{"id":30351,"date":"2021-09-14T18:49:48","date_gmt":"2021-09-14T18:49:48","guid":{"rendered":"https:\/\/analystprep.com\/cfa-level-1-exam\/?p=30351"},"modified":"2025-04-03T11:22:19","modified_gmt":"2025-04-03T11:22:19","slug":"real-options-relevant-to-capital-investment","status":"publish","type":"post","link":"https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-issuers\/real-options-relevant-to-capital-investment\/","title":{"rendered":"Real Options Relevant to Capital Investment (2022)"},"content":{"rendered":"\n<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/cvYoPNbcmfA\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\n<p>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.<\/p>\n<p>The following are types of real options:<\/p>\n<ul>\n<li><strong>Timing options:<\/strong>&nbsp;A company delays investing now with the hopes that improved information in the future could help improve the NPV of the project.<\/li>\n<li><strong>Sizing options:<\/strong>&nbsp;An&nbsp;<em><strong>abandonment option<\/strong><\/em>&nbsp;allows the company to abandon the project when results are discouraging and can be exercised when the cash flow of abandoning a project exceeds the present value of continuing the project. On the other hand, a&nbsp;<em><strong>growth option<\/strong>&nbsp;<\/em>allows the company to make additional investments when strong future financial results.<\/li>\n<li><strong>Flexibility options:<\/strong>&nbsp;The <em><strong>price-setting option <\/strong><\/em>permits the company to increase its prices to take advantage of the excess demand, which it cannot meet by increasing its production due to low capacity. The company can also use&nbsp;<em><strong>production-flexibility options<\/strong><\/em>&nbsp;to profit from additional shifts and overtime to meet the additional demand.<\/li>\n<li><strong>Fundamental options:<\/strong>&nbsp;Payoffs from a project such as mining minerals increase or decrease the value of an investment depending on whether they will find the said mineral. Many research and development projects are examples of fundamental options.<\/li>\n<\/ul>\n<p>There are four common approaches to evaluating capital projects with real options:<\/p>\n<ol>\n<li>Using the DCF (discounted cash flow) without considering options. If the NPV is positive, the firm goes ahead with the investment.<\/li>\n<\/ol>\n<ol start=\"2\">\n<li>Using the formula:&nbsp;<\/li>\n<\/ol>\n<p>$$\\text{Project\u2019s NPV = NPV (based on discount cash flows alone) \u2013 Cost of options + Value of options}$$<\/p>\n<ol start=\"4\">\n<li>Using decision trees.<\/li>\n<li>Using option pricing models.<\/li>\n<\/ol>\n<h4><strong>Example: Determining the Value of Real Options<\/strong><\/h4>\n<p>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.<\/p>\n<p>What is the value of the new assembly plant, including the real option?<\/p>\n<p><strong>Solution<\/strong><\/p>\n<p>$$\\begin{align}\\text{Project\u2019s NPV} &amp;= \\text{NPV (based on discount cash flows alone) \u2013 Cost of options + Value of options}\\\\ &amp;=-600,000-700,000+2,000,000\\\\ &amp;=\\$700,000 \\end{align}$$<\/p>\n<blockquote>\n<h3><strong>Question<\/strong><\/h3>\n<p>Gatsby Solutions is considering a capital project with the following information:<\/p>\n<ul>\n<li>The initial outlay is $190,000.<\/li>\n<li>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.<\/li>\n<li>The project&#8217;s life is 5 years.<\/li>\n<li>The salvage value at the project end is 0.<\/li>\n<li>The required rate of return (RRR) is 12%.<\/li>\n<li>In one year, the company has an abandonment option out of which Gatsby Solutions would receive the salvage value of $100,000.<\/li>\n<\/ul>\n<p>The NPV of the project, assuming the optimal abandonment strategy, is&nbsp;<em>closest<\/em> to:<\/p>\n<ol style=\"list-style-type: upper-alpha;\">\n<li>-$9,761.<\/li>\n<li>$4,257.<\/li>\n<li>$62,334.<\/li>\n<\/ol>\n<p><strong>Solution<\/strong><\/p>\n<p>&nbsp;The correct answer is<strong> B.