Real Options and Other Topics in Capital Budgeting

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Chapter 13
Real Options and Other Topics in Capital Budgeting

Learning Objectives

After reading this chapter, the student should be able to:

◆ Explain why conventional NPV analysis may not capture a project’s impact on the firm’s opportunities.

◆ Identify five different types of real options.

◆ Explain what an abandonment/shutdown option is, give an example of a project that includes this type of option, and explain what an option value is.

◆ Explain what a decision tree is and provide an example of one.

◆ Explain what an investment timing option is, and give an example of a project that includes one.

◆ Explain what a growth option is, and give an example of a project that includes one.

◆ Explain what a flexibility option is, and give an example of a project that includes one.

◆ Use the replacement chain and equivalent annual annuity methods to compare projects with unequal lives, and explain when you might use one method over the other.

◆ List the steps a firm goes through when establishing its optimal capital budget in practice.

Lecture Suggestions

This chapter covers some important but relatively technical topics. Note too that this chapter is more modular than most, i.e., the major sections are discrete, hence they can be omitted without loss of continuity. Therefore, if you are experiencing a time crunch, you could skip sections or even the entire chapter. What we cover, and the way we cover it, can be seen by scanning the slides and Integrated Case solution for Chapter 13, which appears at the end of this chapter solution. For other suggestions about the lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes.

DAYS ON CHAPTER: 2 OF 58 DAYS (50-MINUTE PERIODS)

Answers to End-of-Chapter Questions

13-1a.An abandonment option is the option to abandoning a project if operating cash flows turn out to be lower than expected. This option can both raise expected profitability and lower project risk, because in the case of poor cash flows, the project can be ended and rather than continue realizing negative cash flows, fixed assets are sold and some cash is recovered.

b.An investment timing option occurs when a firm has the option of delaying the start of a project until additional information can be obtained. After the delay, if conditions for the project look unfavorable, the project will not be undertaken, while if conditions are favorable then the project proceeds as usual. However, there are some drawbacks to relying on investment timing options. First, the timing option should raise NPV because the probability of bad returns is less, but that NPV needs to be discounted back one additional year. Second, there might be valuable first mover advantages to a project that will be lost if the project is delayed a year.

c.Growth options exist if an investment creates the opportunity to make other potentially profitable investments that would not otherwise be possible. A common example of a growth option occurs when a firm starts a project in a new country or market. While the project is hoped to add value from its cash flows, it also has value because it opens the door to the firm to operate in the new country/market.

d.Flexibility options permit the firm to alter operations depending on how conditions change during the project’s life. Typically, inputs, outputs, or both can be changed easily to respond to market demands. For example, instead of building an auto factory that builds a specific type of car (compact, SUV, etc.), a manufacturer can build a factory that allows the building of many types of cars. Therefore, as market demand and consumer tastes change the firm can rapidly respond.

13-2Failure to recognize a growth option implies that a project with a negative conventional NPV was rejected despite have an embedded growth option...
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