Corporate Finance

A Real Option’s Perspective of Capital Budgeting 
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can be deferred for 1 year, one could put the investment in a bank for 1 year and withdraw it when the time
is ripe to invest. That is, the investment X would be invested at rffor 1 year. So, the amount now is the
present value of X discounted at rf.

PV (X)= X/(1 + rf)t

Since our objective is to refine NPV to incorporate other option variables like rf, t and σ let’s redefine
NPV as S – PV (X). As with financial options, this can be expressed as a ratio:

= S/PV(X)

Cumulative variance = σt^2 (cumulative volatility is the square root of cumulative variance).

We can use these two values to estimate the value of the option as percentage of value of underlying assets.
An example is in order. A company is investing Rs 300 crore in a project. The project is expected to gen-
erate cash flows of Rs 75 crore per annum, for five years. A company has the option of investing in the
project (i.e., develop the product) in the next five years. That is, the company can delay the project for a
period of five years without seriously jeopardizing the value of the project. A simulation of project cash
flows suggests that the standard deviation of cash flows is 40 percent. The risk-free rate is 6 percent and the
cost of capital for the company is 12 percent.

X= Investment = Rs 300 crore

S= PV of cash flows @ 12 percent

t= 5 years

σ= 40 percent = 0.4

PV(X) = 300/(1.06)^5 = 300/1.338 = Rs 224.2

S= 75 × PVIFA (12 percent, 5 years) = 75 × 3.605 = Rs 270.375 crore

Traditional NPV = Rs 270.375 – Rs 300 crore = Rs –29.625 crore. This analysis does not take into
consideration the possibility of deferring the investment and the volatility of the returns.

S/PV(X) = 270.375/224.2 = 1.2

σ t = 0.4 × 5 = 0.89

The value of the call option as percentage of value of underlying asset from the table is 40.8 percent.
That is,

0.408 × 270.375 = Rs 110 crore.

Growth Option

A growth option is characterized by an early investment (in, say, R&D) which leads to a chain of inter-
related projects opening up future new generation products and processes, access to new markets, oil reserves,
etc. Any investment that creates new investment opportunities can be characterized as a growth option.
Companies derive their value from two sources: assets in place and present value of growth opportunities.
Stock markets realize it when pricing securities.