capital budgeting and real options edited

FIN710

Capital Budgeting and Real Options

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CB and Real Options Agenda for the Day Capital Budgeting

How does it fit in Common mistakes Assessing Risk

Real Options What are they? What types? Why do we care? How do we value them?

CB – Common Mistakes

• Properly accounting for Changes in Net Working Capital (NWC)

• Interest expenses should not be in the cash flows…why not?

• …why not?• Opportunity costs should be counted…like

what?• Timing of cash flows…for ex., ...• Adjusting for ...

Capital Budgeting, Real Options 3

Adjusting for Inflation

Inflation changes both the cash flows and the discount rate.Fortunately, the WACC already reflects inflation…how?We need to adjust almost all cash inflows and outflows over time by inflation. Why?Won’t sales prices and variable cost inputs go up with inflation? What about ...?


CB – Not exactly mistakes

• Cash flow estimation is tough stuff. – Get everybody involved…marketing, production,

accountants, etc.– Use realistic assumptions

• The WACC estimate is also tough stuff• Projecting beyond a certain point is risky, what can

we do about that? – not much• Only project cash flows for a few years and say their

gonna increase “x” percent. Other than that, can’t do much


CB – Assessing Risk

Seems like sophisticated stuff• Sensitivity Analysis• Scenario Analysis• Monte Carlo Simulation


Assessing Risk

Sensitivity AnalysisThe trick is to change one input and see how much the bottom line changes.If the bottom line changes a lot, you’d better pay attention to the input you changedIs that input really risky or is it ..?If it’s really risky, what can we do about it?


Assessing RiskSensitivity Tables and Graphs – One easy picture…see ↙


Assessing Risk

Scenario AnalysisSometimes one input is related to another. Maybe sales goes up when interest rates go down. If so, do a few different scenarios, and see what happens to the bottom line.

You could average out the bottom line if you wanted to. The result may be different from your point estimate.


Assessing Risk

Monte Carlo SimulationA kazillion scenarios … an ...You also get a valuable probability distribution that helps you better understand the risk of the project.We’re not doing it.


Clicker QTilton Corporation builds windmills for use in developing nations. Tilton is a registered charity and as such, does not pay taxes. Ve = $40M, Vd = $0. re = .12, rd = .08

Tilton is considering a new windmill project. This project will take 10 years to complete. The initial cost of the project is $4M. Annual pre-tax operating cash flows are estimated to be $522,000 per year. The firm expects to sell off its salvage for $1,000,000 at the end of the project. The CCA rate for project is 20%.

Which of the following statements is true for Tilton Corporation?a) If the CCA rate for the project changes from 20% to 30%, the NPV

will decreaseb) If the salvage value for the project increases, the NPV will not

changec) If the salvage value for the project increases, the NPV will decreased) If the CCA rate for the project changes from 20% to 30%, the NPV

will not change



Real Options Think of it this way. Someday, you might be

married. Wouldn’t it be nice if you had:1. The option to delay the wedding by a year or

two. Maybe you could live with the person to find out if it will work. We call that an investment timing option.

2. The option to get out of the marriage once you’ve gotten into it (i.e., divorce). We call that an abandonment option.

3. The option to add another husband a few years down the line if it seems like a good idea at that time. We call that a growth option.


Real Options• In business terms, real options exist when

managers can influence the size and risk of a project’s cash flows by taking different actions during the project’s life in response to changing market conditions.

• It’s really cool if you can identify these options. How do you do that?• Purposefully have them on your todo list. Then

you won’t need a brainwave.

• It’s even cooler if you can create them when you create the capital budgeting project.


Real OptionsWhy do we care?• Because assessing projects ... may result in

different decisions and more shareholder wealth.

• Because we have the tools to do so.


The Investment Timing Option If we do a project now, the future cash flows

are uncertain. This means that we might lose money.

If we wait for a period (let’s say a year), maybe the future cash flows will become more certain. If it looks like the cash flows will be poor, we just won’t do the investment.

The idea is to compare the NPV of doing the project now with the NPV of doing it in a year.

All in all, it sounds like a good idea


The Investment Timing OptionMurphy Systems (20.2)New Project idea Initial Cost = 50M, N = 3 years, no salvage, WACC = .14Annual after-tax cash flows:Amount Probability$33M 25%$25M 50%$5M 25%Expected cash flow = (33*.25) + (25*.5) + (5*.25) = $22MNPV = -$50M + = $1.08M


The Investment Timing OptionMurphy Systems (20.2)There’s one catch. The firm can wait for a year before making the investment, at which point it will know the demand for the product (i.e., the cash flows).

What is the NPV of the project now if it chooses to wait? Is it more or less than $1.08M? If it’s more, the option has value.

Let’s work through the numbers. What discount rate should we use?


The Growth OptionKidco Corp. (20.3)New Project idea: Initial Cost = 30M, N = 2 years, no salvage, WACC = .14Annual after-tax cash flows:Amount Probability$34M 25%$20M 50%$2M 25%Expected cash flow = (34*.25) + (20*.5) + (2*.25) = $19MNPV = -$30M + = $1.29M


The Growth OptionKidco Corp. (20-2)There’s one catch. If the demand for the first product is average or high, which you find out at the end of year 1, Kidco believes that it can launch a second-generation product for the same cost, and with the same demand as the first product, just two years down the road.

What is the NPV of the project now if it chooses to wait? Is it more or less than ..? If it’s more, the option has ...

Let’s work through the numbers. What discount rate should we use?


The Abandonment Option andClicker QWouldn’t it be nice if you could get out of a losing business venture before you lose too much money. IC = 26M, N = 4 years, WACC = .12Annual after-tax cash flows:Amount at each year Probability$18M, 23M, 28M, 33M 25%$7M, 8M, 9M, 10M, 50%-$8M, -$9M, -$10M, -$12M 25%

What is the NPV of this project?


The Abandonment Option – Base CaseNPV(M’s) Prob. Prob.*NPV

Good $49.31 .25 $12.33Average ... .5 ...Ugly ... .25 ...

NPV = ...- ..- ...= ...


The Abandonment Option

Now what happens if we can abandon the project at the end of year 1 if results are bad and sell off the assets for $14M.

Amount at each year ProbabilityGood: $18M, 23M, 28M, 33M 25%Average: $7M, 8M, 9M, 10M, 50%Ugly: -$8M, -$9M, -$10M, -$12M 25%I say we’ll ... Cash flows for the “Ugly” stream become: ..., ..., ..., ...How do we treat the ...?How do we know that we shouldn’t abandon the ...

Capital Budgeting and Real Options Agenda for the Day Capital Budgeting

How does it fit in Common mistakes Assessing Risk

Real Options What are they? What types? Why do we care? How do we value them?

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Capital Budgeting Know the common mistakes

Know why risk assessment is important Know how to conduct basic risk assessment



Real Options• Know the ...• Not all firms are using Real Options but

many are. Real options come up all the time in the real world. Think of natural resource companies. They need all three of the options that we talked about…why?

• Sometimes its hard to put a number on the value of the option because you can’t put hard numbers on the inputs. When that happens, you have to ...

capital budgeting and real options edited

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