What is its value Should it be purchased c Does the real option reduce New

# What is its value should it be purchased c does the

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What is its value? Should it be purchased? c. Does the real option reduce New England’s risk in any way? SOLUTION: a. The decision tree without the option is as follows: .3 ———— \$8 — \$8 — \$8 .2 .7 \$6 — \$6 \$6 .8 \$6 — \$6 — \$6 NPV = (.2)(.3)(\$8M)[PVFA 9,3 ] + (.2)(.7)(\$6M)[PVFA 9,3 ] +(.8)(\$6M)[PVFA 9,3 ] = \$.48M(.7722) + \$.84M(.7722) + \$4.8M(.7722) = \$6.12M(.7722) = \$4.73M b. The capacity option changes the decision tree to the following: \$8 — \$8 — \$8 .2 (\$1) .8 \$6 — \$6 — \$6 NPV = - \$1 + (.2)(\$8M)[PVFA 9,3 ] + (.8)(\$6M)[PVFA 9,3 ] = - \$1 + \$1.6M(.7722) + \$4.8M(.7722) = - \$1 + \$6.4M(.7722) = - \$1 + \$4.94M = \$3.94M The capacity option’s value is the increase in expected NPV it generates before consideration of it’s own cost. In this case that’s \$4.94M - \$4.73M = \$.21M Since that’s substantially less than the \$1M cost of the option, New England would be better off not buying it. c. Real options generally have favorable risk effects when they reduce the probability or magnitude of losses. In this case the option doesn’t do that. Rather it guarantees the ability to take advantage of a potential opportunity. That generally wouldn’t be viewed as reducing risk. 48
Risk Topics and Real Options in Capital Budgeting Risk Adjusted Rates – SML: Example 12-6 (page 546) 16. Hudson Furniture specializes in office furniture for self-employed individuals who work at home. Hudson’s furniture emphasizes style rather than utility, and has been quite successful. The firm is now considering entering the more competitive industrial furniture market where volumes are higher but pricing is more competitive. A \$10 million investment is required to enter the new market. Management anticipates positive cash flows of \$1.7 million annually for eight years if Hudson enters the field. An average stock currently earns 8%, and the return on treasury bills is 4%. Hudson’s beta is .5 while that of an important competitor that operates solely in the industrial market is 1.5. Should Hudson consider entering the industrial furniture market? SOLUTION: (\$M) First calculate the appropriate discount rate for the project using the pure play competitor’s beta. k x = k RF + (k M - k RF )b X = 4 + (8 - 4) 1.5 = 10% Use a calculator to arrive at the project’s NPV CFo (10) C01 1.7 F01 8 I 10 NPV (.930625) Since the NPV is negative, Hudson should not enter the new market. It’s important to notice that the opposite result would have been obtained using Hudson’s own beta to calculate a risk adjusted return as follows: k x = k RF + (k M - k RF )b X = 4 + (8 - 4) .5 = 6% and CFo (10) C01 1.7 F01 8 I 6 NPV .5566 So a positive NPV would have indicated going ahead with the new venture, probably an incorrect result. 17. Crest Concrete Inc. has been building basements and slab foundations for new homes in La Crosse, Wisconsin for more than 20 years. However, new home sales have slowed recently and residential construction work is hard to get. As a result, management is considering a venture into commercial construction. Although Crest would still be pouring concrete in commercial building, almost everything else about the business differs substantially from homebuilding which is all the firm has done until now.

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