A B C D E F G H I

1 Tool Kit Chapter 26 10/27/2015

2 Real Options
3
4 26-2 The Investment Timing Option: An Illustration
5
6 Murphy Systems is considering a project that will create a new type of hand-held device for connecting to
7 the Internet. The cost of the project is $50 million, but the future cash flows are uncertain. Murphy
estimates a 25% probability that the new Internet device will be very popular in which case the project
8 will generate cash flows of $30 million each year for three years. There is a 50% probability generating
9 cash flows of $25 million each year for three years. Unfortunately, there is a 25% chance that the Internet
10 device will not be popular, which means that the project will generate only $5 million per year in cash
11 flows. The cost of capital for this project is 14%.
12
13
14
15 Inputs:
16 WACC= 14%
17 Risk-free rate = 6%
18 Initial cost of project= $50
19
20 DCF Analysis
21
22 Expected annual cash flows (in millions):
23 Inputs: Probability Cash Flow
24 25% $33
25 50% $25
26 25% $5
27
28 Expected CF = $22.00
29
30 Time Line Year 0 1 2 3
31 Expected CF −$50.00 $22.00 $22.00 $22.00
32
33 NPV = $1.08
34
35
36
37 Figure 26-1
38 DCF and Decision Tree Analysis for the Investment Timing Option (Millions of Dollars)
39
40
41 Part 1. Scenario Analysis: Proceed with Project Today
42
43 Future Cash Flows NPV of This
44 Now: Year 0 Probability Year 1 Year 2 Year 3 Scenarioa
45
46 → High → 0.25 $33 $33 $33 $26.61
47 ↗
48 −$50 →Average → 0.50 $25 $25 $25 $8.04
49 ↘
50 → Low → 0.25 $5 $5 $5 −$38.39
51 1.00
52 Expected value of NPVb = $1.08
53 Standard deviationb = $24.02
 A B C D E F G H I
54 Coefficient of variationc = 22.32
55
56 Part 2. Decision-Tree Analysis: Implement in One Year Only if Optimal
57
58 Future Cash Flows NPV of This
59 Now: Year 0 Probability Year 1 Year 2 Year 3 Year 4 Scenariod
60
61 → High → 0.25 −$50 $33 $33 $33 $23.35
62 ↗
63 Wait →Average → 0.50 −$50 $25 $25 $25 $7.05
64 ↘
65 → Low → 0.25 $0 $0 $0 $0 $0.00
66 1.00
67 Expected value of NPVb = $9.36
68 Standard deviationb = $8.57
69 Coefficient of variationc = 0.92
70 Notes: a
The WACC is 14%.
71 b
The expected value and standard deviation are calculated as in Chapter 6.
72 c
The coefficient of variation is the standard deviation divided by the expected value.
73 d
The NPV in Part 2 is as of Year 0. Therefore, each of the project cash flows is discounted back
74 one more year than in Part 1.
