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:

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 and their​ probability:

Option​ 1:

Abandonment —The project could be abandoned at the end of 3​ years, resulting in an addition to NPV of $1,230.

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 $2,740 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 $10,100.

Jenny estimated that there was a 20% chance that the abandonment option would need to be​ exercised, a 35% chance that the growth option would be​ exercised, and only a 15% chance that the implementation of certain phases of the project would affect timing.

a. Use the information provided to calculate the strategic​ NPV, NPV Subscript NPV strategic​, 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 = (1230 * 20%) + (2740 * 35%) + (10100*15%) = 2720

NPV Strategic = NPV Traditional + Value of the Real Options = -2256+2720 = +464

b. Thus, as seen in part a, Strategic NPV is > 0 (+464). 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.