13 Chapter model 2/22/2006

ABANDONMENT (Section 13.2)

Table 13-1. Decision Trees Without and With the Abandonment Option (Dollars in Thousands)
Situation 1. Cannot Abandon. WACC = 12%
Predicted Cash Flow for Each Year NPV @
Prob: 0 1 2 3 4 12%
Best Case 25% -26,000 33,810 34,257 33,841 50,224 $87,503
Base 50% -26,000 6,702 7,149 6,733 23,116 $5,166
Worst Case 25% -26,000 -9,390 -8,943 -9,359 7,024 -$43,711
Expected NPV $13,531
Standard Deviation (SD) $47,139
Coefficient of Variation (CV) = Std Dev/Expected NPV 3.48
Situation 2. Can Abandon. WACC = 12%
End of Period Cash Flows: NPV @
Prob. 0 1 2 3 4 12%
Best Case 25% -26,000 33,810 34,257 33,841 50,224 $87,503
Base 50% -26,000 6,702 7,149 6,733 23,116 $5,166
Worst #1 0% -$26,000 -$9,390 -$8,943 -$9,359 $7,024 -$43,711 Disregard
Worst #2 25% -$26,000 -$9,390 $18,244 $0 $0 -$19,840 Choose
Expected NPV $19,499
Standard Deviation (SD) $40,567
Coefficient of Variation (CV) = Std Dev/Expected NPV 2.08
Value of the Real Option to Abandon
Expected NPV with Abandonment $19,499
As noted, the project is risky, but it has a high expected NPV. It would probably be accepted, but if
things turn out badly, this would hurt the company rather badly.
8/3/2014 20:36
Chapter 13. Real Options and Other Topics in Capital Budgeting
In this model we examine four types of real options: abandonment, timing, growth, and flexibility.
We show below decision trees for three scenarios under the "Can't Abandon" and "Can Abandon"
cases. Cash flows are taken from the Chapter 12 model, where they were calculated. In Column B,
we show the probabilities for each scenario. Next, in Columns C through G, we show the annual
cash flows under each scenario. Column H shows the NPV under each scenario at a 12% risk-
adjusted cost of capital. The probability times the NPV for each branch of the tree is calculated in
cell H21 (cell H32 if abandoned); it is the expected NPV. Then, cell H22 (cell H33 if abandoned)
gives the standard deviation, and the coefficient of variation is shown in cell H23 (cell H34 if
abandoned).
We use BQC's computer control project as discussed in Chapter 12 to illustrate abandonment.
Recall that due to labor contracts and other constraints, that originally the project could not be
terminated before the end of its 4-year life.
Expected NPV without Abandonment $13,531
Difference = Value of the Option $5,968
Proceed Immediately, i.e., Invest Now
End of Period:
Prob. 2007 2008 2009 2010 2011
Good Conditions 50% -$5.0 $2.5 $2.5 $2.5 $2.5
Bad Conditions 50% -$5.0 $1.2 $1.2 $1.2 $1.2
Expected NPV = sum, prob. times NPV
Standard Deviation
Coefficient of Variation = Std Dev / Expected NPV
Investment Timing Options (Section 13.3)
An "investment timing option" involves the decision of when to commit to a project. If the project
can be delayed, then the expected NPV might be increased. Perhaps new technology will become
available to cut costs, or perhaps the firm can get a better idea of the size of the market before
committing to the project. In any event, timing options can be valuable.
Problem: Assume that Williams Inc. is considering a project that requires an initial investment of
$5 million in 2007. The project is expected to generate a constant stream of cash flows for the next
4 years. However, the size of the cash flows would depend on future market conditions. If the
product were well received, then sales would be strong in the coming year and would remain
strong for the duration of the project's life. However, if the project performs poorly in the coming
year, cash flows would remain weak into the future. Under good conditions, the annual net cash
flow would be $2.5 million at the end of each of the next 4 years. Under bad conditions, cash flows
would be $1.2 million per year. The probabilities of strong and weak demand are both 50%, and the
firm's cost of capital is 10%. The decision tree is shown below. (All dollar figures are in millions.)
The possiblity of abandonment raises the expected NPV because some negative CFs will not
occur. The standard deviation also declines. Both of these changes cause the CV to decline. The
project's CV ends up close to 2.0, which is the average for BQC's projects, which in turn suggests
that it is appropriate to evaluate the project using the 12% WACC.
Finally, note that the difference between the expected NPV with and without abandonment
represents the value of the abandonment option.
