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Real Options Analysis: Evaluating Investment Decisions Under Uncertainty

An analysis of real options and their use in evaluating investment decisions in uncertain markets.

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    Real Options Analysis: Evaluating Investment Decisions Under Uncertainty, page 1Real Options Analysis: Evaluating Investment Decisions UnderUncertaintyProblem 13-1Growth optionMartin Development Co. is deciding whether to proceed with Project X. The cost would be $10 million inYear 0. There is a 50% chance that X would behugely successful and would generate annual after-taxcash flows of $5 million per year during Years 1, 2, and 3. However, there is a 50% chance that X would beless successful and would generate only $3 million per year for the 3 years. If Project X is hugelysuccessful, it would open the door to another investment, Project Y, that would require $8 million outlay atthe end of Year 2. Project Y would then be sold to another company at a price of $19 million at the end ofYear 3. Martin's WACC is 12%.a. If the company does not consider real options, what is Project X's NPV? Round your answer to twodecimal places. If the answer is negative, use minus sign.$________millionAnswer:$-0.39$ millionb. What is X's NPV considering the growth option? Round your answer to two decimal places. If the answeris negative, use minus sign.$________millionAnswer:$4.90$ millionc. What is the value of the growth option? Round your answer to two decimal places. If the answer isnegative, use minus sign.$________millionAnswer:$5.29$ million2.Problem 13-2Optimal Capital BudgetMarble Construction estimates that its WACC is 10% if equity comes from retained earnings. However, ifthe company issues new stock to raise new equity, it estimates that its WACC will rise to 10.8%. Thecompany believes that it will exhaust its retained earnings at $2,500,000 of capital due to the number ofhighly profitable projects available to the firm and its limited earnings. The company is considering thefollowing seven investment projects:ProjectSize, $IRR, %A650,00014.0

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    Real Options Analysis: Evaluating Investment Decisions Under Uncertainty, page 2

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    Real Options Analysis: Evaluating Investment Decisions Under Uncertainty, page 3B1,050,00013.5C1,000,00011.2D1,200,00011.0E500,00010.7F650,00010.3G700,00010.2Assume that each of these projects is independent and that each is just as risky as the firm's existingassets. Which set of projects should beaccepted?Project Aa._________________Project Bb._________________Project Cc._________________Project Dd._________________Project Ee._________________Project Ff._________________Project Gg._________________(a)Accept(b)Accept(c)Accept(d)Accept(e)Reject(f)Reject(g)RejectWhat is the firm's optimal capital budget? Write out your answer completely. For example, 13 million shouldbe entered as 13,000,000.$________Optimal Capital Budget:$3,900,0003.Problem 13-3Investment timing optionDigital Inc. is considering production of a new cell phone. The project would require an investment of $20million. If the phone were well received, then the project would produce cash flows of $10 million a year for3 years, but if the market did not like the product, then the cash flows would be only $5 million per year.There is a 50% probability of both good and bad market conditions. Digital could delay the project for a yearwhile it could conduct a test to determine if demand would be strong or weak.The delay would not affecteither the project's cost or its cash flows. Digital's WACC is 10%. What action would you recommend?_________________Answer:Delay the project for a year to conduct the test and determine market conditionsbefore investing.4.Problem 13-4

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    Real Options Analysis: Evaluating Investment Decisions Under Uncertainty, page 4Abandonment optionThe Scampini Supplies Company recently purchased a new delivery truck. The new truck costs $22,500,and it is expected to generate after-tax cash flows, including depreciation, of $6,250 per year. The truck hasa 5-year expected life. The expected year-end abandonment values (salvage values after tax adjustments)for the truck are given below. The company's WACC is 10%.YearAnnual After-Tax CashFlowAbandonment Value0$-22,500-16,250$17,50026,25014,00036,25011,00046,2505,00056,2500a. What is the truck's optimal economic life?________year(s)Answer:The truck's optimal economic life is3 years.b. Would the introduction of abandonment values, in addition to operating cash flows, everreducetheexpected NPV and/or IRR of a project?_________________Answer:No, the introduction of abandonment values would not reduce the expectedNPVorIRRof aproject.Explain._________________Explanation:Abandonment values provide additional cash inflows if the project is terminated early, whichcan increase the project's NPV. The option to abandon allows the company to avoid future losses or lowerreturns, thus improving the project's overall financial viability.5.Problem 13-5Optimal capital budgetHampton Manufacturing estimates that its WACC is 12.5%. The company is considering the followingseven investment projects:ProjectSizeIRR

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    Real Options Analysis: Evaluating Investment Decisions Under Uncertainty, page 5A$750,00014.0%B1,250,00013.5C1,250,00013.2D1,250,00013.0E750,00012.7F750,00012.3G750,00012.2Assume that each of these projects is independent and that each is just as risky as the firm's existingassets. Which set of projects should be accepted?Project A_________________Project B_________________Project C_________________Project D_________________Project E_________________Project F_________________Project G_________________What is the firm's optimal capital budget? Write out youranswer completely. For example, 13 million shouldbe entered as 13,000,000.$__________Now, assume that Projects C and D are mutually exclusive. Project D has an NPV of $ 400,000, whereasProject C has an NPV of $350,000. Which set ofprojects should be accepted?

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