Question

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?

Answer 1

a)

Value of real options = ( Addition to NPV with Abandonment option*Probability of abandonment option exercised) + (Addition to NPV with growth option*Probability of growth option exercised) + (Addition to NPV with delay option*Probability of delay option exercised)

Value of real options = (1090*0.3) + (3130*0.35) + (9600*0.05) = $1902.5

Strategic NPV = Traditional NPV + Value of real options

Strategic NPV = -1367+1902.5 = $535.5

b)

Since the strategic NPV is positive after considering the probabilities and NPV as estimated by Jenny, she should recommend the management to accept the proposed capital expenditure.

c)

Without the real options, the project would have been rejected as NPV was negative. However, after considering various options, their NPV and the likelihood of their occurrence the strategic NPV is positive and hence the project can be accepted. Hence the consideration of real options has changed the decision on whether or not to take up the project. Even, in case, a choice is to be made between 2 different projects, the one with a higher NPV would be selected. In both the scenarios, the consideration of various options play a critical role in determining the NPV which eventually leads to acceptance or rejection of projects.