Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionV. Risk and Return 14. Options and Corporate
Finance(^504) © The McGraw−Hill
Companies, 2002
to do one year from now. In this simple case, there are only two contingencies we need
to evaluate, an upward revision and a downward revision, so the extra work is not great.
In one year, if the expected cash flows are revised to $50, then the PV of the cash flows
is revised downwards to $50/.20 $250. We get $400 by abandoning the project, so that
is what we will do (the NPV of keeping the project in one year is $250 400 $150).
If the demand is revised upwards, then the PV of the future cash flows at Year 1 is
$150/.20 $750. This exceeds the $400 abandonment value, so we will keep the project.
We now have a project that costs $550 today. In one year, we expect a cash flow of
$100 from the project. In addition, this project will be worth either $400 (if we abandon
it because it is a failure) or $750 (if we keep it because it succeeds). These outcomes are
equally likely, so we expect the project to be worth ($400 750)/2, or $575.
Summing up, in one year, we expect to have $100 in cash plus a project worth $575,
or $675 total. At a 20 percent discount rate, this $675 is worth $562.50 today, so the
NPV is $562.50 550 $12.50. We should take the project.
The NPV of our project has increased by $62.50. Where did this come from? Our
original analysis implicitly assumed we would keep the project even if it was a failure.
At Year 1, however, we saw that we were $150 better off ($400 versus $250) if we aban-
doned. There was a 50 percent chance of this happening, so the expected gain from
abandoning is $75. The PV of this amount is the value of the option to abandon,
$75/1.20 $62.50.
Strategic Options Companies sometimes undertake new projects just to explore
possibilities and evaluate potential future business strategies. This is a little like testing
the water by sticking a toe in before diving. Such projects are difficult to analyze using
conventional DCF methods because most of the benefits come in the form of strategic
options, that is, options for future, related business moves. Projects that create such op-
tions may be very valuable, but that value is difficult to measure. Research and devel-
opment, for example, is an important and valuable activity for many firms, precisely
because it creates options for new products and procedures.
To give another example, a large manufacturer might decide to open a retail outlet as
a pilot study. The primary goal is to gain some market insight. Because of the high start-
up costs, this one operation won’t break even. However, using the sales experience
gained from the pilot, the firm can then evaluate whether or not to open more outlets, to
change the product mix, to enter new markets, and so on. The information gained and
the resulting options for actions are all valuable, but coming up with a reliable dollar fig-
ure is probably not feasible.
Conclusion We have seen that incorporating options into capital budgeting analysis
is not easy. What can we do about them in practice? The answer is that we need to keep
them in mind as we work with the projected cash flows. We will tend to underestimate
NPV by ignoring options. The damage might be small for a highly structured, very spe-
cific proposal, but it might be great for an exploratory one.
CONCEPT QUESTIONS
14.6a Why do we say that almost every capital budgeting proposal involves mutually
exclusive alternatives?
14.6bWhat are the options to expand, abandon, and suspend operations?
14.6c What are strategic options?
476 PART FIVE Risk and Return
strategic options
Options for future,
related business
products or strategies.