eFM2e, ch 14, Other CB - Chapter 14 Real Options and Other...

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Real Options and Other Topics in Capital Budgeting Chapter 14 Identifying Embedded Options Valuing Real Options in Projects 14-1
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14-2 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.
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14-3 What are some examples of real options? Growth/expansion options Abandonment/shutdown options Investment timing options Flexibility options
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14-4 Investment Timing Option Project X has an up-front cost of $100,000. The project is expected to produce after-tax cash flows of $33,500 at the end of each of the next four years (t = 1, 2, 3, and 4). The project has a WACC=10%. The project’s NPV is $6,190. Therefore, it appears that the company should go ahead with the project. However, if the company waits a year they will find out more about the project’s expected cash flows.
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14-5 Investment Timing Option If they wait a year: There is a 60% chance the market will be strong and the expected cash flows will be $43,500 a year for four years.
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