<\/strong><\/p>\n<p>If higher cash flows occur and Gatsby does not abandon the project, the NPV is:<\/p>\n<p>$$ \\text{NPV}=-190,000+\\sum_{t=1}^{5} \\frac{70,000}{(1.12)^{t}}=\\$ 62,334$$<\/p>\n<p>If Gatsby abandons when the lower cash flows occur, Gatsby receives the first-year cash flow and the abandonment value:<\/p>\n<p>$$ \\text{NPV}=-190,000+\\frac{20,000+100,000}{1.12}=-\\$ 82,857$$<\/p>\n<p>The expected NPV is:<\/p>\n<p>$$ \\text{NPV}=0.4(-82,857)+(0.6)(62,334)=\\$ 4,257$$<\/p>\n<div class=\"notes_inv\"><hr>\n<p>&nbsp;<\/p>\n<\/div>\n<\/blockquote>\n","protected":false},"excerpt":{"rendered":"","protected":false},"author":15,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[25],"tags":[],"class_list":["post-30351","post","type-post","status-publish","format-standard","hentry","category-corporate-issuers","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v26.9 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Real Options in Capital Investment | CFA Level 1<\/title>\n<meta name=\"description\" content=\"Understand real options in capital budgeting\u2014timing, expansion, abandonment, and flexibility. A key CFA Level 1 topic in corporate finance decision-making.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-issuers\/real-options-relevant-to-capital-investment\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Real Options in Capital Investment | CFA Level 1\" \/>\n<meta property=\"og:description\" content=\"Understand real options in capital budgeting\u2014timing, expansion, abandonment, and flexibility. A key CFA Level 1 topic in corporate finance decision-making.\" \/>\n<meta property=\"og:url\" content=\"https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-issuers\/real-options-relevant-to-capital-investment\/\" \/>\n<meta property=\"og:site_name\" content=\"AnalystPrep | CFA\u00ae Exam Study Notes\" \/>\n<meta property=\"article:published_time\" content=\"2021-09-14T18:49:48+00:00\" \/>\n<meta property=\"article:modified_time\" content=\"2025-04-03T11:22:19+00:00\" \/>\n<meta name=\"author\" content=\"Kosikos Tuitoek\" \/>\n<meta name=\"twitter:card\" content=\"summary_large_image\" \/>\n<meta name=\"twitter:label1\" content=\"Written by\" \/>\n\t<meta name=\"twitter:data1\" content=\"Kosikos Tuitoek\" \/>\n\t<meta name=\"twitter:label2\" content=\"Est. reading time\" \/>\n\t<meta name=\"twitter:data2\" content=\"2 minutes\" \/>\n<script type=\"application\/ld+json\" class=\"yoast-schema-graph\">{\"@context\":\"https:\/\/schema.org\",\"@graph\":[{\"@type\":\"Article\",\"@id\":\"https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-issuers\/real-options-relevant-to-capital-investment\/#article\",\"isPartOf\":{\"@id\":\"https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-issuers\/real-options-relevant-to-capital-investment\/\"},\"author\":{\"name\":\"Kosikos Tuitoek\",\"@id\":\"https:\/\/analystprep.com\/cfa-level-1-exam\/#\/schema\/person\/73df713e3b6e82ee139e1eff20cebe20\"},\"headline\":\"Real Options Relevant to Capital Investment (2022)\",\"datePublished\":\"2021-09-14T18:49:48+00:00\",\"dateModified\":\"2025-04-03T11:22:19+00:00\",\"mainEntityOfPage\":{\"@id\":\"https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-issuers\/real-options-relevant-to-capital-investment\/\"},\"wordCount\":578,\"articleSection\":[\"Corporate Issuers\"],\"inLanguage\":\"en-US\"},{\"@type\":\"WebPage\",\"@id\":\"https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-issuers\/real-options-relevant-to-capital-investment\/\",\"url\":\"https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-issuers\/real-options-relevant-to-capital-investment\/\",\"name\":\"Real Options in Capital Investment | CFA Level 1\",\"isPartOf\":{\"@id\":\"https:\/\/analystprep.com\/cfa-level-1-exam\/#website\"},\"datePublished\":\"2021-09-14T18:49:48+00:00\",\"dateModified\":\"2025-04-03T11:22:19+00:00\",\"author\":{\"@id\":\"https:\/\/analystprep.com\/cfa-level-1-exam\/#\/schema\/person\/73df713e3b6e82ee139e1eff20cebe20\"},\"description\":\"Understand real options in capital budgeting\u2014timing, expansion, abandonment, and flexibility. A key CFA Level 1 topic in corporate finance decision-making.