13 Case model
Real Options and Other Topics in Capital Budgeting
21st Century Educational Products is a rapidly growing software company and, consistent with its growth, it
has a relatively large capital budget.
While most of the company’s projects are fairly easy to evaluate, a handful of projects
involve more complex evaluations.
John Keller, a senior member of the company’s finance staff, coordinates the evaluation of these more complex projects.
His group brings their recommendations directly to the company’s CFO and CEO, Kristin Riley and Bob Stevens, respectively.
Considering real options, one of Keller’s colleagues, Barbara Hudson, has suggested that instead of investing in
Project X today, it might make sense to wait a year because 21st Century would learn a lot more about market conditions
and would be better able to forecast the project's cash flows.
Right now, 21st Century forecasts that Project X, which will last
4 years, will generate expected annual net cash flows of $33,500.
However, if the company waits a year, it will learn more
about market conditions.
There is a 50% chance that the market will be strong and a 50% chance it will be weak.
market is strong, the annual cash flows will be $43,500.
If the market is weak, the annual cash flows will be only $23,500.
21st Century chooses to wait a year, the initial investment will remain $100,000.
Assume that all cash flows are discounted
Should 21st Century invest in Project X today, or should it wait a year before deciding whether to invest in the
End of time period
at t = 1
However, in a weak market the firm will not undertake Project X since its NPV < 0.
Consequently, the expected NPV of
waiting one year is (0.5)($0) + (0.5)($37,889.15) = $18,944.58.
However, this is the present value at Year 1, so the firm must discount
it back one year to find the value today of waiting to do Project X.
So, the value today of waiting is calculated as
$18,944.58/1.10 = $17,222.34. Therefore, the firm should wait to obtain more information about the market rather than