75
76
77 Figure 26-2
78
Sensitivity Analysis for the Investment Timing Option Decision Tree (Millions of Dollars)
79
80 Part 1. Decision-Tree Analysis: Implement in One Year Only if Optimal
81 (Discount Cost at the Risk-Free Rate and Operating Cash Flows at the WACC)
82
83 Future Cash Flows NPV of This
84 Now: Year 0 Probability Year 1 Year 2 Year 3 Year 4 Scenarioa
85
86 → High → 0.25 −$50 $33 $33 $33 $20.04
87 ↗
88 Wait →Average → 0.50 −$50 $25 $25 $25 $3.74
89 ↘
90 → Low → 0.25 $0 $0 $0 $0 $0.00
91 1.00
92 Expected value of NPVb = $6.88
93 Standard deviationb = $7.75
94 Coefficient of variationc = 1.13
95
96 Part 2. Sensitivity Analysis of NPV to Changes in the Cost of Capital Used to
97 Discount Cost and Cash Flows
98
99 Cost of Capital Used to Discount the Year-1 Cost
100 $0.00 3% 4% 5% 6% 7% 8% 9%
101 8% $13.1 $13.5 $13.8 $14.1 $14.5 $14.8 $15.1
Year-4 Operating Cash Flows
Discount the Year-2 through

102 9% $11.8 $12.1 $12.5 $12.8 $13.1 $13.5 $13.8

Cost of Capital Used to

103 10% $10.5 $10.9 $11.2 $11.5 $11.9 $12.2 $12.5

104 11% $9.3 $9.6 $10.0 $10.3 $10.6 $11.0 $11.3
 Year-4 Operating Cash Flows
Discount the Year-2 through
Cost of Capital Used to
A B C D E F G H I
105 12% $8.1 $8.4 $8.8 $9.1 $9.5 $9.8 $10.1
106 13% $6.9 $7.3 $7.6 $8.0 $8.3 $8.6 $9.0
107 14% $5.9 $6.2 $6.5 $6.9 $7.2 $7.5 $7.9
108 15% $4.8 $5.1 $5.5 $5.8 $6.2 $6.5 $6.8
109 16% $3.8 $4.1 $4.5 $4.8 $5.1 $5.5 $5.8
110 17% $2.8 $3.1 $3.5 $3.8 $4.1 $4.5 $4.8
111 18% $1.8 $2.2 $2.5 $2.9 $3.2 $3.5 $3.8
112 Notes: a
The Year 2 through Year 4 operating cash flows in are discounted at the WACC of 14%. The
113 cost in Year 1 is discounted at the risk-free rate of 6%.
114 b
The expected value and standard deviation are calculated as in Chapter 6.
115 c
The coefficient of variation is the standard deviation divided by the expected value.
116
117
118 Real Option Analysis
119
120
121
122
The option to defer the project is like a call option. The company has until Year 1 to decide whether or
123 not to implement the project, so the time to maturity of the option is one year. If the company exercises
124 the option, it must pay a strike price equal to the cost of implementing the project. If the company does
125 implement the project, it gains the value of the project. If you exercise a call option, you will own a stock
126 that is worth whatever its price is. If the company implements the project, it will gain a project, whose
value is equal to the present value of its cash flows. Therefore, the present value of a project's future cash
127 flows is analogous to the current value of a stock. The rate of return on the project is equal to its cost of
128 capital. To find the value of a call option, we need the standard deviation of its rate of return; to find the
129 value of this real option, we need the standard deviation of the projects expected rate of return.
130
131 The first step is to find the value of the project's future cash flows, as of the time the option must be
132 exercised. We also need the standard deviation of the project's value as of the date it must be exercised.
133 Finally, we need the present value of the project's future cash flows.
134
135
136 Figure 26-3
137 Estimating the Input for "Stock Price" in the Option Analysis of the Investment Timing Option (Millions of
Dollars)
138
139
140 Future Cash Flows PV of This
141 Now: Year 0 Probability Year 1 Year 2 Year 3 Year 4 Scenarioa
142
143 → High → 0.25 $0 $33 $33 $33 $67.21
144 ↗
145 "P0" →→Average → 0.50 $0 $25 $25 $25 $50.91
146 ↘
147 → Low → 0.25 $0 $5 $5 $5 $10.18
148 1.00
149 Expected value of PVb = $44.80
150 Standard deviationb = $21.07
151 Coefficient of variationc = 0.47
152 Notes: a
Here we find the PV, not the NPV, because the project's cost is ignored. The WACC is 14%. All
153 cash flows in this scenario are discounted back to Year 0.
154 b
The expected value and standard deviation are calculated as in Chapter 6.
155 c
The coefficient of variation is the standard deviation divided by the expected value.