\",\"breadcrumb\":{\"@id\":\"https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-issuers\/real-options-relevant-to-capital-investment\/#breadcrumb\"},\"inLanguage\":\"en-US\",\"potentialAction\":[{\"@type\":\"ReadAction\",\"target\":[\"https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-issuers\/real-options-relevant-to-capital-investment\/\"]}]},{\"@type\":\"BreadcrumbList\",\"@id\":\"https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-issuers\/real-options-relevant-to-capital-investment\/#breadcrumb\",\"itemListElement\":[{\"@type\":\"ListItem\",\"position\":1,\"name\":\"Home\",\"item\":\"https:\/\/analystprep.com\/cfa-level-1-exam\/\"},{\"@type\":\"ListItem\",\"position\":2,\"name\":\"Real Options Relevant to Capital Investment (2022)\"}]},{\"@type\":\"WebSite\",\"@id\":\"https:\/\/analystprep.com\/cfa-level-1-exam\/#website\",\"url\":\"https:\/\/analystprep.com\/cfa-level-1-exam\/\",\"name\":\"AnalystPrep | CFA\u00ae Exam Study Notes\",\"description\":\"\",\"potentialAction\":[{\"@type\":\"SearchAction\",\"target\":{\"@type\":\"EntryPoint\",\"urlTemplate\":\"https:\/\/analystprep.com\/cfa-level-1-exam\/?s={search_term_string}\"},\"query-input\":{\"@type\":\"PropertyValueSpecification\",\"valueRequired\":true,\"valueName\":\"search_term_string\"}}],\"inLanguage\":\"en-US\"},{\"@type\":\"Person\",\"@id\":\"https:\/\/analystprep.com\/cfa-level-1-exam\/#\/schema\/person\/73df713e3b6e82ee139e1eff20cebe20\",\"name\":\"Kosikos Tuitoek\",\"image\":{\"@type\":\"ImageObject\",\"inLanguage\":\"en-US\",\"@id\":\"https:\/\/analystprep.com\/cfa-level-1-exam\/#\/schema\/person\/image\/\",\"url\":\"https:\/\/secure.gravatar.com\/avatar\/8260edaa3f7ba04cf6b536b3f7fd769007ecb789b3289ac0cc4c3ab8b3f7f061?s=96&d=mm&r=g\",\"contentUrl\":\"https:\/\/secure.gravatar.com\/avatar\/8260edaa3f7ba04cf6b536b3f7fd769007ecb789b3289ac0cc4c3ab8b3f7f061?s=96&d=mm&r=g\",\"caption\":\"Kosikos Tuitoek\"},\"url\":\"https:\/\/analystprep.com\/cfa-level-1-exam\/author\/kosikos-tuitoek-enockanalystprep-com\/\"}]}<\/script>\n<meta property=\"og:video\" content=\"https:\/\/www.youtube.com\/embed\/cvYoPNbcmfA\" \/>\n<meta property=\"og:video:type\" content=\"text\/html\" \/>\n<meta property=\"og:video:duration\" content=\"3177\" \/>\n<meta property=\"og:video:width\" content=\"480\" \/>\n<meta property=\"og:video:height\" content=\"270\" \/>\n<meta property=\"ya:ovs:adult\" content=\"false\" \/>\n<meta property=\"ya:ovs:upload_date\" content=\"2021-09-14T18:49:48+00:00\" \/>\n<meta property=\"ya:ovs:allow_embed\" content=\"true\" \/>\n<!-- \/ Yoast SEO plugin. -->","yoast_head_json":{"title":"Real Options in Capital Investment | CFA Level 1","description":"Understand real options in capital budgeting\u2014timing, expansion, abandonment, and flexibility. A key CFA Level 1 topic in corporate finance decision-making.","robots":{"index":"index","follow":"follow","max-snippet":"max-snippet:-1","max-image-preview":"max-image-preview:large","max-video-preview":"max-video-preview:-1"},"canonical":"https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-issuers\/real-options-relevant-to-capital-investment\/","og_locale":"en_US","og_type":"article","og_title":"Real Options in Capital Investment | CFA Level 1","og_description":"Understand real options in capital budgeting\u2014timing, expansion, abandonment, and flexibility. A key CFA Level 1 topic in corporate finance decision-making.","og_url":"https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-issuers\/real-options-relevant-to-capital-investment\/","og_site_name":"AnalystPrep | CFA\u00ae Exam Study Notes","article_published_time":"2021-09-14T18:49:48+00:00","article_modified_time":"2025-04-03T11:22:19+00:00","author":"Kosikos Tuitoek","twitter_card":"summary_large_image","twitter_misc":{"Written by":"Kosikos Tuitoek","Est. reading time":"2 minutes"},"schema":{"@context":"https:\/\/schema.org","@graph":[{"@type":"Article","@id":"https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-issuers\/real-options-relevant-to-capital-investment\/#article","isPartOf":{"@id":"https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-issuers\/real-options-relevant-to-capital-investment\/"},"author":{"name":"Kosikos Tuitoek","@id":"https:\/\/analystprep.com\/cfa-level-1-exam\/#\/schema\/person\/73df713e3b6e82ee139e1eff20cebe20"},"headline":"Real Options Relevant to Capital Investment (2022)","datePublished":"2021-09-14T18:49:48+00:00","dateModified":"2025-04-03T11:22:19+00:00","mainEntityOfPage":{"@id":"https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-issuers\/real-options-relevant-to-capital-investment\/"},"wordCount":578,"articleSection":["Corporate