FIN710

Capital Budgeting and Real Options

CB and Real Options

Agenda for the Day

Capital Budgeting

Real Options

How does it fit in

Common mistakes
Assessing Risk
What are they? What types?
Why do we care?
How do we value them?

CB Common Mistakes
Properly accounting for Changes in Net
Working Capital (NWC)
Interest expenses should not be in the
cash flowswhy not?
why not?
Opportunity costs should be counted
like what?
Timing of cash flowsfor ex., ...
Adjusting for ...
Capital Budgeting, Real Options

Adjusting for Inflation

Inflation changes both the cash flows
and the discount rate.
Fortunately, the WACC already reflects
inflationhow?
We need to adjust almost all cash
inflows and outflows over time by
inflation. Why?
Wont sales prices and variable cost
inputs go up with inflation? What
Capital
Budgeting, Real Options
about
...?

CB Not exactly mistakes

Cash flow estimation is tough stuff.
Get everybody involvedmarketing, production,
accountants, etc.
Use realistic assumptions

The WACC estimate is also tough stuff

Projecting beyond a certain point is risky,
what can we do about that? not much
Only project cash flows for a few years and
say their gonna increase x percent. Other
than that, cant do much
Capital Budgeting, Real Options

CB Assessing Risk
Seems like sophisticated stuff
Sensitivity Analysis
Scenario Analysis
Monte Carlo Simulation

Capital Budgeting, Real Options

Assessing Risk
Sensitivity Analysis
The trick is to change one input and see
how much the bottom line changes.
If the bottom line changes a lot, youd
better pay attention to the input you
changed
Is that input really risky or is it ..?
If its really risky, what can we do about
it?
Capital Budgeting, Real Options

Assessing Risk
Sensitivity Tables and Graphs One easy
picturesee

Capital Budgeting, Real Options

Assessing Risk
Scenario Analysis
Sometimes one input is related to another.
Maybe sales goes up when interest rates go
down. If so, do a few different scenarios,
and see what happens to the bottom line.
You could average out the bottom line if
you wanted to. The result may be different
from your point estimate.
Capital Budgeting, Real Options

Capital Budgeting, Real Options

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Assessing Risk
Monte Carlo Simulation
A kazillion scenarios an ...
You also get a valuable probability
distribution that helps you better
understand the risk of the project.
Were not doing it.

Capital Budgeting, Real Options

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Clicker Q
Tilton Corporation builds windmills for use in developing nations.
Tilton is a registered charity and as such, does not pay taxes.
Ve = $40M, Vd = $0. re = .12, rd = .08
Tilton is considering a new windmill project. This project will take
10 years to complete. The initial cost of the project is $4M.
Annual pre-tax operating cash flows are estimated to be
$522,000 per year. The firm expects to sell off its salvage for
$1,000,000 at the end of the project. The CCA rate for project is
20%.
Which of the following statements is true for Tilton Corporation?
a)
If the CCA rate for the project changes from 20% to 30%, the NPV
will decrease
b)
If the salvage value for the project increases, the NPV will not
change
c)
If the salvage value for the project increases, the NPV will decrease
d)
If the CCA rate for the project changes from 20% to 30%, the NPV
will not change
Capital Budgeting, Real Options

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Real Options
Think of it this way. Someday, you might be
married. Wouldnt it be nice if you had:
1. The option to delay the wedding by a year or
two. Maybe you could live with the person
to find out if it will work. We call that an
investment timing option.
2. The option to get out of the marriage once
youve gotten into it (i.e., divorce). We call
that an abandonment option.
3. The option to add another husband a few
years down the line if it seems like a good
idea at that time. We call that a growth
Capital Budgeting, Real Options
13 option.

Real Options
In business terms, real options exist when
managers can influence the size and risk of a
projects cash flows by taking different
actions during the projects life in response to
changing market conditions.
Its really cool if you can identify these
options. How do you do that?
Purposefully have them on your todo list. Then
you wont need a brainwave.

Its even cooler if you can create them when

you create the capital budgeting project.
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Capital Budgeting, Real Options

Real Options
Why do we care?
Because assessing projects ... may result in
different decisions and more shareholder
wealth.
Because we have the tools to do so.