 A B C D E F G H I
156
157 Figure 26-4
158 Estimating the Input for "Stock Return Variance" in the Option Analysis of the Investment Timing Option
(Millions of Dollars)
159
160 Part 1. Find the Value and Risk of Future Cash Flows at the Time the Option Expires
161
162 PV in Year 1
163 Future Cash Flows for This
164 Now: Year 0 Probability Year 1 Year 2 Year 3 Year 4 Scenarioa
165
166 → High → 0.25 $33 $33 $33 $76.61
167 ↗ ↗
168 Scenario→Average → 0.50 "P1" → $25 $25 $25 $58.04
169 ↘ ↘
170 → Low → 0.25 $5 $5 $5 $11.61
171 1.00
172 Expected value of PVb = $51.08
173 Standard deviationb = $24.02
174 Coefficient of variationc = 0.47
175
176 Part 2. Direct Method: Use the Scenarios to Directly Estimate the Variance of the Project's Return
177
178 PriceYear 0d Probability PVYear 1e ReturnYear 1f
179
180 → High → 0.25 $76.61 71.0%
181 ↗
182 $44.80 →Average → 0.50 $58.04 29.5%
183 ↘
184 → Low → 0.25 $11.61 −74.1%
185 1.00
186
187 Expected returnb = 14.0%
188 Variance of returnb = 0.287
189
190 Part 3. Indirect Method: Use the Scenarios to Indirectly Estimate the Variance of the Project's Return
191
192 Expected "price" at the time the option expires g = $51.08
193 Std. dev. of expected "price" at the time the option expires h = $24.02
194 Coefficient of variation (CV) = 0.47
195 Time (in years) until the option expires (t) = 1.00
196 Variance of the project's expected return = ln(CV 2+1)/t = 0.200
197 Notes: a
The WACC is 14%. The Year 2 through Year 4 cash flows are discounted back to Year 1.
198 b
The expected value, variance, and standard deviation are calculated as in Chapter 6.
199 c
The coefficient of variation is the standard deviation divided by the expected value.
200 d
The Year 0 price is the expected PV from Figure 26-3.
201 e
The Year 1 PVs are from Part 1.
202 f
The returns for each scenario are calculated as (PV Year 1 - PriceYear 0)/PriceYear 0.
203 g
The expected "price" at the time the option expires is taken from Part 1.
204 h
The standard deviation of expected "price" at the time the option expires is taken from Part 1.
 A B C D E F G H I
205
206
207 Figure 26-5
208 Estimating the Value of the of the Investment Timing Option Using a Standard Financial Option (Millions
of Dollars)
209
210 Part 1. Find the Value of a Call Option Using the Black-Scholes Model
211
212 Inputs for Real "Call" Option:
213 rRF = Risk-free interest rate = 6%
214 t = Time until the option expires = 1
215 X = Cost to implement the project = $50.00
216 P = Current value of the project = $44.80 a
217 σ2 = Variance of the project's rate of return = 0.20 b
218 Intermediate Calculations:
219 d1 = { ln (P/X) + [rRF + (σ2 /2) ] t } / (σ t1/2 ) = 0.1124
220 d2 = d1 - σ (t 1 / 2) = −0.3348
221 N(d1) = Area to left of d1 in Normal PD function = 0.5447
222 N(d2) = Area to left of d2 in Normal PD function = 0.3689
223
224 V = P[ N (d1) ] - Xe-(risk-free rate)(t) [ N (d2) ] = $7.04
225
226 Part 2. Sensitivity Analysis of Option Value to Changes in Variance
227
228 Variance Option Value
229 0.12 $5.24
230 0.14 $5.74
231 0.16 $6.20
232 0.18 $6.63
233 0.20 $7.04
234 0.22 $7.42
235 0.24 $7.79
236 0.26 $8.15
237 0.28 $8.49
238 0.30 $8.81
239 0.32 $9.13
240
241 Notes: a
The current value of the project is taken from Figure 26-3.
242 b
The variance of the project's rate of return is taken from Part 3 of Figure 26-4.
