Scenario Name Base Worst Best

Probability of Scenario 50% 25% 25%

Scenario Name Base Worst Best

Equipment cost $7,750 $8,250 $7,250
Salvage value, equipment, Year 4 $639 $639 $639
Units sold, Year 1 11,000 8,500 11,500
Annual change in units sold, after Year 1 15% 5% 25%
Sales price per unit, Year 1 $1.50 $1.25 $1.75
Annual change in sales price, after Year 1 4% 4% 4%
Variable cost per unit (VC), Year 1 $1.07 $1.17 $0.97
Annual change in VC, after Year 1 3% 3% 3%
Nonvariable cost (Non-VC), Year 1 $2,120 $2,330 $1,910
Annual change in Non-VC, after Year 1 3% 3% 3%
Project cost of capital, r 10% 10% 10%
Tax rate 40% 50% 30%
Working capital as % of next year's sales 15% 15% 15%
 A B C D E F G H
1 Real Options
2 Investment Timing and Option to Defer a Project
3 Inputs: Given
4 WACC= 14%
5 Risk-free rate = 6%
6 Project duration (years)= 3
7 Initial cost of project= $50
8
9 DCF Analysis
10
11 Expected annual cash flows (in millions):
12 Inputs: Probability Cash Flow
13 Given 25% $33
14 50% $25
15 25% $5
16
17
18 Part 1. Proceed with Project Today
19 Future Cash Flows NPV of This
20 Now: Year 0 Probability Year 1 Year 2 Year 3 Scenario
21
22 → High →
23 ↗ #N/A #N/A #N/A #N/A
24 →Average →
25 #N/A #N/A #N/A #N/A #N/A
26 ↘ → Low →
27 #N/A #N/A #N/A #N/A
28 Expected value of NPV =
29 Standard deviation=
30 Coefficient of variation=
31
32 Part 2. Implement in One Year Only if Optimal
33
34 Future Cash Flows NPV of This
35 Now: Year 0 Probability Year 1 Year 2 Year 3 Year 4 Scenario
36
37 → High →
38 ↗ #N/A #N/A #N/A #N/A #N/A
39 Wait →Average →
40 ↘ #N/A #N/A #N/A #N/A #N/A
41 → Low →
42 #N/A
43 Expected value of NPV =
44 Standard deviation=
45 Coefficient of variation=
46
47
 A B C D E F G H
48 Real Option Analysis
49
The option to defer the project is like a call option.
50
51 The company has until Year 1 to decide whether or not to implement the project, so the time to maturity of the option is one ye
52 If the company exercises the option, it must pay a strike price equal to the cost of implementing the project.
53 If the company does implement the project, it gains the value of the project. If you exercise a call option, you will own a stock
54 implements the project, it will gain a project, whose value is equal to the present value of its cash flows.
55 The rate of return on the project is equal to its cost of capital.
56 To find the value of this real option, we need the standard deviation of the projects expected rate of return.
57
58
Estimating the Input for "Project Value" in the Real Option Analysis (Millions of Dollars)
59
60
61 Future Cash Flows PV of This
62 Now: Year 0 Probability Year 1 Year 2 Year 3 Year 4 Scenario
63
64 → High →
65 ↗ #N/A #N/A #N/A #N/A
66 "P0" → →Average →
67 ↘ #N/A #N/A #N/A #N/A
68 → Low →
69 #N/A #N/A #N/A #N/A
70 Project Value (PV of Inflows) =
71
72
73
Estimating the Input for "Project Variance" in the Real Option Analysis (Millions of Dollars)
74
75 Part 1. Find the Value and Risk of Future Cash Flows at the Time the Option Expires
76
77 PV in Year 1
78 Future Cash Flows for This
79 Now: Year 0 Probability Year 1 Year 2 Year 3 Year 4 Scenario
80
81 → High →
82 ↗ ↗
83 Scenario →Average →
84 ↘ ↘
85 → Low →
86
87
88 Part 2. Estimate the Variance of the Project's Return
89
90 PriceYear 0 Probability PVYear 1 ReturnYear 1
91
92 → High → 0.25 #N/A
 A B C D E F G H
93 ↗
94 →Average → 0.50 #N/A
95 ↘
96 → Low → 0.25 #N/A
97
98 Expected return = #N/A
99 Variance of return= #N/A
100
101
102
103
Real Option Value (Millions of Dollars)
104
105 Black-Scholes Model
106
107 Inputs for Real "Call" Option:
108 rRF = Risk-free interest rate = 6%
109 t = Time until the option expires = 1
110 X = Cost to implement the project = $0.00
111 P = Current value of the project =
112 s2 = Variance of the project's rate of return =
113 Intermediate Calculations:
114 d1 = { ln (P/X) + [rRF + (σ2 /2) ] t } / (σ t1/2 ) = #DIV/0!
115 d2 = d1 - σ (t 1/2
) = #DIV/0!
116 N(d1) = Area to left of d1 in Normal PD function =
117 N(d2) = Area to left of d2 in Normal PD function =
118
119 V = P[ N (d1) ] - Xe-(risk-free rate)(t) [ N (d2) ] =
120
121
122 Total project value = NPV of original project + Value of Defer option
123 Total project value = +
124 Total project value =
 I J K L M N O
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22 #N/A
23
24 #N/A
25
26 #N/A
27
28 #N/A
29 #N/A
30 #N/A
31
32
33
34
35
36
37 #N/A
38
39 #N/A
40
41 #N/A
42
43 #N/A
44 #N/A
45 #N/A
46
47
 I J K L M N O
48
49
50
he project, so the time51to maturity of the option is one year.
the cost of implementing
52 the project.
oject. If you exercise53
a call option, you will own a stock that is worth whatever its price is. If the company
he present value of its54cash flows.
55
the projects expected56rate of return.
57
58
lysis (Millions of Dollars)
59
60
61
62
63
64 #N/A
65
66 #N/A
67
68 #N/A
69
70 #N/A
71
72
73
Analysis (Millions of Dollars)
74
75
76
77
78
79
80
81 #N/A
82
83 #N/A
84
85 #N/A
86
87
88
89
90
91
92
 I J K L M N O
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110 =-A24
111 #N/A
112 #N/A
113
114 =(LN(H111/H110)+((H108+(0.5*H112))*H109))/(SQRT(H112)*SQRT(H109))
115 =H114-(SQRT(H112)*SQRT(H109))
116 #N/A
117 #N/A
118
119 #N/A
120
121
122
123
124
 P Q R S T
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 P Q R S T
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rice is. If the company
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 U V W X Y Z AA
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 U V W X Y Z AA
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