78106_25_Web_Ch25A_p01-08

# 78106_25_Web_Ch25A_p01-08 - WEB EXTENSION 25A The...

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WEB EXTENSION 25A The Abandonment Real Option This extension illustrates the valuation of abandonment options. 25.1 T HE A BANDONMENT O PTION :A N I LLUSTRATION Synapse Systems produces a variety of switching devices for computer networks at large corporations. It is considering a proposal to develop and produce a wireless net- work targeted at homes and small businesses. The required manufacturing facility will cost \$26 million. Synapse can accurately predict the manufacturing costs, but the sales price is uncertain. There is a 25% probability that demand will be strong and Synapse can charge a high price; see Table 25A-1 for detailed projections of operating cash flows over the 4-year life of the project. There is a 50% chance of moderate demand and average prices as well as a 25% chance of weak demand and low prices. The cost of capital for this project is 12%. Synapse can sell the equipment used in the manufacturing process for \$14 million after taxes at Year 1 if customer acceptance is low. In other words, Synapse can aban- don the project at Year 1 and avoid the negative cash flows in subsequent years. This abandonment option resembles a put option on stock. It gives Synapse the opportunity to sell the project at a fixed price of \$14 million at Year 1 if the cash flows beyond Year 1 are worth less than \$14 million. If the cash flows beyond Year 1 are worth more than \$14 million, then Synapse will let the put option expire and keep the project. Approach 1. DCF Analysis Ignoring the Abandonment Option Using the expected cash flows from Table 25A-1 and ignoring the abandonment option, the traditional NPV is - \$1.74 million: NPV ¼ - \$26 þ \$6 : 00 ð 1 þ 0 : 12 Þ 1 þ \$7 : 50 ð 1 þ 0 : 12 Þ 2 þ \$9 : 00 ð 1 þ 0 : 12 Þ 3 þ \$10 : 25 ð 1 þ 0 : 12 Þ 4 ¼ - \$1 : 74 : Based only on this DCF analysis, Synapse should reject the project. Approach 2. DCF Analysis with a Qualitative Consideration of the Abandonment Option The DCF analysis ignores the potentially valuable abandonment option. Qualita- tively, we would expect the abandonment option to be valuable because the project 1

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is quite risky, and risk increases the value of an option. The option has 1 year until it expires, which is relatively long for an option. Again, this suggests that the option might be valuable. Approach 3. Decision-Tree Analysis of the Abandonment Option Part 1 of Figure 25A-1 shows a scenario analysis for this project. There is a 25% chance that customers will accept a high price for the product, with the cash flows shown in the top line. There is a 50% chance that Synapse can charge a moderately high price; the cash flows of this scenario are in the middle row. However, if custo- mers are reluctant to buy the product then Synapse will have to cut prices, resulting in the negative cash flows shown in the bottom row. The sum in the last column in Part 1 shows the expected NPV of - \$1.74 million, which is the same value as calcu- late using traditional DCF analysis. Part 2 of Figure 25A-1 shows a decision-tree analysis in which Synapse abandons
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78106_25_Web_Ch25A_p01-08 - WEB EXTENSION 25A The...

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