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FIN710
Capital Budgeting and Real Options
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CB and Real Options Agenda for the Day Capital Budgeting
How does it fit in Common mistakes Assessing Risk
Real Options What are they? What types? Why do we care? How do we value them?
CB – Common Mistakes
• Properly accounting for Changes in Net Working Capital (NWC)
• Interest expenses should not be in the cash flows…why not?
• …why not?• Opportunity costs should be counted…like
what?• Timing of cash flows…for ex., ...• Adjusting for ...
Capital Budgeting, Real Options 3
Adjusting for Inflation
Inflation changes both the cash flows and the discount rate.Fortunately, the WACC already reflects inflation…how?We need to adjust almost all cash inflows and outflows over time by inflation. Why?Won’t sales prices and variable cost inputs go up with inflation? What about ...?
Capital Budgeting, Real Options 4
CB – Not exactly mistakes
• Cash flow estimation is tough stuff. – Get everybody involved…marketing, production,
accountants, etc.– Use realistic assumptions
• The WACC estimate is also tough stuff• Projecting beyond a certain point is risky, what can
we do about that? – not much• Only project cash flows for a few years and say their
gonna increase “x” percent. Other than that, can’t do much
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CB – Assessing Risk
Seems like sophisticated stuff• Sensitivity Analysis• Scenario Analysis• Monte Carlo Simulation
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Assessing Risk
Sensitivity AnalysisThe trick is to change one input and see how much the bottom line changes.If the bottom line changes a lot, you’d better pay attention to the input you changedIs that input really risky or is it ..?If it’s really risky, what can we do about it?
Capital Budgeting, Real Options 7
Assessing RiskSensitivity Tables and Graphs – One easy picture…see ↙
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Assessing Risk
Scenario AnalysisSometimes one input is related to another. Maybe sales goes up when interest rates go down. If so, do a few different scenarios, and see what happens to the bottom line.
You could average out the bottom line if you wanted to. The result may be different from your point estimate.
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Capital Budgeting, Real Options 10
Assessing Risk
Monte Carlo SimulationA kazillion scenarios … an ...You also get a valuable probability distribution that helps you better understand the risk of the project.We’re not doing it.
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Clicker QTilton Corporation builds windmills for use in developing nations. Tilton is a registered charity and as such, does not pay taxes. Ve = $40M, Vd = $0. re = .12, rd = .08
Tilton is considering a new windmill project. This project will take 10 years to complete. The initial cost of the project is $4M. Annual pre-tax operating cash flows are estimated to be $522,000 per year. The firm expects to sell off its salvage for $1,000,000 at the end of the project. The CCA rate for project is 20%.
Which of the following statements is true for Tilton Corporation?a) If the CCA rate for the project changes from 20% to 30%, the NPV
will decreaseb) If the salvage value for the project increases, the NPV will not
changec) If the salvage value for the project increases, the NPV will decreased) If the CCA rate for the project changes from 20% to 30%, the NPV
will not change
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Real Options Think of it this way. Someday, you might be
married. Wouldn’t it be nice if you had:1. The option to delay the wedding by a year or
two. Maybe you could live with the person to find out if it will work. We call that an investment timing option.
2. The option to get out of the marriage once you’ve gotten into it (i.e., divorce). We call that an abandonment option.
3. The option to add another husband a few years down the line if it seems like a good idea at that time. We call that a growth option.
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Real Options• In business terms, real options exist when
managers can influence the size and risk of a project’s cash flows by taking different actions during the project’s life in response to changing market conditions.
• It’s really cool if you can identify these options. How do you do that?• Purposefully have them on your todo list. Then
you won’t need a brainwave.
• It’s even cooler if you can create them when you create the capital budgeting project.
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Real OptionsWhy do we care?• Because assessing projects ... may result in
different decisions and more shareholder wealth.
• Because we have the tools to do so.
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The Investment Timing Option If we do a project now, the future cash flows
are uncertain. This means that we might lose money.
If we wait for a period (let’s say a year), maybe the future cash flows will become more certain. If it looks like the cash flows will be poor, we just won’t do the investment.
The idea is to compare the NPV of doing the project now with the NPV of doing it in a year.
All in all, it sounds like a good idea
Capital Budgeting, Real Options 17
The Investment Timing OptionMurphy Systems (20.2)New Project idea Initial Cost = 50M, N = 3 years, no salvage, WACC = .14Annual after-tax cash flows:Amount Probability$33M 25%$25M 50%$5M 25%Expected cash flow = (33*.25) + (25*.5) + (5*.25) = $22MNPV = -$50M + = $1.08M
Capital Budgeting, Real Options 18
The Investment Timing OptionMurphy Systems (20.2)There’s one catch. The firm can wait for a year before making the investment, at which point it will know the demand for the product (i.e., the cash flows).
What is the NPV of the project now if it chooses to wait? Is it more or less than $1.08M? If it’s more, the option has value.
Let’s work through the numbers. What discount rate should we use?
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Capital Budgeting, Real Options 21
The Growth OptionKidco Corp. (20.3)New Project idea: Initial Cost = 30M, N = 2 years, no salvage, WACC = .14Annual after-tax cash flows:Amount Probability$34M 25%$20M 50%$2M 25%Expected cash flow = (34*.25) + (20*.5) + (2*.25) = $19MNPV = -$30M + = $1.29M
Capital Budgeting, Real Options 22
The Growth OptionKidco Corp. (20-2)There’s one catch. If the demand for the first product is average or high, which you find out at the end of year 1, Kidco believes that it can launch a second-generation product for the same cost, and with the same demand as the first product, just two years down the road.
What is the NPV of the project now if it chooses to wait? Is it more or less than ..? If it’s more, the option has ...
Let’s work through the numbers. What discount rate should we use?
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The Abandonment Option andClicker QWouldn’t it be nice if you could get out of a losing business venture before you lose too much money. IC = 26M, N = 4 years, WACC = .12Annual after-tax cash flows:Amount at each year Probability$18M, 23M, 28M, 33M 25%$7M, 8M, 9M, 10M, 50%-$8M, -$9M, -$10M, -$12M 25%
What is the NPV of this project?
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The Abandonment Option – Base CaseNPV(M’s) Prob. Prob.*NPV
Good $49.31 .25 $12.33Average ... .5 ...Ugly ... .25 ...
NPV = ...- ..- ...= ...
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The Abandonment Option
Now what happens if we can abandon the project at the end of year 1 if results are bad and sell off the assets for $14M.
Amount at each year ProbabilityGood: $18M, 23M, 28M, 33M 25%Average: $7M, 8M, 9M, 10M, 50%Ugly: -$8M, -$9M, -$10M, -$12M 25%I say we’ll ... Cash flows for the “Ugly” stream become: ..., ..., ..., ...How do we treat the ...?How do we know that we shouldn’t abandon the ...
Capital Budgeting and Real Options Agenda for the Day Capital Budgeting
How does it fit in Common mistakes Assessing Risk
Real Options What are they? What types? Why do we care? How do we value them?
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Capital Budgeting, Real Options 28
Capital Budgeting and Real Options
Capital Budgeting Know the common mistakes
Know why risk assessment is important Know how to conduct basic risk assessment
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Capital Budgeting and Real Options
Real Options• Know the ...• Not all firms are using Real Options but
many are. Real options come up all the time in the real world. Think of natural resource companies. They need all three of the options that we talked about…why?
• Sometimes its hard to put a number on the value of the option because you can’t put hard numbers on the inputs. When that happens, you have to ...