Corporate Finance

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Corporate Finance

Just as a package of bond and warrants are valued separately, the option component embedded in projects
should be evaluated separately and then added to the value obtained from the DCF methodology. Assume
that a project is expected to lead to a second-generation investment. The NPV of the entire proposal may be
written as:

NPV = NPV (Phase1) + Call Value of Phase 2.

To evaluate growth options embedded in projects:

• Segregate discretionary expenditure and its associated cash flows of phase–2 project from phase–1 project.


• Find the NPV of phase using the traditional DCF approach.


• Discount the discretionary spending to the present using an appropriate risk free rate. If the discretionary
  spending that leads to phase–2 project is Rs 30 crore to be made in the third year, discount it to the present
  by using a three-year risk free rate. This constitutes X.


• Find the present value of cash flows (net of inflows and routine expenditure on working capital and fixed
  assets) using WACC. This is S.


• Find S/PV(X).
  
  
  • Estimate cumulative volatility (σ t); t is 3 years in this case. Volatility can be estimated in several ways.
    One approach is to estimate the historical volatility of the company’s stock and take it as proxy for the
    volatility of returns from the project undertaken by the company. Another approach is to use implied
    volatility of options on the company’s stock traded in exchanges. The third approach is to simulate project
    cash flows and find the standard deviation of NPV using a standard package like Crystal Ball.^3
  
  
  
  


• Find the value of the call option and add it to the NPV of phase–1.

An example is in order. Cox Communications, a cable company based in the US uses real options analysis
to value additional capacity. Of the 750 MHz available in upgraded cable systems, approximately 648 MHz are
being used for four streams: analog video, digital video, high-speed data and telephone. The remaining 102
MHz is a future tier of interactive services like video telephone, interactive e-commerce, interactive games
and other applications that require high bandwidth that does not exist today. The value of the growth option
is not reflected in the DCF methodology.

Abandonment Option

If market conditions deteriorate severely, management can abandon operations and realize resale value of
project assets in second-hand markets. Abandonment options are important in capital-intensive industries,
financial services and new product introduction in uncertain markets.
In a competitive industry with over capacity management has to continuously consider whether to stay or
get out. The actual decision depends on the value of the project below which the management may choose to
abandon and the value above which extension could take place. An abandonment option is a put option.

Value of put = –S e(b – r)T N (–d 1 ) + X e–rT N (–d 2 )

(^3) Crystal Ball is a product of Decisioneering, Inc.; visit http://www.decisioneering.com.