduce a
project’s downside risk.
Value of an Option

1) Value of the Underlying=Value of Project PV(CF)

2) Strike Price=cost of investment
3) Time to Expiration=when the option to the project expires
4) Volatility=Change in cash flows from the project (the
uncertainity)
5) Interest Rates=the riskless rate
6) Dividends=Cost of delay
7) Kind of Option (American or European)