Exam 13: Real Options

Real options can affect the size of a project's expected NPV but not project's risk as measured by the standard deviation or coefficient of variation of the NPV.

Capital rationing is the situation in which a firm can raise only a specified, limited amount of capital regardless of how many good projects it has.

Gleason Research regularly takes real options into account when evaluating its proposed projects. Specifically, it considers the option to abandon a project whenever it turns out to be unsuccessful (the abandonment option), and it evaluates whether it is better to invest in a project today or to wait and collect more information (the investment timing option). Assume the proposed projects can be abandoned at any time without penalty. Which of the following statements is CORRECT?

Which one of the following will NOT increase the value of a real option?

The option to abandon a project is a real option, but a call option on a stock is not a real option.

A firm's optimal capital budget consists of all independent projects with positive NPVs plus those mutually exclusive projects that have the highest positive NPVs.

Which one of the following is NOT a real option?

Sheehan Inc. is deciding whether to invest in a project today or to postpone the decision until next year. The project has a positive expected NPV, but its cash flows might turn out to be lower than expected, in which case the NPV could be negative. No competitors are likely to invest in a similar project if the firm decides to wait. Which of the following statements best describes the issues that the firm faces when considering this investment timing option?

Traditionally, an NPV analysis assumes that projects will be accepted or rejected, which implies that they will be undertaken now or never. However, in practice, companies sometimes have a third choice--delay the decision until later, when more information will be available. Because the analysis extends out at least one additional year from the original analysis, it is unlikely that the firm would ever delay a project--particularly given the loss of the "first mover advantage."

Texas Wildcatters Inc. (TWI)t = 0. A $400 feasibility study would be conducted at t = 0. The results of this study would determine if the company should commence drilling operations or make no further investment and abandon the project. There is an 80% probability that the feasibility study would indicate that an exploratory well should be drilled. There is a 20% probability that no further work would be done. T = 1. If the feasibility study indicates good potential, the firm would spend $1,000 at t = 1 to drill an exploratory well. The best estimate is that there is a 60% probability that the exploratory well would indicate good potential and thus that further work would be done, and a 40% probability that the outlook would look bad and the project would be abandoned. T = 2. If the exploratory well tests positive, the firm would go ahead and spend $10,000 to obtain an accurate estimate of the amount of oil in the field at t = 2. T = 3. If the full drilling program is carried out, there is a 50% probability of finding a lot of oil and receiving a $25,000 cash inflow at t = 3, and a 50% probability of finding less oil and then only receiving a $10,000 inflow. Since the project is considered to be quite risky, a 20.0% cost of capital is used. What is the project's expected NPV, in thousands of dollars?

Norris Production Company (NPC)NPC is considering whether to make the investment today or to wait a year to find out about the FDA's decision. If it waits a year, the project's up-front cost at t = 1 will remain at $2,500, the subsequent cash flows will remain at $750 per year if the competitor's product is rejected and $50 per year if the alternative product is approved. However, if NPC decides to wait, the subsequent cash flows will be received only for six years (t = 2 ... 7)This is a risky project, so a WACC of 16.0% is to be used. If NPC chooses to wait a year before proceeding, what is the value of the timing option today?

Carlson Inc. is evaluating a project in India that would require a $6.2 million investment today (t = 0). The after-tax cash flows would depend on whether India imposes a new property tax. There is a 50-50 chance that the tax will pass, in which case the project will produce after-tax cash flows of $1,350,000 at the end of each of the next 5 years. If the tax doesn't pass, the after-tax cash flows will be $2,000,000 for 5 years. The project has a WACC of 12.0%. The firm would have the option to abandon the project 1 year from now, and if it is abandoned, the firm would receive the expected $1.35 million cash flow at t = 1 and would also sell the property for $4.75 million at t = 1. If the project is abandoned, the company would receive no further cash inflows from it. What is the value (in thousands) of this abandonment option?

For planning purposes, managers must forecast the total capital budget because the amount of capital raised affects the WACC.

Which of the following statements is CORRECT?

Lindley Corp. is considering a new product that would require an investment of $10 million now, at t = 0. If the new product is well received, then the project would produce after-tax cash flows of $5 million at the end of each of the next 3 years (t = 1, 2, 3), but if the market did not like the product, then the cash flows would be only $2 million per year. There is a 50% probability that the market will be good. The firm could delay the project for a year while it conducts a test to determine if demand is likely to be strong or weak. The project's cost and expected annual cash flows would be the same whether the project is delayed or not. The project's WACC is 10.0%. What is the value (in thousands) of the project after considering the investment timing option?

Chrustuba Inc. is evaluating a new project that would cost $9 million at t = 0. There is a 50% chance that the project would be highly successful and generate annual after-tax cash flows of $6 million during Years 1, 2, and 3. However, there is a 50% chance that it would be less successful and would generate only $1 million for each of the 3 years. If the project is highly successful, it would open the door for another investment of $10 million at the end of Year 2, and this new investment could be sold for $20 million at the end of Year 3. Assuming a WACC of 10.0%, what is the project's expected NPV (in thousands) after taking into account this growth option?

In the previous problem you were asked to find the expected NPV of a project TWI is considering. Use the same data to calculate the project's coefficient of variation. (Hint: Use the expected NPV as found in Problem 40.)

The true expected value of a project with a growth option is the expected NPV of the project (including the value of the option) less the cost of obtaining that option.

Real options are most valuable when the underlying source of risk--such as uncertainty about unit sales, or the sales price, or input costs--is very low.