Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionV. Risk and Return 14. Options and Corporate
Finance(^502) © The McGraw−Hill
Companies, 2002
Disney Co. with a 49 percent share, thought Europeans would go goofy over the park
and envisioned enormous profits. Instead, by the end of its first fiscal year, the park was
actually losing about $2.5 million per day.
Originally, ED’s owners thought that the park would draw 11 million visitors annu-
ally, far more than the 7 to 8 million visitors it would take to break even. In this they
were correct; the park actually drew about one million per month.
Unfortunately, however, ED opened in the middle of a European recession. ED
quickly realized that whereas it had expected customers to stay more than four days,
they were staying only two on average. Part of the problem was that the park’s hotels
were overpriced. In addition, ED suffered from dramatic seasonal swings in attendance.
The number of visitors per day during peak times could be 10 times larger than that dur-
ing slack times. The need to lay off employees in quiet times did not square well with
France’s inflexible labor schedules. ED responded by cutting hotel room rates and of-
fering lower admission prices in off-season times.
ED had also miscalculated by initially banning alcohol in the park, in a country in
which wine is customary with meals. This policy was reversed. Also, ED had been told
that Europeans don’t eat breakfast, so it had built smaller-than-usual cafés, only to find
that customers showed up in large numbers. The owners found that they were trying to
serve 2,500 breakfasts in 350-seat restaurants.
Many other changes were considered and implemented at ED. As this example sug-
gests, the possibility of future actions is important. We discuss some of the most com-
mon types of managerial actions in the next few sections.
Contingency Planning The various what-if procedures, particularly the break-even
measures, we discussed in an earlier chapter have a use beyond that of simply evaluat-
ing cash flow and NPV estimates. We can also view these procedures and measures as
primitive ways of exploring the dynamics of a project and investigating managerial op-
tions. What we think about in this case are some of the possible futures that could come
about and what actions we might take if they do.
For example, we might find that a project fails to break even when sales drop below
10,000 units. This is a fact that is interesting to know, but the more important thing is to
then go on and ask: What actions are we going to take if this actually occurs? This is
called contingency planning, and it amounts to an investigation of some of the man-
agerial options implicit in a project.
There is no limit to the number of possible futures or contingencies that we could in-
vestigate. However, there are some broad classes, and we consider these next.
The Option to Expand One particularly important option we have not explicitly ad-
dressed is the option to expand. If we truly find a positive NPV project, then there is an
obvious consideration. Can we expand the project or repeat it to get an even larger
NPV? Our static analysis implicitly assumes that the scale of the project is fixed.
For example, if the sales demand for a particular product were to greatly exceed ex-
pectations, we might investigate increasing production. If this is not feasible for some
reason, then we could always increase cash flow by raising the price. Either way, the po-
tential cash flow is higher than we have indicated because we have implicitly assumed
that no expansion or price increase is possible. Overall, because we ignore the option to
expand in our analysis, we underestimateNPV (all other things being equal).
The Option to Abandon At the other extreme, the option to scale back or even aban-
don a project is also quite valuable. For example, if a project does not break even on a
474 PART FIVE Risk and Return
contingency planning
Taking into account the
managerial options
implicit in a project.