Chapter 12
Real Options
MINI CASE
Assume that you have just been hired as a financial analyst by Tropical Sweets Inc., a
midsized California company that specializes in creating exotic candies from tropical
fruits such as mangoes, papayas, and dates.
The firm's CEO, George Yamaguchi,
recently returned from an industry corporate executive conference in San Francisco, and
one of the sessions he attended was on real options.
Since no one at Tropical Sweets is
familiar with the basics of real options, Yamaguchi has asked you to prepare a brief
report that the firm's executives could use to gain at least a cursory understanding of the
topics.
To begin, you gathered some outside materials the subject and used these materials to
draft a list of pertinent questions that need to be answered.
In fact, one possible
approach to the paper is to use a questionandanswer format.
Now that the questions
have been drafted, you have to develop the answers.
a.
What are some types of real options?
Answer:
1. Investment timing options
2.
Growth options
a.
Expansion of existing product line
b.
New products
c.
New geographic markets
3.
Abandonment options
a.
Contraction
b.
Temporary suspension
c.
Complete abandonment
4.
Flexibility options.
b.
What are five possible procedures for analyzing a real option?
Answer:
1.
DCF analysis of expected cash flows, ignoring option.
2.
Qualitatively assess the value of the real option.
3.
Decision tree analysis.
4.
Use a model for a corresponding financial option, if possible.
5.
Use financial engineering techniques if a corresponding financial option is not
available.
Mini Case:
12 1
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Tropical Sweets is considering a project that will cost $70 million and will
generate expected cash flows of $30 per year for three years.
The cost of
capital for this type of project is 10 percent and the riskfree rate is 6 percent.
After discussions with the marketing department, you learn that there is a 30
percent chance of high demand, with future cash flows of $45 million per year.
There is a 40 percent chance of average demand, with cash flows of $30 million
per year.
If demand is low (a 30 percent chance), cash flows will be only $15
million per year. What is the expected NPV?
Answer:
Initial Cost = $70 Million
Expected Cash Flows = $30 Million Per Year For Three Years
Cost Of Capital = 10%
PV Of Expected CFs = $74.61 Million
Expected NPV = $74.61  $70
= $4.61 Million
Alternatively, one could calculate the NPV of each scenario:
Demand
Probability
Annual Cash Flow
High
30%
$45
Average
40%
$30
Low
30%
$15
Find NPV of each scenario:
PV High:
N=3
I=10
PV=?
PMT=45
FV=0
PV= 111.91
NPV High = $111.91  $70 = $41.91 Million.
PV Average: N=3
I=10
PV=?
PMT=30
FV=0
PV= 74.61
NPV Average = $74.61  $70 = $4.71 Million.
PV Low: N=3
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 Spring '08
 Buddin
 Net Present Value

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