It often turns out that without abandonment, the bad case outcome is so bad that it causes the
expected NPV to be negative, hence causes the project to look unacceptable. However, when
abandonment possibilities are factored in, the worse case outcome is not nearly as bad, and the
expected NPV becomes positive. Clearly, abandonment option possibilities must be considered to
obtain valid assessments for different projects.
Delay Decision: Invest Only If Conditions Are Good
End of Period:
2008 2009 2010 2011 2012
Good Conditions 50% Delay -$5.0 $2.5 $2.5 $2.5 $2.5
Bad but irrelevant 50% Delay $0.0 $0.0 $0.0 $0.0 $0.0
Expected NPV
Standard Deviation
Coefficient of Variation
Discount the expected NPV back 1 year to make it comparable to "go now" NPV
Value of the Timing Option: NPV Considering the Timing Option
NPV Without Considering the Timing Option
Value of the Timing Option
Analysis of a Growth Option
Project Disregarding the Growth Option:
End of Period NPV@
With an expected NPV of $.864 million, the project appears to be profitable, but it does have a high
SD and CV, hence it is risky. That risk might warrant the use of a higher WACC, which might make
the NPV turn negative. However, note that the project's risk arises because we do not know how
demand will turn out next year. If we could wait until we had more information about demand, the
project's risk could be reduced. The expected NPV would be either high, in which case we would
accept the project, or low, in which case we would reject it. How should the project be analyzed
under this condition?
Problem: Suppose Williams can wait until next year to make the decision. If it waits, it will have
more information about market conditions. Whereas today it can only guess what demand will be,
if it waits a year it will know precisely what conditions actually are. All other aspects of the project
would be identical to conditions in the"Go Now" scenario shown above with the sole exception
that the decision will be delayed until 2008. What is the NPV if the project is delayed for a year?
Growth Options (Section 13.4)
Some projects provide the firm with opportunities to pursue other profitable projects in the future.
Although a project appears to have a negative conventional NPV, it could be attractive if it opens
the door to new products or markets.
To illustrate, assume that Crum Corporation is considering a Chinese distribution center that
requires an initial investment of $3 million. If conditions are strong, it will provide 3 annual cash
flows of $1.5 million each. However, if conditions are weak, each annual cash flow will only be
$0.75 million. There is a 50% probability for each condition. Crum's WACC is 12%. Management
believes that if conditions are strong, this investment would lead to subsequent investment
opportunities in Year 2 that would cost $10 million, and the investment could be sold for $20
million at the end of Year 3. What's the distribution center's NPV if we disregard the potential new
investment? What would the NPV be giving consideration to the option?
0 1 2 3 12%
Distr Ctr Good 50% -$3.0 $1.500 $1.500 $1.500 $0.603
Bad 50% -$3.0 $0.750 $0.750 $0.750 -$1.199
Expected NPV: -$0.298
Project Considering the Growth Option:
End of Period NPV@
Good 0 1 2 3 12%
Distr Ctr 50% -$3.000 $1.500 $1.500 $1.500
New Inv. -$10.000 $20.000
NPV for good considering growth: -$3.000 $1.500 -$8.500 $21.500 $6.866
Bad Distr Ctr 50% -$3.000 $0.750 $0.750 $0.750 -$1.199
Total Expected NPV: $2.834
NPV considering growth: $2.834
NPV not considering growth: -$0.298
Value of the growth option: $3.132
Project Disregarding the Flexibility Option: End of Period
0 1 2 3
Strong demand 50% -$5.0 $2.5 $2.5 $2.5
Weak demand 50% -$5.0 $1.5 $1.5 $1.5
Expected NPV:
Project Considering the Flexibility Option: End of Period
0 1 2 3
Strong demand 50% -$5.0 $2.5 $2.5 $2.5
Weak demand Don't switch products 0% -$5.0 $1.5 $1.5 $1.5
Switch products 50% -$5.0 $1.5 $2.2 $2.2
Expected NPV:
Flexibility options, where plants are designed to use alternative inputs and/or to produce
alternative outputs depending on market conditions, are also important. For example, suppose
BQC is considering a new plant with a cost of $5 million. There is a 50% probability of strong
demand, in which case the project will provide annual cash flows of $2.5 million for 3 years, and a
50% probability of weak demand and cash flows of only $1.5 million. However, if demand is weak,
the company can convert the plant and produce an alternative product, and in this case the cash
flows in Years 2 and 3 would be $2.2 million. The situation is set forth in the decision tree below. In
a conventional NPV analysis, only the upper tree would be considered, the NPV would be -$0.278,
so the project would be rejected. However, if the flexibility option were considered, the lower tree
would be relevant, the expected NPV would be $0.239, and the project would be accepted.
