Capital Budgeting Analysis Part 3: Real Options

This video is part of a series of lectures that comprise an MBA level course in Corporate Finance. The lectures build on concepts and principals developed in previous lectures and, therefore, are best viewed in sequence. However, each lecture is divided into topics which can provide students (MBA and advanced undergraduates) with a helpful review of a specific topic. Persons preparing to take the CFA Exams will also find these lectures useful. The course consists of the following video lectures:

1. Investment Decisions and the Fundamentals of Value.
2. Financial Statements and Cash Flow (5 parts)
3. Discounted Cash Flow Valuation (6 parts)
4. Investment Decision Rules (5 parts)
5. Making Capital Investment Decisions (2 parts)
6. Valuation of Bonds (4 parts)
7. Stock Valuation (3 parts)
8. Lessons from Capital Market History (3 parts)
9. Risk and Return (3 parts)
10. CAPM (3 parts)
11. Risk and Capital Budgeting (3 parts)
12. Capital Budgeting Analysis (3 parts)

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Closed Caption:

real options standard net present value
analysis is static analysis assumes that
once the project is initiated the firm
passively holds the assets and
everything flows exactly as forecast
without change financial assets like
stocks and bonds are passive assets
investor has no influence on the
financial assets cash flows but rule
assets are not passive assets manager
will actions can influence their cash
flows corporations manage assets in a
dynamic environment always subject to
change managers have the option to
modify projects to adapt to change and
take advantage of new opportunities or
respond to problems options to modify
projects are called real options these
options of the flexibilities that are
inherent in the project real options
exist when managers can influence the
size and riskiness the project cash
flows by taking different actions over
the life of the project
suppose you have two mutually exclusive
projects with the same net present value
one project music commitment to a
particular technology it would be too
costly to switch the new technology
anytime in the next 10 years the other
project makes no long-term commitment
anyone technology and would allow for
switching technology if a better one is
developed which project has a higher
value now both projects have the same
net present value but the project that
can switch technologies of a better one
is developed is intuitively more
valuable it has flexibility has a real
option to switch to a better technology
in the future let's note the net present
value does not incorporate the value of
real options associated with a project
net present values of present value
expected cash flows
it says nothing about actions that can
take place after the project has been
accepted and place an operation that
might cause cash flows a change in the
future so capital budgeting analysis
requires not only the calculation net
present value but also identifying and
value and the real options associated
with the project so total project value
is equal to its net present value plus
the value of its real options any
investment approach that ignores roll
options is likely to underestimate the
value of the project some common real
options the option to expand these are
options to take additional valuable
investment in the future that result
from the current investment if
investment creates an opportunity to
make other potentially profitable
investments that would not otherwise be
possible then investment is said to
contain an option to expand for example
years ago a pharmaceutical from John a
drug called minoxidil that was used to
treat certain heart conditions
they discovered that this drug could
also grow hair patients taking the
knoxville reporting for their doctors
that they were growing hair after taking
the drug and doctors were taking a
Knoxville and dissolving it in the
alcohol and rubbing it on their bold and
scalps Upjohn realize that balding man
we're huge market for this drug so they
marketed knoxville as regain the
treatment for male pattern baldness the
option to abandon when we evaluate
projects we generally said the firm will
operate assets for their full physical
lives however this is not always the
best course of action if things turn
south it might be wise a cutlass losses
and bail out this is the option to
terminate a project before the end of
this originally projected economic life
it also includes the option to abandon
part of the projects operations the
investment timing option
this is the option to delay investment
conventional net present value analysis
assumes the project will either be
accepted or rejected which implies that
there will be undertaken now or never
however in practice company sometimes
have a third option postpone the
investment for more information becomes
available or until conditions change for
example firm is considering a proposed
expansion project the project really
cash flows depend upon market conditions
there's a fifty percent probability mark
will be good and fifty percent
probability it will be bad
the firm can reject the project take the
project now or wait a year when the
markets conditions will be known
the production flexibility option this
is the option to alter operations
depending on how conditions change and
what production technologies develop
over the left the project and let's note
and options are right to do something
without any obligation to do it
however if an option is ignored the firm
will be incurring an opportunity costs
by forgoing the value of the real option
option pricing Theory used to price real
options as an advanced topic that we
won't cover here
however we can describe real options
embedded in a project with a decision
tree decision trees can help identifying
how future decisions can affect the
value of project in a decision tree to
identify things that might happen after
project is accepted and the decisions
that will be made in the event these
things materialize the squares in a
decision tree represent decision points
the circles represent the receipt of new
information that can be acted on
in this example the first introduce a
new product and must enter the market
now to secure a niche in the market but
the firm what know the demand for the
product until it develops over the first
year there's a seventy-five percent
probability that the man for the product
will be high and twenty-five percent
probability that the man will be low if
the man is high the project will earn
four million dollars in the first year
and given that the man is high a
decision must be made the project can be
kept as is and don't expand if the
decisions made not to expand the present
value of subsequent cash flow at the end
of your one is 16 million dollars in the
firm decides to expand the project to
take advantage high demand across the
expansion will be 2 million dollars and
the present value of subsequent cash
flows at the end of your 130 million
dollars if the man is low the project
will earn eight hundred thousand dollars
in the first year and given that the man
is low a decision must be made the
project can be kept as is and not
terminated the decisions made not to
terminate the present value of social
cash flow at the end of one year is
three million dollars at the firm
decides to terminate the project in the
face of low demand the cost is shutting
down the project is $500,000 and the
present value of subsequent cash flow
from the liquidation the project at the
end of your one is six million dollars
to get a solution we work backwards from
the future
considering the decisions that should be
taken in each case net present values
for the alternative decisions are
calculated at the decision points
if demand is high the net present value
at your one of the solution not expand
is 16 million dollars the present value
at your one of the decision to expand
its 30 million dollars its cost as two
million dollars as net present value is
28 million dollars based on the net
present value the decision is to expand
if the man is high we add the 28 million
dollar net present value 24 million
dollar cash flow and you're one to get
the project value at the end of your 132
million dollars if demand is low net
present value at year one of the
decision not to terminate is three
million dollars the present value at
your one of the decision to terminate is
six million dollars its cost $500,000 as
net present value 5.5 million dollars
based on the net present value the
decision is to terminate the project if
demand is low we had the 5.5 million net
present value to the $80,000 cash flow
and you're one to get the project value
at the end of your 16.3 million dollars
the total net present value of project
is a semi five percent probability as a
decimal size 32 million dollar your one
value given high demand plus a
twenty-five percent probability as a
decimal times a 6.3 million dollar your
one value given low demand and that's
discounted back at your one of the ten
percent cause a capital the 12 million
dollar initial investment subtracted
from the present value to get a net
present value of 11.25 million dollars
what's the value of the real options
let's calculate the total net present
value without the real options where the
decision is made to keep the project as
is that net present value is 3.95
million dollars to the estimate the
value of the real options is 11.25 net
present value with the options was a
3.95 million dollars without the options
for 7.2 million dollars now decision
trees just get an approximation of value
of the real options real options can
change the risk of the cash flows
increasing or decreasing the risk
because of risk changes discounted cash
flow calculations can only approximate
the value of real options better
estimates cannae using more advanced
models from option pricing theory