243
244
245 26-3 The Growth Option: An Illustration
246
247
248
249 Kidco Corporation designs and produces products aimed at the pre-teen market. Most of these products
250 have a very short life cycle, given the rapidly changing tastes of pre-teens. Kidco is considering one such
251 project, which will cost $30 million to implement and will last only two years. Kidco believes there is a 25
252 percent chance that the project will catch the fancy of pre-teens. In this scenario, it will generate cash
flows of $34 million in each of the next two years, after which pre-teen tastes are likely to change. There
253 is a 50 percent chance of average demand for the new product, which produces expected cash flows of
254 $19 million annually for two years. There is a 25% chance that the pre-teens won’t like the product, and
255 it will generate cash flows of only $3 million per year. The cost of capital for this project is 14%.
 A B C D E F G H I
256 Inputs:
257 WACC= 14%
258 Risk-free rate= 6%
259 Initial cost= $30
260
261
262 DCF Analysis
263
264 Expected annual cash flows (in millions):
265 Probability Cash Flow Prob. x CF
266 25% $34 $8.50
267 50% $20 $10.00
268 25% $2 $0.50
269 100%
270 Expected CF = $19.00
271
272 Time Line Year 0 1 2
273 Expected CF −$30 $19 $19
274
275 NPV = $1.29
276
277
278 Figure 26-6
279
Scenario Analysis and Decision Tree Analysis for the Kidco Project (Millions of Dollars)
280
281 Part 1. Scenario Analysis of Kidco's First-Generation Project
282
283 Future Cash Flows NPV of This
284 Now: Year 0 Probability Year 1 Year 2 Scenarioa
285
286 → High → 25% $34 $34 $25.99
287 ↗
288 ### →Average → 50% $20 $20 $2.93
289 ↘
290 → Low → 25% $2 $2 ###
291
292 Expected value of NPVb = $1.29
293 Standard deviationb = $18.70
294 Coefficient of variationc = 14.54
295
296 Part 2. Decision-Tree Analysis of the Growth Option
297
298 Future Cash Flows NPV of This
299 Now: Year 0 Probability Year 1 Year 2d Year 3 Year 4 Scenarioe
300
301 25% $34 $34 $34 $34 $42.37
302 → High → −$30
303 ↗
304 ### →Average → 50% $20 $20 $20 $20 $1.57
305 ↘ −$30
306 ↘
307 → Low → 25% $2 $2 $0 $0 −$26.71
308 1.00
 A B C D E F G H I
309
310 Expected value of NPVb = $4.70
311 Standard deviationb = $24.62
312 Coefficient of variationc = 5.24
313 Notes: a
The operating cash flows are discounted by the WACC of 14%.
314 b
The expected value and standard deviation are calculated as in Chapter 6.
315 c
The coefficient of variation is the standard deviation divided by the expected value.
316 d
The total cash flows in Year 2 are equal to the operating cash flows for the first
317 generation product minus the $30 million cost to implement the second generation
318 product, if it is optimal to do so.
319
320 The operating cash flows in Year 1 through Year 4, which do not include the $30
e

million cost of implementing the second generation project in Year 2 for the high
321 demand and average demand scenarios, are discounted at the WACC of 14%. The
322 implementation cost in Year 2 for the high demand and average demand scenarios is
323 discounted at the risk-free rate of 6%.
324
325
326 Figure 26-7
327
Sensitivity Analysis of the Kidco Decision Tree Analysis in Figure 26-6 (Millions of Dollars)
328
329 Cost of Capital Used to Discount the $30 Million Implementation
330 Cost in Year 2 of the Second-Generation Project
331 $4.70 3% 4% 5% 6% 7% 8% 9%
332 8% $11.0 $11.4 $11.8 $12.1 $12.5 $12.9 $13.2
Year-4 Operating Cash Flowsa
Discount the Year-1 through

333 9% $9.6 $10.0 $10.4 $10.8 $11.2 $11.5 $11.9

Cost of Capital Used to

334 10% $8.3 $8.7 $9.1 $9.5 $9.9 $10.2 $10.6

335 11% $7.0 $7.4 $7.8 $8.2 $8.6 $9.0 $9.3
336 12% $5.8 $6.2 $6.6 $7.0 $7.4 $7.7 $8.1
337 13% $4.7 $5.1 $5.5 $5.8 $6.2 $6.6 $6.9
338 14% $3.5 $3.9 $4.3 $4.7 $5.1 $5.4 $5.8
339 15% $2.4 $2.8 $3.2 $3.6 $4.0 $4.3 $4.7
340 16% $1.4 $1.8 $2.2 $2.5 $2.9 $3.3 $3.6
341 17% $0.3 $0.7 $1.1 $1.5 $1.9 $2.3 $2.6
342 18% −$0.7 −$0.3 $0.1 $0.5 $0.9 $1.3 $1.6
343 Note: aThe operating cash flows do not include the $30 million implemetation cost of the second
344 generation project in Year 2.
