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7 npvstrategic npvtraditional value of real options

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Unformatted text preview: s indicated by Equation 10.7. NPVstrategic NPVtraditional Value of real options (10.7) Application of this relationship is illustrated in the following example. EXAMPLE Assume that a strategic analysis of Bennett Company’s projects A and B (see cash flows and NPVs in Table 10.1) finds no real options embedded in project A and two real options embedded in project B. The two real options in project B are as CHAPTER 10 Risk and Refinements in Capital Budgeting 447 follows: (1) The project would have, during the first two years, some downtime that would result in unused production capacity that could be used to perform contract manufacturing for another firm, and (2) the project’s computerized control system could, with some modification, control two other machines, thereby reducing labor cost, without affecting operation of the new project. Bennett’s management estimated the NPV of the contract manufacturing over the 2 years following implementation of project B to be \$1,500 and the NPV of the computer control sharing to be \$2,000. Management felt there was a 60% chance that the contract manufacturing option would be exercised and only a 30% chance that the computer control sharing option would be exercised. The combined value of these two real options would be the sum of their expected values. Value of real options for project B (0.60 \$900 \$1,500) (0.30 \$600 \$1,500 \$2,000) Substituting the \$1,500 real options value along with the traditional NPV of \$10,924 for project B (from Table 10.1) into Equation 10.7, we get the strategic NPV for project B. NPVstrategic \$10,924 \$1,500 \$12,424 Bennett Company’s project B therefore has a strategic NPV of \$12,424, which is above its traditional NPV and now exceeds project A’s NPV of \$11,071. Clearly, recognition of project B’s real options improved its NPV (from \$10,924 to \$12,424) and causes it to be preferred over project A (NPV of \$12,424 for B NPV of \$11,071 for A), which has no real options embedded in it. It is important to realize that the recognition of attractive real options when determining NPV could cause an otherwise unacceptable project (NPVtraditional \$0) to become a...
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