Issuers"],"inLanguage":"en-US"},{"@type":"WebPage","@id":"https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-issuers\/real-options-relevant-to-capital-investment\/","url":"https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-issuers\/real-options-relevant-to-capital-investment\/","name":"Real Options in Capital Investment | CFA Level 1","isPartOf":{"@id":"https:\/\/analystprep.com\/cfa-level-1-exam\/#website"},"datePublished":"2021-09-14T18:49:48+00:00","dateModified":"2025-04-03T11:22:19+00:00","author":{"@id":"https:\/\/analystprep.com\/cfa-level-1-exam\/#\/schema\/person\/73df713e3b6e82ee139e1eff20cebe20"},"description":"Understand real options in capital budgeting\u2014timing, expansion, abandonment, and flexibility. A key CFA Level 1 topic in corporate finance decision-making.","breadcrumb":{"@id":"https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-issuers\/real-options-relevant-to-capital-investment\/#breadcrumb"},"inLanguage":"en-US","potentialAction":[{"@type":"ReadAction","target":["https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-issuers\/real-options-relevant-to-capital-investment\/"]}]},{"@type":"BreadcrumbList","@id":"https:\/\/analystprep.com\/cfa-level-1-exam\/corporate-issuers\/real-options-relevant-to-capital-investment\/#breadcrumb","itemListElement":[{"@type":"ListItem","position":1,"name":"Home","item":"https:\/\/analystprep.com\/cfa-level-1-exam\/"},{"@type":"ListItem","position":2,"name":"Real Options Relevant to Capital Investment (2022)"}]},{"@type":"WebSite","@id":"https:\/\/analystprep.com\/cfa-level-1-exam\/#website","url":"https:\/\/analystprep.com\/cfa-level-1-exam\/","name":"AnalystPrep | CFA\u00ae Exam Study Notes","description":"","potentialAction":[{"@type":"SearchAction","target":{"@type":"EntryPoint","urlTemplate":"https:\/\/analystprep.com\/cfa-level-1-exam\/?s={search_term_string}"},"query-input":{"@type":"PropertyValueSpecification","valueRequired":true,"valueName":"search_term_string"}}],"inLanguage":"en-US"},{"@type":"Person","@id":"https:\/\/analystprep.com\/cfa-level-1-exam\/#\/schema\/person\/73df713e3b6e82ee139e1eff20cebe20","name":"Kosikos Tuitoek","image":{"@type":"ImageObject","inLanguage":"en-US","@id":"https:\/\/analystprep.com\/cfa-level-1-exam\/#\/schema\/person\/image\/","url":"https:\/\/secure.gravatar.com\/avatar\/8260edaa3f7ba04cf6b536b3f7fd769007ecb789b3289ac0cc4c3ab8b3f7f061?s=96&d=mm&r=g","contentUrl":"https:\/\/secure.gravatar.com\/avatar\/8260edaa3f7ba04cf6b536b3f7fd769007ecb789b3289ac0cc4c3ab8b3f7f061?s=96&d=mm&r=g","caption":"Kosikos Tuitoek"},"url":"https:\/\/analystprep.com\/cfa-level-1-exam\/author\/kosikos-tuitoek-enockanalystprep-com\/"}]},"og_video":"https:\/\/www.youtube.com\/embed\/cvYoPNbcmfA","og_video_type":"text\/html","og_video_duration":"3177","og_video_width":"480","og_video_height":"270","ya_ovs_adult":"false","ya_ovs_upload_date":"2021-09-14T18:49:48+00:00","ya_ovs_allow_embed":"true"},"_links":{"self":[{"href":"https:\/\/analystprep.com\/cfa-level-1-exam\/wp-json\/wp\/v2\/posts\/30351","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/analystprep.com\/cfa-level-1-exam\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/analystprep.com\/cfa-level-1-exam\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/analystprep.com\/cfa-level-1-exam\/wp-json\/wp\/v2\/users\/15"}],"replies":[{"embeddable":true,"href":"https:\/\/analystprep.com\/cfa-level-1-exam\/wp-json\/wp\/v2\/comments?post=30351"}],"version-history":[{"count":6,"href":"https:\/\/analystprep.com\/cfa-level-1-exam\/wp-json\/wp\/v2\/posts\/30351\/revisions"}],"predecessor-version":[{"id":44282,"href":"https:\/\/analystprep.com\/cfa-level-1-exam\/wp-json\/wp\/v2\/posts\/30351\/revisions\/44282"}],"wp:attachment":[{"href":"https:\/\/analystprep.com\/cfa-level-1-exam\/wp-json\/wp\/v2\/media?parent=30351"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/analystprep.com\/cfa-level-1-exam\/wp-json\/wp\/v2\/categories?post=30351"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/analystprep.com\/cfa-level-1-exam\/wp-json\/wp\/v2\/tags?post=30351"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}