345
346
347 Figure 26-8
348 Estimating the Input for "Stock Price" in the Growth Option Analysis of the Investment Timing Option
(Millions of Dollars)
349
350 Future Cash Flows PV of This
351 Now: Year 0 Probability Year 1 Year 2 Year 3 Year 4 Scenarioa
352
353 → High → 25% $0 $0 $34 $34 $43.08
354 ↗
355 "P0" →→Average → 50% $0 $0 $20 $20 $25.34
356 ↘
357 → Low → 25% $0 $0 $2 $2 $2.53
358 1.00
 A B C D E F G H I
359 Expected value of PVb = $24.07
360 Standard deviationb = $14.39
361 Coefficient of variationc = 0.60
362
363 Notes: a
Here we find the PV, not the NPV, because the project's cost is ignored. The WACC is 14%. All
364 cash flows in this scenario are discounted back to Year 0.
365 b
The expected value and standard deviation are calculated as in Chapter 6.
366 c
The coefficient of variation is the standard deviation divided by the expected value.
367
368
369 Figure 26-9
370
Estimating the Input for "Stock Return Variance" in the Growth Option Analysis (Millions of Dollars)
371
372 Part 1. Find the Value and Risk of Future Cash Flows at the Time the Option Expires
373
374 PV in Year 2
375 Future Cash Flows for This
376 Now: Year 0 Probability Year 1 Year 2 Year 3 Year 4 Scenarioa
377
378 → High → 25% $34 $34 $55.99
379 ↗ ↗
380 Scenario →Average → 50% "P2" → $20 $20 $32.93
381 ↘ ↘
382 → Low → 25% $2 $2 $3.29
383 1.00
384 Expected value of PVYear 2b = $31.29
385 Standard deviation of PVYear 2b =
$18.70
386 Coefficient of variation of PVYear 2c =
0.60
387 Part 2. Direct Method: Use the Scenarios to Directly Estimate the Variance of the Project's Return
388
389 PriceYear 0d Probability PVYear 2e ReturnYear 2f
390
391 → High → 25% $55.99 52.5%
392 ↗
393 $24.07 →Average → 50% $32.93 17.0%
394 ↘
395 → Low → 25% $3.29 −63.0%
396 1.00
397
398 Expected returnb,g = 5.9%
399 Variance of returnb = 0.179
400
401 Part 3. Indirect Method: Use the Scenarios to Indirectly Estimate the Variance of the Project's Return
402
403 Expected "price" at the time the option expires h = $31.29
404 Std. dev. of expected "price" at the time the option expires i = $18.70
405 Coefficient of variation (CV) = 0.60
406 Time (in years) until the option expires (t) = 2
407 Variance of the project's expected return = ln(CV 2+1)/t = 0.153
408
 A B C D E F G H I
409 Notes: a
The WACC is 14%. The Year 3 through Year 4 cash flows are discounted back to Year 2.
410 b
The expected value, variance, and standard deviation are calculated as in Chapter 6.
411 c
The coefficient of variation is the standard deviation divided by the expected value.
412 d
The Year 0 price is the expected PV from Figure 26-8.
413 e
The Year 2 PVs are from Part 1.
414 f
The annualized returns for each scenario are calculated as (PV Year 2/ PriceYear 0)0.5 - 1.
