Chapter 13

REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING

Learning Objectives

After reading this chapter, students should be able to:

Explain what real options are, how they influence capital budgeting, and
how they can be analyzed.
Discuss how projects NPVs are affected by the size of the firms total
capital budget, the process involved in determining a firms capital
budget, and the analysis undertaken in selecting value-maximizing
projects.
Describe the post-audit, which is an important part of the capital
budgeting process, and discuss its relevance in capital budgeting
decisions.

Overview
Capital budgeting analysis is in many respects straightforward. A project is
deemed acceptable if it has a positive NPV, where the NPV is calculated by
discounting the estimated cash flows at the projects risk-adjusted cost of
capital. However, things often get more complicated in the real world. One
complication is that many projects include a variety of embedded options
that dramatically affect their value. These embedded options are called real
options.
A typical corporation considers many projects each year, and each project
may contain one or more different types of embedded real options. Examples
include growth/expansion options, abandonment/shutdown options,
investment timing options, and flexibility options.
This chapter describes various factors that managers consider when they
evaluate individual projects. For planning purposes, managers must also
forecast the total capital budget because the amount of capital raised affects
the WACC. In order to maximize firm value, the firm should invest out to
the point where the return on the marginal project is just equal to the
marginal cost of capital.
One final aspect of the capital budgeting process is the post-audit, which
involves (1) comparing actual results with those predicted by the projects
sponsors and (2) explaining why any differences occurred.

