Question

In: Finance

Real options and the strategic NPV   Jenny​ Rene, the CFO of Asor​ Products, Inc., has just...

Real options and the strategic NPV   Jenny​ Rene, the CFO of Asor​ Products, Inc., has just completed an evaluation of a proposed capital expenditure for equipment that would expand the​ firm's manufacturing capacity. Using the traditional NPV​ methodology, she found the project unacceptable​ because:

NPVtraditional=−$1,367<0

Before recommending rejection of the proposed​ project, she has decided to assess whether real options might be embedded in the​ firm's cash flows. Her evaluation uncovered three options and their​ probability:

Option​ 1: Abandonment—The project could be abandoned at the end of 3​ years, resulting in an addition to NPV of $1,090.

Option​ 2: Growth—If the projected outcomes​ occurred, an opportunity to expand the​ firm's product offerings further would become available at the end of 4 years. Exercise of this option is estimated to add $3,130 to the​ project's NPV.

Option​ 3: Timing—Certain phases of the proposed project could be delayed if market and competitive conditions caused the​ firm's forecast revenues to develop more slowly than planned. Such a delay in implementation at that point has an NPV of $9,600.

Jenny estimated that there was a 30% chance that the abandonment option would need to be​ exercised, a 35% chance that the growth option would be​ exercised, and only a 5% chance that the implementation of certain phases of the project would affect timing.

a. Use the information provided to calculate the strategic​ NPV, NPVstrategic​, for Asor​ Products' proposed equipment expenditure.

b. On the basis of your findings in part ​(a​), what action should Jenny recommend to management with regard to the proposed equipment​ expenditure?

c. In​ general, how does this problem demonstrate the importance of considering real options when making capital budgeting​ decisions?

Solutions

Expert Solution

a. Value of Real Options = (1090 * 30%) + (3130 * 35%) + (9600*5%) = 327+ 1096+480 = 1903

NPV Strategic = NPV Traditional + Value of the Real Options = -1367+1903 = +536

b. Thus, as seen in part a, Strategic NPV is > 0 (+536). Jenny should recommend to management to go ahead with the proposed equipment​ expenditure since it adds value to the investment.

c. It is important to realize that the recognition of attractive real options when determining NPV could cause an otherwise unacceptable project (NPV traditional <$0) to become acceptable (NPV strategic>$0). The failure to recognize the value of real options could therefore cause management to reject projects that are acceptable. Although doing so requires more strategic thinking and analysis, it is important for the financial manager to identify and incorporate real options in the NPV process. The procedures for doing this efficiently are emerging, and the use of the strategic NPV that incorporates real options is expected to become more common in future.


Related Solutions

Real options and the strategic NPV   Jenny​ Rene, the CFO of Asor​ Products, Inc., has just...
Real options and the strategic NPV   Jenny​ Rene, the CFO of Asor​ Products, Inc., has just completed an evaluation of a proposed capital expenditure for equipment that would expand the​ firm's manufacturing capacity. Using the traditional NPV​ methodology, she found the project unacceptable​ because: NPV Subscript traditional NPVtraditional=−$1,825<0 Before recommending rejection of the proposed​ project, she has decided to assess whether real options might be embedded in the​ firm's cash flows. Her evaluation uncovered three options and their​ probability: Option​...
Real options and the strategic NPV   Jenny​ Rene, the CFO of Asor​ Products, Inc., has just...
Real options and the strategic NPV   Jenny​ Rene, the CFO of Asor​ Products, Inc., has just completed an evaluation of a proposed capital expenditure for equipment that would expand the​firm's manufacturing capacity. Using the traditional NPV​methodology, she found the project unacceptable​ because: NPVtraditional=−$1,367<0 Before recommending rejection of the proposed​ project, she has decided to assess whether real options might be embedded in the​firm's cash flows. Her evaluation uncovered three options and their​ probability: Option​ 1: Abandonment—The project could be abandoned...
Real options and the strategic NPV   Jenny​ Rene, the CFO of Asor​ Products, Inc., has just...
Real options and the strategic NPV   Jenny​ Rene, the CFO of Asor​ Products, Inc., has just completed an evaluation of a proposed capital expenditure for equipment that would expand the​ firm's manufacturing capacity. Using the traditional NPV​ methodology, she found the project unacceptable​ because: NPV Subscript traditional = -$ 2,256 < 0 Before recommending rejection of the proposed​ project, she has decided to assess whether real options might be embedded in the​ firm's cash flows. Her evaluation uncovered three options...
understanding about real options with the knowledge on strategic alliances.
understanding about real options with the knowledge on strategic alliances.
Jenny is a real estate investor who just sold an income property for a gain of...
Jenny is a real estate investor who just sold an income property for a gain of $200,000. The closing took place on February 1, 2019. Jenny plans to use the proceeds from this sale to immediately purchase a new income property that reliably generates $30,000 rental income each year. Once acquired, Jenny does not intend to make any renovations and/or changes to the new income property, and she plans to dispose of it in approximately ten years. Jenny does not...
Explain why real options have the potential to be an important tool for firms in strategic...
Explain why real options have the potential to be an important tool for firms in strategic and financial analysis.
The Jenny Inc. stock sells for $50, and last year’s dividend was $2.10. Jenny also has...
The Jenny Inc. stock sells for $50, and last year’s dividend was $2.10. Jenny also has $100 par preferred stock with a 3.30% dividend, and new preferred stock could be sold at a price of $31.25 per share, with a flotation cost of 4%. It is projected that the common stock dividend will grow at 7% a year. The firm can issue new 10 year at par bonds with coupon rate of 10%, and its marginal tax rate is 35%....
McNulty, Inc., produces desks and chairs. A new CFO has just been hired and announces a...
McNulty, Inc., produces desks and chairs. A new CFO has just been hired and announces a new policy that if a product cannot earn a margin of at least 15 percent, it will be dropped. The margin is computed as product gross profit divided by reported product cost. Manufacturing overhead for year 1 totaled $910,000. Overhead is allocated to products based on direct labor cost. Data for year 1 show the following. Chairs Desks Sales revenue $ 1,112,100 $ 2,570,400...
McNulty, Inc., produces desks and chairs. A new CFO has just been hired and announces a...
McNulty, Inc., produces desks and chairs. A new CFO has just been hired and announces a new policy that if a product cannot earn a margin of at least 20 percent, it will be dropped. The margin is computed as product gross profit divided by reported product cost. Manufacturing overhead for year 1 totaled $800,000. Overhead is allocated to products based on direct labor cost. Data for year 1 show the following: Chairs Desks Sales revenue $ 1,150,000 $ 2,105,000...
McNulty, Inc., produces desks and chairs. A new CFO has just been hired and announces a...
McNulty, Inc., produces desks and chairs. A new CFO has just been hired and announces a new policy that if a product cannot earn a margin of at least 25 percent, it will be dropped. The margin is computed as product gross profit divided by reported product cost. Manufacturing overhead for year 1 totaled $630,000. Overhead is allocated to products based on direct labor cost. Data for year 1 show the following. Chairs Desks Sales revenue $ 1,106,400 $ 2,033,200...
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT