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Options are financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date. Likewise, real options are capital allocation options that allow managers the right, but not the obligation, to undertake certain business initiatives in the future, such as deferring, abandoning, or expanding a project. Fundamentally, these can alter the value of the investment decisions made today.
The following are types of real options:
There are four common approaches to evaluating capital projects with real options:
$$\text{Project’s NPV = NPV (based on discount cash flows alone) – Cost of options + Value of options}$$
McGill Automotive estimates the NPV of a new assembly plant to be -$600,000. The firm is evaluating an additional investment of $700,000 (present value) to enable management to pay overtime wages to workers in the new assembly plant if the new product crosses over to global markets. The option has an estimated present value of $2 million.
What is the value of the new assembly plant, including the real option?
Solution
$$\begin{align}\text{Project’s NPV} &= \text{NPV (based on discount cash flows alone) – Cost of options + Value of options}\\ &=-600,000-700,000+2,000,000\\ &=\$700,000 \end{align}$$
Question
Gatsby Solutions is considering a capital project with the following information:
- The initial outlay is $190,000.
- The annual after-tax operating cash flows have a 40% probability of being $20,000 for 5 years and a 60% probability of being $70,000 for the same 5 years.
- The project’s life is 5 years.
- The salvage value at the project end is 0.
- The required rate of return (RRR) is 12%.
- In one year, the company has an abandonment option out of which Gatsby Solutions would receive the salvage value of $100,000.
The NPV of the project, assuming the optimal abandonment strategy, is closest to:
- -$9,761.
- $4,257.
- $62,334.
Solution
The correct answer is B.
If higher cash flows occur and Gatsby does not abandon the project, the NPV is:
$$ \text{NPV}=-190,000+\sum_{t=1}^{5} \frac{70,000}{(1.12)^{t}}=\$ 62,334$$
If Gatsby abandons when the lower cash flows occur, Gatsby receives the first-year cash flow and the abandonment value:
$$ \text{NPV}=-190,000+\frac{20,000+100,000}{1.12}=-\$ 82,857$$
The expected NPV is:
$$ \text{NPV}=0.4(-82,857)+(0.6)(62,334)=\$ 4,257$$