Fundamentals of Financial Management (Concise 6th Edition)

384 Part 4 Investing in Long-Term Assets: Capital Budgeting

SEL

F^ TEST Why might DCF techniques not lead to proper capital budgeting decisions?

What is a real option?

What are some types of real options? Brie! y explain each one.

Would you expect an abandonment option to increase or decrease a

project’s NPV and its risk as measured by the coe$ cient of variation? Why or

why not?

How can the value of an option be estimated?

But when abandonment is considered, the expected NPV becomes positive.

Clearly, abandonment must be considered to obtain valid assessments for differ-

ent projects, and the opportunity to abandon is an important way to limit down-

side losses.

Note too that it might be necessary for the " rm to make arrangements so that

it has the option of abandoning a project when it is making the initial decision.

This might require contractual arrangements with suppliers, customers, and its

union; and there might be some costs to obtaining the advance permissions. Any

such costs could be compared with the value of the option as we calculated it,

which would enter into the initial decision.

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A B C D E F G H I J

Situation 1. No Abandonment

Prob:

Best Case

Base Case

Worst Case

25%

50%

25%

-$750

-$1,000

-$1,250

$2,685

$500

-$1,077

$2,520

$400

-$1,119

$2,390

$300

-$1,213

$2,135

$100

-$1,343

Expected NPV

Standard Deviation (SD)

Coe$cient of Variation (CV) = Std Dev/Expected NPV

7.50%

10.00%

12.50%

$7,450.38

$78.82

-$4,782.40

$706.40

$5,028.94

7.12

0 1 2 3 4 WACC NPV

Predicted Cash Flow for Each Year

Situation 2. Can Abandon

Prob.

Best Case

Base Case

Worst #1

Worst #2

25%

50%

0%

25%

-$750

-$1,000

-$1,250

-$1,250

$2,685

$500

-$1,077

-$1,077

$2,520

$400

-$1,119

$0

$2,390

$300

-$1,213

$0

$2,135

$100

-$1,343

$0

Expected NPV (includes #2, excludes #1)

Standard Deviation (SD)

Coe$cient of Variation (CV) = Std Dev/Expected NPV

Value of the Real Option to Abandon

Expected NPV with Abandonment

Expected NPV without Abandonment

Di#erence = Value of the Option

$1,350.09

$706.40

$643.68

Don’t use

Use

7.50%

10.00%

12.50%

12.50%

$7,450.38

$78.82

-$4,782.40

-$2,207.67

$1,350.09

$4,121.03

3.05

0 1 2 3 4 WACC NPV

Predicted Cash Flow for Each Year

Tabl e 12 - 3 Decision Tree for Abandonment Option (Dollars in Thousands)