13 Chapter model

13 Chapter model - 13 Chapter model 3/22/2010 7:08...

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13 Chapter model 3/22/2010 7:08 2/22/2006 Chapter 13. Real Options and Other Topics in Capital Budgeting In this model we examine four types of real options: abandonment, timing, growth, and flexibility. Table 13-1. Decision Trees Without and With the Abandonment Option (Dollars in Thousan Situation 1. Cannot Abandon. WACC = 12% Predicted Cash Flow for Each Year NPV @ Prob: 0 1 2 3 4 12% Best Case 25% -26,000 33,810 34,257 33,841 50,224 $87,503 Base 50% -26,000 6,702 7,149 6,733 23,116 $5,166 Worst Case 25% -26,000 -9,390 -8,943 -9,359 7,024 -$43,711 Expected NPV $13,531 Standard Deviation (SD) $47,139 Coefficient of Variation (CV) = Std Dev/Expected NPV 3.48 Situation 2. Can Abandon. WACC = 12% End of Period Cash Flows: NPV @ Prob. 0 1 2 3 4 12% Best Case 25% -26,000 33,810 34,257 33,841 50,224 $87,503 Base 50% -26,000 6,702 7,149 6,733 23,116 $5,166 Worst #1 0% -$26,000 -$9,390 -$8,943 -$9,359 $7,024 -$43,711 Disregard Worst #2 25% -$26,000 -$9,390 $18,244 $0 $0 -$19,840 Choose Expected NPV $19,499 Standard Deviation (SD) $40,567 Coefficient of Variation (CV) = Std Dev/Expected NPV 2.08 Value of the Real Option to Abandon Expected NPV with Abandonment $19,499 Expected NPV without Abandonment $13,531 ABANDONMENT (Section 13.2) We use BQC's computer control project as discussed in Chapter 12 to illustrate abandonment. Recall that due to labor contracts and other constraints, that originally the project could not be terminated before the end of its 4-year life. We show below decision trees for three scenarios under the "Can't Abandon" and "Can Abandon" cases. Cash flows are taken from the Chapter 12 model, where they were calculated. In Column B, we show the probabilities for each scenario. Next, in Columns C through G, we show the annual cash flows under each scenario. Column H shows the NPV under each scenario at a 12% risk-adjusted cost of capital. The probability times the NPV for each branch of the tree is calculated in cell H21 (cell H32 if abandoned); it is the expected NPV. Then, cell H22 (cell H33 if abandoned) gives the standard deviation, and the coefficient of variation is shown in cell H23 (cell H34 if abandoned). As noted, the project is risky, but it has a high expected NPV. It would probably be accepted, but if things turn out badly, this would hurt the company rather badly.
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Difference = Value of the Option $5,968 Proceed Immediately, i.e., Invest Now End of Period: Prob. 2007 2008 2009 2010 2011 Good Conditions 50% -$5.0 $2.5 $2.5 $2.5 $2.5 Bad Conditions 50% -$5.0 $1.2 $1.2 $1.2 $1.2 Expected NPV = sum, prob. times NPV Standard Deviation Coefficient of Variation = Std Dev / Expected NPV The possiblity of abandonment raises the expected NPV because some negative CFs will not occur. The standard deviation also declines. Both of these changes cause the CV to decline. The project's CV ends up close to 2.0, which is the average for BQC's projects, which in turn suggests that it is appropriate to evaluate the project using the 12% WACC. Finally, note that the difference between the expected NPV with and without abandonment
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This note was uploaded on 03/21/2010 for the course BUSINESS AB102 taught by Professor Woo during the Spring '10 term at Nanzan.

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13 Chapter model - 13 Chapter model 3/22/2010 7:08...

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