Question

Write a paragraph describing, with one or two examples, a real option associated with a capital investment decision.

Answer 1

	A real option is a right, but not an obligation,
	to take certain business decisions, depending on
	some outcomes, in course of implementation of
	a decision.
	In capital budgeting, it is the right to abandon,
	defer, expand, contract an investment project.
	For instance, consider a project which has the
	following cash flows, with their probabilities.
	Initial investment = $9,000
	Discount rate = 13%
	Life of the project = 4 years
	Cash inflows:
	$10,000, probability 0.50
	$20,000, probability 0.25
	-$4,000, probability 0.25
	There is an option to abandon the project if, the
	worst outcome arises in year two which is a cash
	loss of $4,000. If that occurs, the cash inflow in
	year 2, including capital inflows, would be $3,000.
	This option to abandon the project after year 2,
	is a real option.
	The value of the real option can be calculated as
	given below:
1]	Expected cash inflow = 10000*0.5+20000*0.25-4000*0.25 =	$             9,000
	Expected NPV = 9000*(1.13^4-1)/(0.13*1.13^4)-9000 =	$           17,770
2]	PV of base case cash flow = 10000*(1.13^4-1)/(0.13*1.13^4) =	$           29,745
	PV of best case cash flow = 20000*(1.13^4-1)/(0.13*1.13^4) =	$           59,489
	PV of worst case cash flow = -4000/1.13+4000/1.13^2 =	$               -407
	Expected NPV = -9000+29745*0.5+59489*0.25-407*0.25 =	$           20,643
3]	Value of the option to abandon the project after year 2 = 22900-20745 =	$             2,873
	Thus, the value of the option is $2,873.