Capital budgeting III: Real options

What is a real option?

https://www.youtube.com/watch?v=T1JKwzJ-KMc

So far, everything about a project is given and fixed.

In reality, managers need to make decisions and changes along the project’s life all the time.

Think of two mutually exclusive projects with same NPV:

Residential area vs. shopping mall

Residential area requires more work on construction both for building up and tearing down

The area is expanding quickly, which brings potential opportunities for new use of the land in the future

Which project do you prefer given thought on the option to change the land to other usage in the future?

What is a real option?

Shopping mall project has an additional option to switch land use at a lower cost, which makes the project more valuable.

A real option is the right to make a decision at your own will in the middle of a project

A right, not an obligation

Has additional value to the project

Think of real options as flexibility of a project

Total project value = currently estimated NPV + Incremental value of real options

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Common Real Options

Option to delay

The option to “time” an investment

You don’t need to invest right now, you can rather wait

Costs of investing may fall, demand for the project can rise, new technologies can make existing components obsolete, etc.

Wait only when doing so adds value

Ex. Shale oil production. Production costs is high so when oil price is too low to cover it, oil companies possessing the technology will delay the project.

Delay to put on a movie in theater to avoid competition from blockbusters. Do not announce specific in-theater date too early!

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Common Real Options

Option to expand

The option to start with limited capacity, and expand only if product is successful

Ex. Drug companies generally start with one type of medicine. However, it is easy to expand product lines given established labs and talents hired

Ex. Uber. Expanded to food delivery business

Option to abandon

The option to walk away if product is unsuccessful, rather than bleeding money

Software maintenance: Windows, game apps, etc.

Bottom line: Greater flexibility increases value of project!

Summary of capital budgeting

Forecasting, not recording

Independent from financing activities

Budgeting process: from revenue to cash flows

Investment rules: how to pick projects

Real options

Now you are an expert in capital budgeting!

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Next…

Shifting gears from “Time” to “Risk”

We took everything as “deterministic” until now

In reality, it’s an “uncertain” world

Cost of capital (chp 11, 12, 13)

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