Outline
I. In recent years a growing number of academics and
practitioners have demonstrated that DCF valuation techniques
do not always tell the complete story about a projects value and
that rote use of DCF can, at times, lead to incorrect capital
budgeting decisions.
A. DCF techniques were originally developed to value securities such as
stocks and bonds.
1. These securities are passive investmentsonce they have been
purchased, most investors have no influence over the cash flows
the assets produce.
B. Real assets are not passive investmentsmanagers often can take
actions to alter the cash flow stream even after the project is in
operation.
1. Investing in a new project often brings with it a potential increase
in the firms future opportunities.
2. These opportunities are real options. They are real to
distinguish them from financial options and they provide the right
but not the obligation to take some future action.
C. Real options are valuable, but that value is not captured by a
traditional NPV analysis. Therefore, real options must be analyzed
separately.
1. It is critically important that managers identify any such options
and include them in the analysis.
2. One should recognize that as a result of embedded options some
projects have more or less value than is indicated by their NPVs,
and this value should, at a minimum, be subjectively considered
when making capital budgeting decisions.
D. Examples of real options include growth/expansion options,
abandonment/shutdown options, investment timing options, and
flexibility options (inputs/outputs).
II. A growth option creates the opportunity to make other
potentially profitable investments that would not otherwise be
possible.
A. This option is also known as an expansion option where the project
can be expanded if demand for the project turns out to be stronger
than expected.
B. The analysis begins with a diagram that shows all possible outcomes
that result from a decision.
 C. The option value is the additional value of the project if the option
exists.
1. If the expected NPV of the project with and without the option is
positive, the value of the option will be the additional NPV
resulting from the option.
2. If the NPV without the option is negative but the NPV with the
option is positive, the value of the option is simply the expected
NPV with the option.
a. This is the value of the option because without it, the project
would have been rejected and there would have been no
positive NPV.
3. A positive option value expands the firms opportunities.
D. Any costs that might be required to purchase the option must be
considered in the analysis.
E. In the chapter, we simplify the analysis be assuming that all of the
cash flows are discounted at the same WACC.
1. In most cases, you might expect that cash flows related to the
growth option are more uncertain. Therefore, you would
discount these cash flows at a higher rate.
2. In practice, many analysts use insights from option pricing
theory to help estimate the value of various types of real
options.
III. An abandonment option is the option of stopping a project if
operating cash flows turn out to be lower than expected. This
option can both raise expected profitability and lower project
risk.
A. It often turns out that if we fail to consider abandonment, the bad
case is so bad that the expected NPV is negative, but when
abandonment is considered, the expected NPV becomes positive.
1. Abandonment must be considered to obtain valid assessments for
different projects.
2. The opportunity to abandon projects allows companies to limit
downside losses.
3. It might be necessary for the firm to arrange things so that it has
the possibility of abandonment when it is making the initial
decision.
a. Any costs of these arrangements must be compared with the
value of the option.
IV. A conventional NPV analysis implicitly assumes that projects
will either be accepted or rejected, which implies that they will
be undertaken now or never. However, in practice companies
sometimes have a third choicedelay the decision until later,
when more information is available.
A. An investment timing option is an option as to when to begin a
project. Often, if a firm can delay a decision, it can increase a
projects expected NPV.
B. In many respects, the investment timing decision is similar to
choosing among mutually exclusive projects.
1. The mutually exclusive projects are: (a) investing in the project
today and (b) waiting for some period of time before deciding
whether or not to invest in the project. Only one of these
projects can be accepted.
2. The company should select the strategy with the higher expected
net present value.
C. With an investment timing option there is a wait case NPV and a
proceed immediately NPV.
1. To make the NPVs comparable, the wait NPV must be discounted
back to find the projects value in todays dollars.
2. If the firm chooses to accept the project today, it is effectively
giving up the option to pursue the project later.
D. When making go now versus wait decisions, financial managers
need to consider several factors:
1. If a firm decides to wait, it may lose any strategic advantages
associated with being the first competitor to enter a new line of
business, and this could reduce the projects cash flows.
2. Costs may increase if the firm waits which will also lower the
projects calculated NPV.
3. Waiting may enable the company to avoid a costly mistake.
E. In general, the more uncertainty there is about future market
conditions, the more attractive it becomes to wait, but this risk
reduction may be offset by the loss of the first mover advantage.
1. Any such first mover advantage can be compared with the value
of the option.
V. A flexibility option permits operations to be altered depending
on how conditions change during a projects life.
A. Typically, inputs, outputs, or both can be changed.
 B. Flexibility options tend to reduce the risk of a bad outcome, and this
increases the expected NPV and reduces risk.
C. Flexibility options do have costs, but those costs can be compared
with the calculated option values.
VI. For planning purposes, managers must also forecast the total
amount of investment that will be made, because the amount of
capital raised affects the WACC.
A. The optimal capital budget is the annual investment in long-term
assets that maximizes the firms value. The size of the capital
budget is optimized where the rate of return on the marginal project
is equal to the marginal cost of capital.
B. Typically, there are six steps for estimating the optimal capital
budget.
1. Estimate the firms overall composite WACC.
2. Financial managers within each of the firms divisions estimate
the relevant cash flows and calculate the IRRs of potential
projects.
a. This listing of potential projects, ranked from highest to lowest
IRR, is the IRR schedule.
3. Develop the firms WACC schedule that identifies the firms
marginal cost of capital, the cost of each dollar raised.
4. Combine the MCC schedule and IRR schedule to develop the
WACC where the two schedules intersect. This WACC is reported
to division managers.
5. Each division will scale WACC up or down to reflect the divisions
capital structure and risk characteristics.
6. Each division manager then calculates the NPV of the various
projects using the risk-adjusted cost of capital.
a. The optimal capital budget consists of all independent projects
with positive NPVs plus those mutually exclusive projects with
the highest positive NPVs.
C. Smaller firms, new firms, and firms with dubious track records may
have difficulties raising capital, even for projects that the firm
concludes have positive NPVs.
1. In such circumstances, the size of the firms capital budget may
be constrained.
 2. Capital rationing is the situation in which a firm is constrained in
raising capitalit can raise only a specified, limited amount of
capital regardless of how many good projects it has.
a. In such situations capital is scarce, and it should be used in the
most efficient way possible.
b. Procedures have been explored for allocating capital to
maximize the firms aggregate NPV subject to the constraint
that the capital rationing ceiling is not exceeded.
D. The steps discussed above force the firm to think carefully about
each divisions relative risk, about the risk of each project within
each division, and about the relationship between the total amount
of capital raised and the cost of that capital.
1. This procedure forces the firm to adjust its capital budget to
reflect capital market conditions.
2. If the costs of debt and equity increase, this fact will be reflected
in the cost of capital used to evaluate projects, and projects that
would be marginally acceptable when capital costs were low
would correctly be ruled unacceptable when capital costs become
high.
VII. An important aspect of the capital budgeting process is the
post-audit, which involves comparing actual results with those
predicted by the projects sponsors and explaining why any
differences occurred.
A. The results of the post-audit help to improve forecasts and to
increase efficiency of the firms operations.
B. The post-audit is not a simple, mechanical processa number of
factors can cause complications.
1. Each element of the cash flow forecast is subject to uncertainty,
so a percentage of all projects undertaken by any reasonably
aggressive firm will necessarily go awry.
2. Projects sometime fail to meet expectations for reasons beyond
the control of their sponsors and for reasons that no one could
be expected to anticipate.
3. It is often difficult to separate the operating results of one
investment from those of a larger system.
4. It is often hard to hand out blame or praise, because the
executives who were responsible for launching a given
investment have moved on by the time the results are known.
C. Observations of both businesses and governmental units suggest
that the best-run and most successful organizations put a great
deal of emphasis on post-audits.
1. Post-audits are an important element in a good capital budgeting
system.