Question

Real options and the strategic NPV Jenny Rene, the CFO of Asor Products, Inc., has just completed an evaluation of a proposed capital expenditure fo equipment that would expand the firm's manufacturing capacity. Using the traditional NPV methodology, she found the project unacceptable because NPV, traditional $958 <0 Before recommending rejection of the proposed project, she has decided to assess whether there might be real options embedded in the firm's cash flows Her evaluation uncovered three options and their probability Option 1: Abandonment The project could be abandoned at the end of 3 years, resulting in an addition to NPV of $1,270 Option 2: Growth-If the projected outcomes occurred, an opportunity to expand the firm's product offerings further would occur at the end of 4 years Exercise of this option is estimated to add $2,620 to the projects NPV Option 3: Timing-Certain phases of the proposed project could be delayed if market and competitive conditions caused the firm's forecast revenues to develop more slowly than planned. Such a delay in implementation at that point has an NPV of $10,000 Jenny estimated that there was a 20% chance that the abandonment option would need to be exercised, a 25% chance that the growth option would be exercised, and only a 5% chance that the implementation of certain phases of the project would affect timing a. The value of the real options is $. (Round to the nearest dollar.)

Answer 1

The value of the real options is calculated as below:

Value of Real Options = Addition to NPV with Abandonment Option*Probability of Abandonment Option to be Exercised + Addition to NPV with Growth Option*Probability of Growth Option to be Exercised + Addition to NPV with Delay Option*Probability of Delay Option to be Exercised

Substituting values in the above formula, we get,

Value of Real Options = 20%*1,270 + 25%*2,620 + 5%*10,000 = $1,409

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Part a)

The strategic NPV is determined as follows:

Strategic NPV = NPV traditional + Value of Real Options

Substituting values in the above formula, we get,

Strategic NPV = -958 + 1,409 = $451

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Part b)

As the value of strategic NPV is turning out be positive with the proposed capital expenditure, Jenny should recommend the management to accept the proposed capital expenditure.

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Part c)

Without taking into account the value of real options, the NPV was coming out to be a negative figure (-$958) which would have resulted in the non-acceptance of the proposed capital expenditure. However, with the calculation and inclusion of real options in arriving at the value of NPV (NPV strategic), the management is now in a position to determine the exact value addition that can be derived from the proposed project and take a decision accordingly. A project that would have otherwise been rejected (based on traditional NPV), will now get accepted because of the value of real options. Therefore, it can be concluded that the real options play an important role in making capital budgeting decisions.