CHAPTER 12 Other Topics in Capital Budgeting

1 / 21

# CHAPTER 12 Other Topics in Capital Budgeting - PowerPoint PPT Presentation

CHAPTER 12 Other Topics in Capital Budgeting. Evaluating projects with unequal lives Identifying embedded options Valuing real options in projects. Evaluating projects with unequal lives. Projects S and L are mutually exclusive, and will be repeated. If k = 10%, which is better?

I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.

## PowerPoint Slideshow about ' CHAPTER 12 Other Topics in Capital Budgeting' - imani-powers

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.

- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript

### CHAPTER 12Other Topics in Capital Budgeting

Evaluating projects with unequal lives

Identifying embedded options

Valuing real options in projects

Evaluating projects with unequal lives

Projects S and L are mutually exclusive, and will be repeated. If k = 10%, which is better?

Expected Net CFs

Year Project SProject L

0 (\$100,000) (\$100,000)

1 59,000 33,500

2 59,000 33,500

3 - 33,500

4 - 33,500

Solving for NPV, with no repetition
• Enter CFs into calculator CFLO register for both projects, and enter I/YR = 10%.
• NPVS = \$2,397
• NPVL = \$6,190
• Is Project L better?
• Need replacement chain analysis.
Replacement chain
• Use the replacement chain to calculate an extended NPVS to a common life.
• Since Project S has a 2-year life and L has a 4-year life, the common life is 4 years.

0

1

2

3

4

10%

-100,000 59,000 59,000 59,000 59,000

-100,000

-41,000

NPVS = \$4,377 (on extended basis)

What is real option analysis?
• Real options exist when managers can influence the size and riskiness of a project’s cash flows by taking different actions during the project’s life.
• Real option analysis incorporates typical NPV budgeting analysis with an analysis for opportunities resulting from managers’ decisions.
What are some examples of real options?
• Investment timing options
• Abandonment/shutdown options
• Growth/expansion options
• Flexibility options
Illustrating an investment timing option
• If we proceed with Project L, its annual cash flows are \$33,500, and its NPV is \$6,190.
• However, if we wait one year, we will find out some additional information regarding output prices and the cash flows from Project L.
• If we wait, the up-front cost will remain at \$100,000 and there is a 50% chance the subsequent CFs will be \$43,500 a year, and a 50% chance the subsequent CFs will be \$23,500 a year.
Investment timing decision tree

-\$100,000 43,500 43,500 43,500 43,500

• At k = 10%, the NPV at t = 1 is:
• \$37,889, if CF’s are \$43,500 per year, or
• -\$25,508, if CF’s are \$23,500 per year, in which case the firm would not proceed with the project.

50% prob.

-\$100,000 23,500 23,500 23,500 23,500

50% prob.

0 1 2 3 4 5

Years

Should we wait or proceed?
• If we proceed today, NPV = \$6,190.
• If we wait one year, Expected NPV at t = 1 is 0.5(\$37,889) + 0.5(0) = \$18,944.57, which is worth \$18,944.57 / (1.10) = \$17,222.34 in today’s dollars (assuming a 10% discount rate).
• Therefore, it makes sense to wait.
Issues to consider with investment timing options
• What’s the appropriate discount rate?
• Note that increased volatility makes the option to delay more attractive.
• If instead, there was a 50% chance the subsequent CFs will be \$53,500 a year, and a 50% chance the subsequent CFs will be \$13,500 a year, expected NPV next year (if we delay) would be:

0.5(\$69,588) + 0.5(0) = \$34,794 > \$18,944.57

Factors to consider when deciding when to invest
• Delaying the project means that cash flows come later rather than sooner.
• It might make sense to proceed today if there are important advantages to being the first competitor to enter a market.
• Waiting may allow you to take advantage of changing conditions.
0 1 2 3

k = 10%

-\$200,000 80,000 80,000 80,000

NPV = -\$1,051.84

Abandonment/shutdown option
• Project Y has an initial, up-front cost of \$200,000, at t = 0. The project is expected to produce after-tax net cash flows of \$80,000 for the next three years.
• At a 10% discount rate, what is Project Y’s NPV?
Abandonment option
• Project Y’s A-T net cash flows depend critically upon customer acceptance of the product.
• There is a 60% probability that the product will be wildly successful and produce A-T net CFs of \$150,000, and a 40% chance it will produce annual A-T net CFs of -\$25,000.
Abandonment decision tree

150,000 150,000 150,000

• If the customer uses the product,

NPV is \$173,027.80.

• If the customer does not use the product,

NPV is -\$262,171.30.

• E(NPV) = 0.6(173,027.8) + 0.4(-262,171.3)

= -1,051.84

60% prob.

-\$200,000

-25,000 -25,000 -25,000

40% prob.

0

1 2 3

Years

Issues with abandonment options
• The company does not have the option to delay the project.
• The company may abandon the project after a year, if the customer has not adopted the product.
• If the project is abandoned, there will be no operating costs incurred nor cash inflows received after the first year.
NPV with abandonment option

150,000 150,000 150,000

• If the customer uses the product,

NPV is \$173,027.80.

• If the customer does not use the product,

NPV is -\$222,727.27.

• E(NPV) = 0.6(173,027.8) + 0.4(-222,727.27)

= 14,725.77

60% prob.

-\$200,000

-25,000

40% prob.

0

1 2 3

Years

Is it reasonable to assume that the abandonment option does not affect the cost of capital?
• No, it is not reasonable to assume that the abandonment option has no effect on the cost of capital.
• The abandonment option reduces risk, and therefore reduces the cost of capital.
Growth option
• Project Z has an initial up-front cost of \$500,000.
• The project is expected to produce A-T cash inflows of \$100,000 at the end of each of the next five years. Since the project carries a 12% cost of capital, it clearly has a negative NPV.
• There is a 10% chance the project will lead to subsequent opportunities that have an NPV of \$3,000,000 at t = 5, and a 90% chance of an NPV of -\$1,000,000 at t = 5.
NPV with the growth option

\$3,000,000

• At k = 12%,
• NPV of top branch (10% prob) = \$1,562,758.19
• NPV of lower branch (90% prob) = -\$139,522.38

100,000 100,000 100,000 100,000 100,000

10% prob.

-\$1,000,000

-\$500,000

100,000 100,000 100,000 100,000 100,000

90% prob.

0

1 2 3 4 5

Years

NPV with the growth option
• If it turns out that the project has future opportunities with a negative NPV, the company would choose not to pursue them.
• Therefore, the NPV of the bottom branch should include only the -\$500,000 initial outlay and the \$100,000 annual cash flows, which lead to an NPV of -\$139,522.38.
• Thus, the expected value of this project should be:

NPV = 0.1(\$1,562,758) + 0.9(-\$139,522)

= \$30,706.

Flexibility options
• Flexibility options exist when it’s worth spending money today, which enables you to maintain flexibility down the road.