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Npv Analysis Treats Projects as “now-Or-Never” Opportunities

By:   •  January 31, 2018  •  Thesis  •  1,048 Words (5 Pages)  •  907 Views

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Real Options

  • NPV misuse

NPV analysis treats projects as “now-or-never” opportunities

It fails to account for the value associated with managerial flexibility and the value gained (destroyed) when that flexibility is created (removed).

* Decision biases

  • If an investment is irreversible and can be delayed then, there is an opportunity cost of investing today (giving up the flexibility of waiting and possibly not investing later)
  • Underinvestment problem

By ignoring flexibility  NPV undervalues projects

  • Real options

Real options give the flexibility to decide what to do with a project

  • Discretionary investment opportunities “embedded” in a capital project
  • Arise from ability to make or revise decisions over the life of a project in response to uncertain future events
  • Allows management to add value

By making the correct decisions  exercising options in an optimal way

* Levers of Financial and Real Options

Financial Options

Real Options

Comments

Option Value

Stock (market) price

NPV of project cash flows

Greater NPV

→ Higher option value

Exercise (strike) price

Investment cost

Higher cost

→ Lower option value

Volatility

Uncertainty

Higher volatility

→ Higher option value

Time-to-maturity

Expected life of option

Opportunity to learn

Dividends

Value lost over duration of option

Loss of cash

→ Lower option value

Risk-free rate

Risk-free rate

Higher interest rate

→ Higher option value

  • Types of Real Options

Option to Delay

Option to Expand

Option to Abandon

Type

Call option

Call option

Put option

Exercise price

Up-front investment to go ahead

Costs of expansion

Salvage value of the assets that can be sold

Value of underlying asset

PV of net cash flows from operating project

PV of incremental net cash flows from expansion

PV of net cash flows from continued project

Option premium (price)

Cost of establishing the right to delay

Cost of establishing the right to expand

Cost of establishing the right to abandon

Volatility

Variance of future cash flows from the project

Variance of future incremental cash flows

Variance of future cash flows from the project

Term to expiry

The period of time with right to exercise

The period of time with right to exercise

The period of time with right to exercise

  1. Option to Invest (Delay investment)

[pic 1]

E.g. [pic 2]

You will need to have purchased relevant permits for £500 

If you choose to go ahead you will need to spend £40,000 up-front

  1. Option to Expand

[pic 3]

E.g.[pic 4]

Factory B could facilitate increased production activity if required.

It would also cost an additional £1,000 up-front.

To rejig your factory to increase production would cost £60,000

  1. Option to Abandon

[pic 5]

E.g.

You can pay an additional £20,000 up-front – give you the right to cease operations and sell off your equipment at any time.

The salvage value of your assets at the moment is £120,000.

[pic 6]

  • Early exercise of an Option

* Call options

Never exercise early except maybe for dividend paying asset.

=> Option to delay investment

  • The longer you delay the more cash flows you may give up.
  • May be optimal to exercise early to avoid forgoing cash flows.

* Put Options

The option is deep-in-the-money such that there is little likelihood that you will regret receiving the exercise price early.

=> Option to abandon 

– May exercise when the PV of cash flows from continued operations is far below the salvage value of assets (deep-in-the-money)

  • Valuations of Real Options

DCF-based approach using decision-tree analysis

E.g.

You are trying to decide whether to invest $200,000 up-front in a new retail outlet – with a life of 5 years.

• There is a 50% chance that the retail outlet will experience high demand in the 1st year – generating $150,000. In this case demand will continue to be high for the remaining 4 years.

• If demand is low in year 1, it will remain low – with only $50,000 generated each year.

• If demand is high in the 1st year then the store will have the option to spend an additional $50,000 to expand its range of products – this will increase the expected net cash flows for the next 4 years to $170,000 per annum.

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