460 PART 3 Long-Term Investment Decisions
10–14 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 tra-
ditional NPV methodology, she found the project unacceptable because
NPVtraditional$1,700$0
Before recommending rejection of the proposed project, she has decided to assess
whether there might be real options embedded in the firm’s cash flows. Her eval-
uation uncovered the following three options.
Option 1: Abandonment—The project could be abandoned at the end of 3
years, resulting in an addition to NPV of $1,200.
Option 2: Expansion—If the projected outcomes occurred, an opportunity to
expand the firm’s product offerings further would occur at the end of 4 years.
Exercise of this option is estimated to add $3,000 to the project’s NPV.
Option 3: Delay—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 a NPV of $10,000.
Rene estimated that there was a 25% chance that the abandonment option
would need to be exercised, a 30% chance the expansion option would be exer-
cised, and only a 10% chance that the implementation of certain phases of the
project would have to be delayed.
a. Use the information provided to calculate the strategic NPV, NPVstrategic, for
Asor Products’ proposed equipment expenditure.
b. Judging on the basis of your findings in part a,what action should Rene
recommend to management with regard to the proposed equipment
expenditures?
c. In general, how does this problem demonstrate the importance of considering
real options when making capital budgeting decisions?10–15 Capital rationing—IRR and NPV approaches Valley Corporation is attempting
to select the best of a group of independent projects competing for the firm’s
fixed capital budget of $4.5 million. The firm recognizes that any unused por-
tion of this budget will earn less than its 15% cost of capital, thereby resulting in
a present value of inflows that is less than the initial investment. The firm has
summarized the key data to be used in selecting the best group of projects in the
following table.Present value of
Project Initial investment IRR inflows at 15%A $5,000,000 17% $5,400,000
B 800,000 18 1,100,000
C 2,000,000 19 2,300,000
D 1,500,000 16 1,600,000
E 800,000 22 900,000
F 2,500,000 23 3,000,000
G 1,200,000 20 1,300,000LG6LG6