415 g
The expected annualized return is not equal to the cost of capital, 14%. However, if you do
416 the calculations then you’ll see that the expected 2-year return is 29.26%, which is equal to the
417 2-year compounded cost of capital: (1.14) 2 − 1 = 29.26%.
418 h
The expected "price" at the time the option expires is taken from Part 1.
419 i
The standard deviation of expected "price" at the time the option expires is taken from Part 1.
420
421 Figure 26-10
422
Estimating the Value of the of the Growth Option Using a Standard Financial Option (Millions of Dollars)
423
424 Part 1. Find the Value of a Call Option Using the Black-Scholes Model
425
426 Inputs for Real "Call" Option:
427 rRF = Risk-free interest rate = 6%
428 t = Time until the option expires = 2
429 X = Cost to implement the project = $30.00
430 P = Current value of the project = $24.07 a
431 σ = Variance of the project's rate of return
2
= 0.153 b
432 Intermediate Calculations:
433 d1 = { ln (P/X) + [rRF + (σ2 /2) ] t } / (σ t1/2 ) = 0.095
434 d2 = d1 - σ (t 1 / 2) = -0.46
435 N(d1) = Area to left of d1 in Normal PD function = 0.54
436 N(d2) = Area to left of d2 in Normal PD function = 0.32
437
438 V = P[ N (d1) ] - Xe-(risk-free rate)(t) [ N (d2) ] = $4.34
439
440 Part 2. Sensitivity Analysis of Option Value to Changes in Variance
441
442 Variance Option Value
443 0.113 $3.60
444 0.133 $3.98
445 0.153 $4.34
446 0.173 $4.68
447 0.193 $4.99
448 0.213 $5.29
449 0.233 $5.57
450 0.253 $5.84
451 0.273 $6.10
452 0.293 $6.35
453 0.313 $6.59
454
455 Notes: a
The current value of the project is taken from Figure 26-7.
456 b
The variance of the project's rate of return is taken from Part 3 of Figure 26-8.
457
458
 A B C D E F G H I
459
460 Total project value = NPV of first generation project + Value of growth option
461 Total project value = $1.29 + $4.34
462 Total project value = $5.63
463
 J K L M N O
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 J K L M N O
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415 Probability Unannualized 2-year return
416 High 25% 133%
417 Average 50% 37%
418 Low 25% -86%
4191.
xpires is taken from Part Expected: 29.96%
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 A B C D E F G H
1
2 Web 26A: THE ABANDONMENT OPTION
3
4 Intial Cost= $26
5 WACC= 12%
6 Risk free rate = 6%
7 After-tax salvage value = $14
8
9
10 DCF Analysis
11
12 Table 26A-1
13 Expected Operating Cash Flows for Project at Synapse Systems (Millions of Dollars)
14
15 Operating Cash Flow
16 Demand Probability Year 1 Year 2 Year 3 Year 4
17 High 25% $18 $23 $28 $33
18 Average 50% $7 $8 $9 $10
19 Low 25% -$8 -$9 -$10 -$12
20 Expected operating cash flow = $6.00 $7.50 $9.00 $10.25
21
22
23 Time Line Year Now: Year 0 Year 1 Year 2 Year 3 Year 4
24 Expected CF -$26.00 $6.00 $7.50 $9.00 $10.25
25
26 NPV = -1.74
27
28
29 Figure 26A-1
30 Scenario Analysis and Decision Tree Analysis for the Synapse Project (Millions of Dollars)
31
32 Part 1. Scenario Analysis of the Project (Ignoring the Option to Abandon)
33 Future Cash Flows NPV of This
34 Now: Year 0 Probability Year 1 Year 2 Year 3 Year 4 Scenarioa
35
36 → High → 0.25 $18 $23 $28 $33 $49.31
37 ↗
38 −$26 →Average → 0.50 $7 $8 $9 $10 −$0.61
39 ↘
40 → Low → 0.25 −$8 −$9 −$10 −$12 −$55.06
41 1.00
42 Expected value of NPVb = −$1.74
43 Standard deviationb = $36.92
44 Coefficient of variationc = −21.17
45
46 Part 2. Decision-Tree Analysis of the Abandonment Option
47 Future Cash Flows NPV of This
48 Now: Year 0 Probability Year 1d Year 2e Year 3e Year 3e Scenariof
49
50 → High → 0.25 $18 $23 $28 $33 $49.31
51 ↗
52 −$26 →Average → 0.50 $7 $8 $9 $10 −$0.61
 A B C D E F G H
53 ↘
54 → Low → 0.25 $6 $0 $0 $0 −$19.94
55 1.00
56 Expected value of NPVb = $7.04
57 Standard deviationb = $25.65
58 Coefficient of variationc = 3.64
59 Notes: a
The operating cash flows are discounted by the WACC of 12%.
