Npv Analysis Treats Projects as “now-Or-Never” Opportunities
By: RTTT • January 31, 2018 • Thesis • 1,048 Words (5 Pages) • 1,001 Views
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 |
- 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
- 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
- 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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