Flexibility Options (Section 13.5)
Table 13-1. Decision Trees Without and With the Abandonment Option (Dollars in Thousands)
NPV @
10%
$2.92
-$1.20
$0.864
$2.060
2.38
NPV @
10%
$2.92
$0.00
$1.462
$1.462
1.00
$1.329
$1.329
$0.864
$0.465
NPV@
13%
$0.903
-$1.458
-$0.278
NPV@
13%
$0.903
-$1.458
-$0.425
$0.239
COMPARING MUTUALLY EXCLUSIVE PROJECTS WITH UNEQUAL LIVES (Section 13.6)
Figure 13-1. Analysis of Mutually Exclusive Projects with Unequal Lives
I. Traditional Analysis WACC = 12%
Project C End of Period:
0 1 2 3 4 5 6
($40,000) $8,000 $14,000 $13,000 $12,000 $11,000 $10,000
NPV
C
= $6,491 IRR
C
= 17.5%
Project F End of Period:
0 1 2 3
($20,000) $7,000 $13,000 $12,000
NPV
F
= $5,155 IRR
F
= 25.2%
II. Replacement Chain Method for Adjusting for Unequal Lives
Project C: No change in the analysis WACC = 12%
0 1 2 3 4 5 6
($40,000) $8,000 $14,000 $13,000 $12,000 $11,000 $10,000
NPV
C
= $6,491 IRR
C
= 17.5%
Project F: Replacement Chain modification
0 1 2 3 4 5 6
($20,000) $7,000 $13,000 $12,000
($20,000) $7,000 $13,000 $12,000
($20,000) $7,000 $13,000 ($8,000) $7,000 $13,000 $12,000
NPV
F
= $8,824 IRR
F
= 25.2%
III. Equivalent Annual Annuity (EAA) Method for Adjusting
A firm is considering two mutually exclusive projects, a conveyor system (Project C) or a fleet
of forklift trucks (Project F), for moving materials. The cost of capital is 12%. We show a
traditional analysis in Part I and modified analyses in Parts II and III.
Two modifications can be used: The Replacement Chain method or the Equivalent Annual
Annuity (EAA) method. These two approaches always reach the same conclusion.
Based on a traditional analysis, Project C appears to be the better investment. However, if the
firm chooses Project F, it would have the opportunity (which is a real option) to repeat the
investment 3 years from now. Therefore, we can reevaluate Project F using an extended life of
6 years. The time lines are shown below. Note that only F is changed. If the projects had had
lives of say 3 and 7 years, then it would have been necessary to extend the analysis out to a
common year, when both end, in this case to Year 21.
On the basis of the replacement chain analysis, we see that Project F is the better choice.
III. Equivalent Annual Annuity (EAA) Method for Adjusting for Unequal Lives
For Project C, insert these values into a calculator: N = 6, I/YR = 12%, PV = 6491, FV = 0, and
then press PMT to find the constant annuity payment whose PV is $6,491. This payment is:
EAA
C
= $1,578.78
Then do the same thing with Project F, using N = 3, I = 12%, PV = 5155, and FV = 0:
FV = 0, getting PMT = EAA
F
= $2,146.28
We could get the same results using Excel's PMT function.
The EAA method is easier to implement, but the replacement chain method is easier to explain
to senior managers. Also, it is easier to modify the replacement chain data to reflect cost
changes for the replaced assets and/or changes in the cash flows due to productivity
improvements, inflation, and so on.
The unequal life problem was first tackled by electrical engineers who were designing power
plants and distribution lines where they could use either assets with relatively low costs but
relatively short lives or high initial costs and longer lives. The facilities were expected to be
used forever (or at least as far as one could forecast), so the issue became this: Which choice
would result in the higher NPV over an infinite life?
The engineers decided to do an analysis where they took the varying annual cash flows and
converted them into a constant cash flow stream whose NPV was equal to, or equivalent to,
the NPV of the varying stream.
To apply the EAA method to Projects C and F, we first find the constant cash flow that has the
same NPV as the NPV we found using the traditonal analysis. For Project C, we need to find
the constant CF for 6 years that results in the same NPV.
With the EAA method, we would choose the project with the higher EAA, Project F. We see
that the EAA and replacement chain methods result in the same choice, Project F.
COMPARING MUTUALLY EXCLUSIVE PROJECTS WITH UNEQUAL LIVES (Section 13.6)