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Given that projects x and y are mutually exclusive

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Unformatted text preview: over project Y. Given that projects X and Y are mutually exclusive, project X would be the recommended project because it provides the higher annualized net present value. Recognizing Real Options real options Opportunities that are embedded in capital projects that enable managers to alter their cash flows and risk in a way that affects project acceptability (NPV). Also called strategic options. The procedures described in Chapters 8 and 9 and thus far in this chapter suggest that to make capital budgeting decisions, we must (1) estimate relevant cash flows, (2) apply an appropriate decision technique such as NPV or IRR to those cash flows, and (3) recognize and adjust the decision technique for project risk. Although this traditional procedure is believed to yield good decisions, a more strategic approach to these decisions has emerged in recent years. This more modern view considers any real options—opportunities that are embedded in capital projects (“real,” rather than financial, asset investments) that enable managers to alter their cash flows and risk in a way that affects project acceptability (NPV). Because these opportunities are more likely to exist in, and be more important to, large “strategic” capital budgeting projects, they are sometimes called strategic options. Some of the more common types of real options—abandonment, flexibility, growth, and timing—are briefly described in Table 10.4. It should be clear from their descriptions that each of these types of options could be embedded in a 446 PART 3 Long-Term Investment Decisions TABLE 10.4 Major Types of Real Options Option type Description Abandonment option The option to abandon or terminate a project prior to the end of its planned life. This option allows management to avoid or minimize losses on projects that turn bad. Explicitly recognizing the abandonment option when evaluating a project often increases its NPV. Flexibility option The option to incorporate flexibility into the firm’s operations...
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