Types of Real Options

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. In the same vein, real options are capital allocation options that allow managers the right, but not the obligation, to undertake specific business initiatives in the future. Such initiatives may include deferment, abandonment, or project expansion. Fundamentally, these initiatives can impact the value of capital investments.

The following are types of real options:

• Timing options: A company delays investing now with the hopes that improved information in the future could help improve the NPV of a project.
• Sizing options: An abandonment option allows a company to abandon a project with discouraging results. This option can be exercised when the cash flow of abandoning a project exceeds the present value of continuing the project. On the other hand, a growth option allows a company to make additional investments based on the prospects of future solid financial results.
• Flexibility options: The price-setting option permits a company to increase its prices. A company can take advantage of excess demand, which it cannot meet by increasing its production due to low capacity. The company can also use production-flexibility options to profit from additional shifts and overtime to meet the additional demand.
• Fundamental options: Payoffs from a project, such as mining minerals, increase or decrease the value of an investment depending on whether they will find the mineral. Many research and development projects are examples of fundamental options.

There are three common approaches to evaluating capital projects with real options:

1. Investment analysis without considering options. If the NPV is positive without considering real options, a firm makes an investment.
2. Calculation of NPV with the real options and adding the real options value using the formula:$$ \text{Project’s NPV}=\text{NPV (without options)} – \text{Option cost} + \text{Option value} $$
3. Decision trees and option pricing models. Firms may use decision trees or option pricing models to evaluate capital investments with future decisions and possible outcomes. These methods help determine the investment’s value by assigning probabilities and expected timings to future outcomes when calculating the project’s NPV.

Example: Project NPV with a Real Option

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). This firm will enable the 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

$$ \begin{align*} \text{Project’s NPV}& =\text{NPV (based on discount cash flows alone)}-\text{Cost of options} \\ & +\text{value of options} \\ & =–600,000-700,000+2,000,000 \\ &=\$700,000 \end{align*} $$

The project has a positive NPV after considering the costs and benefits of the real options. The company should invest in the project.

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 five years and a 60% probability of $70,000 for the same five years.
• The project’s life is five 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:

1. -$9,761.
2. $4,257.
3. $62,334.

The correct answer is B.

If higher cash flows occur and Gatsby does not abandon the project, the NPV is:

$$ NPV=-190,000+\sum_{t=1}^{5}{\frac{70,000}{{(1.12)}^5}= \$62,334} $$

If Gatsby abandons the project when lower cash flows occur, it receives the first-year cash flow and the abandonment value:

$$ NPV=-190,000+\frac{20,000+100,000}{1.12}=-\$82,857 $$

The expected NPV is:

$$ NPV=0.4\left(-82,857\right)+\left(0.6\right)\left(62,334\right)=\$4,257 $$