Introduction to Corporate Finance

11: Risk and Capital Budgeting

The oil extraction problem is analogous to the test-marketing problem in the previous section. In both

cases, managers have the option of spending additional resources at a future date. These options add

to a project’s value in a way that traditional NPV analysis often ignores because of its static approach to

decision making. In general, we can say that the value of a project equals the sum of two components –

the part captured by NPV, and the remaining value of real options:

Project value = NPV ± Option value including premium

The NPV may either understate or overstate a project’s value, depending on whether the proposed

investment creates or destroys future options for the company. In the oil drilling example, buying

extraction rights creates an option – to pump or not to pump oil in the future – and the NPV understates

the investment’s value. But it is just as easy to imagine projects that eliminate options rather than create

them. For instance, by signing a long-term contract to supply a refinery with a certain quantity of crude

oil each month, a company loses its flexibility in the extraction decision.

11- 3b TYPES OF REAL OPTIONS

Real options analysis is growing in popularity in many industries. We now turn to a description of common

types of real options encountered in capital budgeting decisions: expansion, follow-on investment,

abandonment and flexibility options.

Expansion Options

What do companies do when one of their investments becomes a huge success? They look for new

markets in which to expand that investment. For instance, once Blu-Ray technology gained significant

popularity, consumers could rent Blu-Ray DVDs in video stores, grocery stores and many other places

where they were previously unavailable. Likewise for Blu-Ray players: the number of retail outlets selling

them also expanded dramatically.

Naturally, companies invest in expansion only for their most successful investments. As mentioned in the

decision-tree problem, the risk of expanding an already successful project is much less than the risk when the

project first begins. A traditional NPV calculation misses both of these attributes – the option to expand or

not, depending on initial success, and the change in risk that occurs when the initial outcome is favourable.

Follow-On Investment Options

A follow-on investment option is similar to an expansion option. It entitles a company to make additional

investments should earlier investments prove to be successful. The difference between this and the

expansion option is that here the subsequent investments are more complex than a simple expansion of

the earlier ones.

Hollywood movies offer an excellent example of follow-on options. The rights to make sequels to

commercial movies are sometimes bought and sold before the original film is completed. By purchasing

the right to produce a sequel, a movie studio obtains the opportunity to make an additional investment

should the first film become a commercial success.

Abandonment Options

Just as companies have the right to invest additional resources to expand projects that enjoy early

success, they also can withdraw resources from projects that fail to live up to short-run expectations. In

an extreme case, a company may decide to withdraw its entire commitment to a particular project and

exercise its option to abandon.

LO11.5

LO11.5

Sometimes companies use the

first part of real options analysis,

laying out a decision tree, in

their decision making; but they

do not continue with the full

analysis using probabilities,

differently discounted cash

flows and multiple branches at

the nodes in the decision trees.

Why do you think companies

may be reluctant to undertake

the ‘full’ real options analysis

for a given investment?

thinking cap

question