60 b
The standard deviation and expected return are calculated as in Chapter 6.
61 c
The coefficient of variation is the standard deviation divided by the expected value.
62 d
The cash flow in Year 1 for the low demand scenario is equal to the -$8 million operating
63 cash flow plus the after-tax salvage value of $14 million, since Synapse will abandon the
64 proejct in this scenario.
65
66 e
The cash flows in Years 2 though Year 4 for the low demand scenario are zero, because
67 Synapse abandons the project immediately after the -$8 million operating loss in Year 1.
68 The operating cash flows in Year 1 though Year 4, which do not include the $14 million after-tax salvage
f

69 value, are discounted at the WACC of 12%. The $14 million salvage value in the low demand scenario in Year
70 1 is discounted at the risk-free rate of 6%.
71
72 Real Option Analysis Where Firm Has the Option to Abandon
73
74
75
Break the project into two projects plus an option to abandon the second project. Project A starts at time zero and lasts
76 one year. It has the initial cost and first-year operating cash flows of the original project. Project B begins at Year 2 and
77 last through Year 4. It has no initial cost, but has the Year 2 through 4 operating cash flows of the original project. There
78 is also a real option that allows you to abandon Project B if the value of B at time 1 is less than the abandonment amount.
79
80
81 Figure 26A-2
82 Breaking Synapse's Project into Two Separate Projects of the Investment Timing Option (Millions of Dollars)
83
84 Part 1. DCF Analysis of Project A that Lasts One Year
85
86 Cash Flow NPV of This
87 Now: Year 0 Probability Year 1 Scenarioa
88
89 → High → 0.25 $18 −$9.93
90 ↗
91 −$26 →Average → 0.50 $7 −$19.75
92 ↘
93 → Low → 0.25 −$8 −$33.14
94 1.00
95 Expected value of NPVb = −$20.64
96 Standard deviationb = $8.26
97 Coefficient of variationc = −0.40
98 Part 2. DCF Analysis of Project B that Starts at Year 1 If Project A is Already in Place
99
100 Future Cash Flows NPV of This
101 Now: Year 0 Probability Year 1 Year 2 Year 3 Year 4 Scenarioa
102
103 → High → 0.25 $0 $23 $28 $33 $59.24
104 ↗
 A B C D E F G H
105 "P0" → →Average → 0.50 $0 $8 $9 $10 $19.14
106 ↘
107 → Low → 0.25 $0 −$9 −$10 −$12 −$21.92
108 1.00
109 Expected value of NPVb = $18.90
110 Standard deviationb = $28.69
111 Coefficient of variationc = 1.52
112
113 Notes: a
The WACC is 12%. All cash flows in this scenario are discounted back to Year 0.
114 b
The expected value and standard deviation are calculated as in Chapter 6.
115 c
The coefficient of variation is the standard deviation divided by the expected value.
