Question

Assume you have just been hired as a financial analyst by Tropical Sweets Inc., a mid-sized California company that specializes in creating exotic candies from tropical fruits such as mangoes, papayas, and dates. The firm’s CEO, George Yamaguchi, recently returned from an in- dustry corporate executive conference in San Francisco, and one of the sessions he attended addressed real op- tions. Because no one at Tropical Sweets is familiar with the basics of real options, Yamaguchi has asked you to prepare a brief report that the firm’s executives can use to gain a cursory understanding of the topic.To begin, you gathered some outside materials on the subject and used these materials to draft a list of questions that need to be answered. Now that the ques- tions have been drafted, you must develop the answers.

What are some types of real options?

What are five possible procedures for analyzinga real option?

Tropical Sweets is considering a project that willcost $70 million and will generate expected cash flows of $30 million per year for 3 years. The cost of capital for this type of project is 10%, and the risk-free rate is 6%. After discussions with the marketing department, you learn that there is a 30% chance of high demand with associ- ated future cash flows of $45 million per year. There is also a 40% chance of average demand with cash flows of $30 million per year as well as a 30% chance of low demand with cash flows of only $15 million per year. What is the expected NPV?

d. Now suppose this project has an investment timing option, because it can be delayed for a year. The cost will still be $70 million at the end of the year, and the cash flows for the sce- narios will still last 3 years. However, Tropical Sweets will know the level of demand and will implement the project only if it adds value to the company. Perform a qualitative assessment of the investment timing option’s value.

e. Use decision-tree analysis to calculate the NPV of the project with the investment timing option. f. Use a financial option pricing model to estimate the value of the investment timing option.

g. Now suppose that the cost of the project is $75 million and the project cannot be delayed. However, if Tropical Sweets implements the proj- ect, then the firm will have a growth option: the opportunity to replicate the original project at the end of its life. What is the total expected NPV ofthe two projects if both are implemented?

h. Tropical Sweets will replicate the original proj- ect only if demand is high. Using decision-tree analysis, estimate the value of the project with the growth option.

i. Use a financial option model to estimate the value of the project with the growth option.

j. What happens to the value of the growth option if the variance of the project’s return is 14.2%? What if it is 50%? How might this explain the high valuations of many start-up high-tech companies that have yet to show positive earnings?

Answer 1

Ans:

a.Real option is about making a particular business decision such as new investment. The following are the types of real options:

1. Growth option- real option to invest in future. There are different options available for growth of the firm like expansion of existing product, enter into a new market or launching of a new product.
2. Abandonment Option- It is the option of disinvestment. There are different options under abandonment like temporary suspension, contraction or complete abandonment.
3. Investment Timing option- Wait for appropriate time to make an investment.
4. Flexibility- It is the option to make decision as per the situation. b. Real options can be analyzed using the following techniques:
5. Discounted Cash Flow (DCF) method.
6. Decision tree analysis
7. Qualitative assessment of options
8. Financial modeling
9. Other financial engineering techniques c.NPV calculation

Year	0	1	2	3
Cash Flow	-70000000	30000000	30000000	30000000
Cost of capital	10%
NPV	4605559.73

So, NPV of the cash flow is $4.61 million.

Now let us calculate the NPV for different scenarios:

Demand	Probability	Annual Cash Flow (in $ million)
High	30%	45
Average	40%	30
Low	30%	15

NPV High

Year	0	1	2	3
Cash Flow	-70000000	45000000	45000000	45000000
Cost of capital	10%
NPV	41908339.59

NPV high is $41.91 mn

NPV- Average

Year	0	1	2	3
Cash Flow	-70000000	30000000	30000000	30000000
Cost of capital	10%
NPV	4605559.73

NPV average is $4.61 million

NPV Low

Year	0	1	2	3
Cash Flow	-70000000	15000000	15000000	15000000
Cost of capital	10%
NPV	-32697220.14

NPV low is -$32.70 million

Expected NPV= 0.3($41.91)+0.4($4.61)+0.3(-$32.70)

= $4.61 million

d. There is a huge variation in the project NPV in different scenarios. NPV is high at the level of $41.91 million in case of high demand and it is negative at $32.70 million in case of low demand. If the project investment cost remains at the same level even after one year, the decision can be taken after a period of one year when more information is available. If the demand is low, the project should be abandoned. In this view, it is advisable to wait for a period of one year for implementation of the project.