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Capital Budgeting, Real Options

The Investment Timing Option

If we do a project now, the future cash flows
are uncertain. This means that we might
lose money.
If we wait for a period (lets say a year),
maybe the future cash flows will become
more certain. If it looks like the cash flows
will be poor, we just wont do the investment.
The idea is to compare the NPV of doing the
project now with the NPV of doing it in a year.
All in all, it sounds like a good idea

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Capital Budgeting, Real Options

The Investment Timing Option

Murphy Systems (20.2)

New

Project idea
Initial Cost = 50M, N = 3 years, no salvage,
WACC = .14
Annual after-tax cash flows:
Amount
Probability
$33M
25%
$25M
50%
$5M
25%
Expected cash flow = (33*.25) + (25*.5) +
(5*.25) = $22M
NPV = -$50M + = $1.08M
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Capital Budgeting, Real Options

The Investment Timing Option

Murphy Systems (20.2)
Theres one catch. The firm can wait for a year
before making the investment, at which point it
will know the demand for the product (i.e., the
cash flows).
What is the NPV of the project now if it chooses
to wait? Is it more or less than $1.08M? If its
more, the option has value.
Lets work through the numbers.
What discount rate should we use?
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Capital Budgeting, Real Options

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Capital Budgeting, Real Options

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Capital Budgeting, Real Options

The Growth Option

Kidco Corp. (20.3)

New

Project idea:
Initial Cost = 30M, N = 2 years, no salvage,
WACC = .14
Annual after-tax cash flows:
Amount
Probability
$34M
25%
$20M
50%
$2M
25%
Expected cash flow = (34*.25) + (20*.5) +
(2*.25) = $19M
NPV = -$30M + = $1.29M
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Capital Budgeting, Real Options

The Growth Option

Kidco Corp. (20-2)
Theres one catch. If the demand for the first product
is average or high, which you find out at the end of
year 1, Kidco believes that it can launch a secondgeneration product for the same cost, and with the
same demand as the first product, just two years down
the road.
What is the NPV of the project now if it chooses to
wait? Is it more or less than ..? If its more, the option
has ...
Lets work through the numbers.
What discount rate should we use?
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Capital Budgeting, Real Options

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Capital Budgeting, Real Options

The Abandonment Option and

Clicker Q
Wouldnt it be nice if you could get out of a losing
business venture before you lose too much money.
IC = 26M, N = 4 years, WACC = .12
Annual after-tax cash flows:
Amount at each year Probability
$18M, 23M, 28M, 33M 25%
$7M, 8M, 9M, 10M, 50%
-$8M, -$9M, -$10M, -$12M
25%
What is the NPV of this project?
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Capital Budgeting, Real Options

The Abandonment Option Base Case

NPV(Ms) Prob.
Prob.*NPV
Good
$49.31
.25
$12.33
Average...
.5
...
Ugly
...
.25
...
NPV = ...- ..- ...= ...

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Capital Budgeting, Real Options

The Abandonment Option

Now what happens if we can abandon the project at
the end of year 1 if results are bad and sell off the
assets for $14M.

Amount at each year

Probability
Good: $18M, 23M, 28M, 33M
25%
Average: $7M, 8M, 9M, 10M,
50%
Ugly: -$8M, -$9M, -$10M, -$12M
25%
I say well ...
Cash flows for the Ugly stream
become: ..., ..., ..., ...
How do we treat the ...?
How do we know that we shouldnt abandon the ...
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Capital Budgeting, Real Options

Capital Budgeting and Real Options

Agenda for the Day

Capital Budgeting

How does it fit in

Common mistakes
Assessing Risk

Real Options

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What are they? What types?

Why do we care?
How do we value them?

Capital Budgeting and Real Options

Capital Budgeting

Know the common mistakes

Know why risk assessment is important

Know how to conduct basic risk assessment

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Capital Budgeting, Real Options

Capital Budgeting and Real Options

Real Options

Know the ...

Not all firms are using Real Options but
many are. Real options come up all the
time in the real world. Think of natural
resource companies. They need all three of
the options that we talked aboutwhy?
Sometimes its hard to put a number on the
value of the option because you cant put
hard numbers on the inputs. When that
happens, you have to ...

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Capital Budgeting, Real Options