FFM CH13 - Chapter13 RealOptionsandOther...

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Real Options and Other  Topics in Capital Budgeting Chapter 13 Identifying Embedded Options Valuing Real Options in Projects 13-1
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13-2 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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13-3 What are some examples of real options? Growth/expansion options Abandonment/shutdown options Investment timing options Flexibility options
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13-4 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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13-5 Investment Timing Option If they wait a year: There is a 50% chance the market will be strong  and the expected cash flows will be $43,500 a year  for four years. There is a 50% chance the market will be weak  and the expected cash flows will be $23,500 a year  for four years. The project’s initial cost will remain $100,000, but it  will be incurred at t = 1 only if it makes sense at  that time to proceed with the project. Should the company go ahead with the project  today or wait for more information?
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13-6 Investment Timing Decision Tree At WACC = 10%, the NPV at t = 1 is: $37,889, if CF’s are $43,500 per year, or  
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FFM CH13 - Chapter13 RealOptionsandOther...

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