Other Topics in Capital Budgeting.pptVIP

CHAPTER 13Other Topics in Capital Budgeting Evaluating projects with unequal lives Evaluating projects with embedded options Valuing real options in projects S and L are mutually exclusive and will be repeated. k = 10%. Which is better? Note that Project S could be repeated after 2 years to generate additional profits. Use replacement chain to calculate extended NPVS to a common life. Since S has a 2-year life and L has a 4-year life, the common life is 4 years. What is real option analysis? Real options exist when managers can influence the size and riskiness of a project’s cash flows by taking different actions during the project’s life. Real option analysis incorporates typical NPV budgeting analysis with an analysis for opportunities resulting from managers’ decisions. What are some examples of real options? Investment timing options Abandonment/shutdown options Growth/expansion options Flexibility options An Illustration of Investment Timing Options If we proceed with Project L, its NPV is $6,190. (Recall the up-front cost was $100,000 and the subsequent CFs were $33,500 a year for four years). However, if we wait one year, we will find out some additional information regarding output prices and the cash flows from Project L. Investment Timing (Continued) If we wait, there is a 50% chance the subsequent CFs will be $43,500 a year, and a 50% chance the subsequent CFs will be $23,500 a year. If we wait, the up-front cost will remain at $100,000. Investment Timing Decision Tree Should we wait or proceed? If we proceed today, NPV = $6,190. If we wait one year, Expected NPV at t = 1 is 0.5($37,889) + 0.5(0) = $18,944.58, which is worth $18,944.58/(1.10) = $17,222.34 in today’s dollars (assuming a 10% discount rate). Therefore, it makes sense to wait. Issues to Consider What’s the appropriate discount rate? Note that increased volatility makes the option to delay more attractive. If instead, there was a 50% chance the subsequent CFs will be $53,500 a year, and a