116
117 Figure 26A-3
118
Estimating the Input for "Stock Return Variance" in the Abandonment Option Analysis (Millions of Dollars)
119
120 Part 1. Find the Value and Risk of Future Cash Flows at the Time the Option Expires
121
122 PV in Year 1
123 Future Cash Flows for this
124 Now: Year 0 Probability Year 1 Year 2 Year 3 Year 4 Scenarioa
125
126 → High → 0.25 $23 $28 $33 $66.35
127 ↗ ↗
128 Scenario →Average → 0.50 "P1" → $8 $9 $10 $21.44
129 ↘ ↘
130 → Low → 0.25 −$9 −$10 −$12 −$24.55
131 1.00
132 Expected value of PVb = $21.17
133 Standard deviationb = $32.14
134 Coefficient of variationc = 1.52
135
136 Part 2. Direct Method: Use the Scenarios to Directly Estimate the Variance of the Project's Return
137
138 PriceYear 0d Probability PVYear 1e ReturnYear 1f
139
140 0.25 $66.35 251.1%
141 ↗ High
142 $18.90 Average 0.50 $21.44 13.4%
143 ↘ Low
144 0.25 −$24.55 −229.9%
145 1.00
146
147 Expected returnb = 12.0%
148 Variance of returnb = 2.89
149
150 Part 3. Indirect Method: Use the Scenarios to Indirectly Estimate the Variance of the Project's Return
151 Expected "price" at the time the option expires g = $21.17
152 Std. dev. of expected "price" at the time the option expires h = $32.14
153 Coefficient of variation (CV) = 1.52
154 Time (in years) until the option expires (t) = 1
 A B C D E F G H
155 Variance of the project's expected return = ln(CV 2+1)/t = 1.20
156
157 Notes: a
The WACC is 12%. The Year 2 through Year 4 cash flows are discounted back to Year 1.
158 b
The standard deviation, variance, and expected return are calculated as in Chapter 6.
159 c
The coefficient of variation is the standard deviation divided by the expected value.
160 d
The Year 0 price is the expected NPV from Part 2 of Figure 26A-2.
161 e
The Year 1 PVs are from Part 1.
162 f
The returns for each scenario are calculated as (PV Year 1/ PriceYear 0) - 1.
163 g
The expected "price" at the time the option expires is taken from Part 1.
164 h
The standard deviation of expected "price" at the time the option expires is taken from Part 1.
165
166
167
168 Figure 26A-4
169 Estimating the Value of the of the Abandonment Option Using a Standard Financial Option (Millions of
170 Dollars)
171
172 Inputs for Real "Call" Option:
173 rRF = Risk-free interest rate = 6%
174 t = Time until the option expires = 1
175 X = Salvage value if abandon = $14.00
176 P = Current value of the Project B = $18.90 a
177 σ2 = Variance of Project B's rate of return = 1.75 b
178 Intermediate Calculations:
179 d1 = { ln (P/X) + [rRF + (s2 /2) ] t } / (s t1/2 ) = 0.9336
180 d2 = d1 - s (t 1 / 2) = −0.3893
181 N(d1) = Area to left of d1 in Normal PD function = 0.8247
182 N(d2) = Area to left of d2 in Normal PD function = 0.3485
183
184 V of Call = P[ N (d1) ] - Xe-(risk-free rate)(t) [ N (d2) ] = $10.99
185
186 V of Put = Call − P + X e-rRF t
187 V of Put = $10.99 − $18.90 + $13.18
188 V of Put = $5.28
189
190
191 Notes: a
The current value of the project is taken from Figure 26A-2.
192 b
The variance of the project’s rate of return is chosen to be a value between the variances
193 from Parts 2 and 3 of Figure 26A-3.
194
195 Total NPV= NPV of A + NPV of B + Value of abandonment option
196 Total NPV= -$20.64 + $18.90 + $5.28
197 Total NPV= $3.53
198
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1 10/27/2015
T OPTION 2
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nclude the $14 million 68after-tax salvage
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ge value in the low demand
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oject. Project A starts at time zero and lasts
ginal project. Project B76begins at Year 2 and
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ting cash flows of the original project. There
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ime 1 is less than the abandonment amount.
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ming Option (Millions of 82Dollars)
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n Analysis (Millions of Dollars)
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n expires is taken from164
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Value of abandonment195 option
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