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Real Options

Real Options. Why NPV may not always give the right answers Advanced Managerial Finance Spring 2013. NPV. NPV is the standard tool for evaluating capital investments. NPV however, can systematically overstate of understate the value of some investments.

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Real Options

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  1. Real Options Why NPV may not always give the right answers Advanced Managerial Finance Spring 2013

  2. NPV • NPV is the standard tool for evaluating capital investments. • NPV however, can systematically overstate of understate the value of some investments. • Why? Because NPV is a static method, i.e. it doesn’t allow for management flexibility.

  3. NPV • Management flexibility: Options that managers can exploit to increase the value of an investment. For example, if a firm makes an investment that turns out better than expected, managers have the option to expand that investment, making it even more valuable. • Or scale back the investment when CFs are smaller than anticipated, and redeploy resources to more productive uses.

  4. NPV and Real Options • Real option: The right, but not the obligation, to take a future action (e.g., cancel or delay) when implementing a project. • Project valuation: Project value = NPV ± Option value • Types of real options: • Expansion options: If a project or product is a hit, expand production

  5. NPV and Real Options • Follow-on Investment options: Similar to expansion options, but more complex (e.g., movie rights to sequel) • Flexibility options: Ability to use multiple production inputs (e.g., dual-fuel (oil or gas) industrial boiler) or produce multiple outputs (e.g., an oil refinery than can switch its output between different grades/types of fuel)

  6. NPV and Real Options • Abandonment options: right to withdraw resources from projects that fail to live up to short-run expectations. • Firm can abandon a project if not successful. Share value = NPV + value of default option

  7. NPV and real options • A simple example: You are biding on the rights to extract oil from a proven site over the next year. You expect extraction costs from this field to run about $79 per barrel. Currently, oil sells for $75 per barrel. How much should you bid? • Oil prices follow a random walk: next period’s value for a variable equals this period’s value ± a random shock. Since future and past prices are statistically unrelated, the best estimate of the future price is the current price.

  8. Real Options Example Stanley Marcus, a financial intern at Mega Manufacturing Company (MMC), was asked by the CFO to review the NPV calculations on a major new product investment. After analyzing the cash flows and other calculations, Stanley confirmed that the NPV was $1.5 million. In the process of investigating all aspects of the project and its cash flows, Stanley learned that should the new product be successful, it would open the door to a number of opportunities to further expand the firm’s product line. Using option valuation techniques that he learned in an advanced finance course, he estimated the value of these expansion options to be $0.45 million. a. Based on Stanley’s analysis, what is the value of the proposed new product investment? b. How can Stanley explain the value found in part (a) to the CFO, who is unfamiliar with the concept of real options?

  9. Real Options Example Tech Industries, a contract manufacturer of circuit boards, is evaluating an investment in a new production line to handle the growing demand from its customers, who produce consumer electronic products. Based on reasonable growth assumptions, the NPV of the new production line was found to be -$2.3 million. Management feels obligated to therefore reject the project. It recognizes that the production line would provide a high degree of output flexibility because it could be repurposed easily and inexpensively to produce circuit boards for numerous other applications. The firm’s project analyst estimated the value of this output flexibility option to be $3.3 million. a. Based on the information provided, what is the true value of Tech Industries’ proposed new production line? b. What recommendation would you give Tech Industries regarding the proposed new production line? Explain.

  10. Decision Trees • A visual representation of the sequential choices that managers face with regard to a particular investment. • They have value because they force analysts to think though a series of if-then statements that describe how they will react as the future unfolds.

  11. Decision Trees • Trinkle foods Limited of Canada has invented a new salt substitute, Odessa, which it plans to use in snack foods such as potato chips and crackers. The company is trying to decided whether to spend C$5 million to test-market in Vancouver the new product. If consumer acceptance is high, the company predicts that its full line will generate net cash inflows of $C12 million per year for ten years. If acceptance is low it will be only C$2 million. WACC is 15%. • The firm estimates the probability of high and low demands to be 50 % and 50%, respectively. • After the firm sees the test results, it will decide whether to invest $C50 million for a major product lunch. The test-market will last one year.

  12. Decision Trees • Problems with decision trees • The risk of many investment changes as you move from one point in the decision tree to another. Analysts rarely attempt to make adjustments to the discount rate to reflect these risk changes. • Determining the probabilities for each branch of the tree. Why not 80% and 20%. Large pharmaceutical companies have enough experience investing in potential drug compounds to make reasonable estimates of the odds that a drug will make it to market.

  13. Example In order to pursue a project, $500 must be spent now (t=0) to explore the project’s feasibility. Next year (t=1), the option or decision to continue or abandon the project will be exercised. The cost of capital is r=15% per year. If the project is accepted next year, it will cost an additional $1500 at t=1 and will produce cash flows in years 2 through 6 (t=2 through t=6 years). Based on current forecasts, there is a 70% and 30% probability that cash flows CF2 through CF6 will be $1000 and $400 per year, respectively. At t=1, we will know whether the final outcome is $1000 or $400 per year.

  14. Example At t=0, a project’s probability of success or failure are each 50%. At t=1, we will actually know whether the project is a success or failure. The project costs $1100 today and the cost of capital is r=10% per year. If a success or failure, then the project generates perpetual cash flows of $180 or $30 per year forever, respectively. The first cash flow of the perpetuity occurs at t=1. However, if abandoned at t=1, the project’s assets can be sold for a salvage value of $500, just when the first (and last) cash flow of $30 is received. Estimate the static and dynamic NPVs and the value of the option to abandon.

  15. Economic Value Added (EVA®) • A method for analyzing capital investments which determines whether an investment produces net cash flow sufficient to cover the firm’s cost of capital. • Registered trademark of Stern Stewart & Company • EVA is based on the idea of economic profit: a profit that exceeds a normal, competitive rate of return in a industry or line of business. • Normal profit: it occurs when economic profit = 0, i.e. the firm is earning accounting profit but no economic profits.

  16. Economic Value Added (EVA®) EVA = NOPAT - (Capital Invested x WACC) • Operating profit or EBIT = Operating Revenue - COGS - Operating Expenses - Depreciation & Amortization • NOPAT = EBIT(1 – Tax rate) • NOPAT is a more accurate look at operating efficiency for leveraged companies. It does not include the tax savings many companies get because they have existing debt. • E.g. EVA is more appropriate for a car manufacturer than a software maker.

  17. Economic Value Added (EVA®) EVA Investment Rule • Accept any investment for which the present value (at the project’s cost of capital) of all future EVAs is positive. • When invested capital is constant, the EVA rule and the NPV rule will coincide. Example: A firm has an investment opportunity which requires an upfront investment of $150 million. The annual end-of-year NOPAT CFs of $14 million dollars are expected to last forever. The firm’s cost of capital is 8%. Should the firm accept the investment?

  18. Economic Value Added (EVA®) Example 2: Ralph is considering an investment in a machine to manufacture rubber chickens. It will generate revenues of $20,000 each year for 4 years and cost $60,000. The machine is expected to depreciate evenly over the 4 years. The current interest rate is 5% Should he invest in the machine?

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