Paper 2 Adv Corp

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1. They discussed Di scounted Cash F low(DCF) methods. What was one we used inclass?

One fundamental method of discounted cash flows which was used in class is Net

Present Value method. In Net Present Valuemethod which takes into account the time value

of money, the expected total cash inflows are multiplied to discount rate to bring them back to

their PV. The amount of initial investment or other cash-outflows are deducted from the PV to

reach at the NPV of investment. A positive NPV means an appropriate investment project.

2. What happens to valuation of a project if one uses DCF versus Real Options?At the present time, Discounted Cash Flow method is one of the most well- known

tools of valuation, which uses the concept of Time Value of Money to assess the value of

different projects. In accordance with DCF, the higher the risk of the project, the higher the

return required by the investor and, consequently, the lower the present value of this project.

Clearly, the valuation technique of the projects or investment opportunities under DCF and

Real options methods is different and can result in dissimilar decisions regarding project

implementation. To explain, the DCF model does not take into account the ability of the

management to change or adopt companys strategies to the alterations in market conditions.

Thus, it is common under DCF model to undervalue an asset that generates little or zero cash

flow. On the other hand, Real Option model does consider the managements ability to adjust

their strategy to the market changes by exercising for example option to expand in case of

favorable market conditions and option to abandon in adverse market situation. Therefore,

when the value of the project is negative, companys management can simply discontinue the

project instead of incurring losses with negative cash flows. To illustrate, take for the instance

situation presented in the Valuing Mineral Opportunities in Optionsarticle.


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According to the graph, it is clear that with NPV valuation the value of the project is

negative at lower prices of copper. However, under the Real options model, it has a form of

call option (upper curves) and, in contrast to the DCF method, management can exercise an

option to abandon the project and, therefore, face no negative payoffs.

To conclude, if one uses DCF method for assessment of the value of the asset, the

asset value will be lower than with real option valuation. Moreover, the longer the option

period, the higher the value of the option under the real option model, since management can

expand the project in case of favorable market conditions, this cannot be done with DCF.

3. What does the term fl exibil ity mean and how is it related to value? You can use theexample of projects A versus B in article.

The concept of flexibility is highly important for the valuation of options. Flexibility

can be considered as a feature of the project that allows firms management to change the

course of an action or investment with regard to the alterations in market environment.

According to McKnight (n.d.), flexibility provides the ability to the manager to respond to

future circumstances in ways that will lead to rise in the companys value. Hence, the more

flexible the project or investment is, the higher is its value for the owner. Take for example

the case of projects A and B provided in the Valuing Mineral Opportunities in Options.

Other things held equal (e.g. interest rate and expenditure commitments), the project B which

allows for making the production decision in five years is much more attractive and beneficial

alternative in comparison with project A, which gives a period of two years only. To explain,

project B is more valuable as it provides more flexibility to the owner in terms of time for

careful assessment of the project, evaluation and evolvement of opportunities and even

development of the project when prices are higher (McKnight, n.d.).

Hence, it is clear that greater flexibility of the project result in a higher value of this

project for the firm or investor. Valuation methods that neglect the flexibility feature inherent

in the project can result in poor managers decision regarding the selection of right alterative,

and, as a consequence, in significant loss of companys potential value(McKnight, n.d.).

4. How does a project involving Temporar y mine closing and one involvingDownsizing simil ar to a Put Option and how does it add value?

Real options are present in all types of business decisions, thus we need to understand

how options increase value. With regard to McKnight (n.d.), real options in business can be of

two major types, call-like or put-like options. To illustrate, the options of Temporary


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mine closing and Downsizingof projects can be considered as examples of put-like real

option. If there is a prediction that product prices are going to decline or economic conditions

change negatively in the nearest future, managers may decide to close or downsize production

or some expensive mine operations in order to cut firms costs. In this example, closure costs

can be interpreted as exercising the put option. Such management decisions add more value to

the projects due to the fact that they result in lower costs and perhaps, the company avoids

larger losses that could be faced by the firm in case of unfavorable market conditions or

further decline in prices, incurring only closure costs.

5. Numeri cal ExampleThe NVIDIA company is considering a new project. They anticipate to sell 5,000 units

per annum at $40 net cash flow for the next 5 years. So operating cash flow per year is

projected to be $40 * 5,000 units = $200,000. Discount rate is equal to 13%. The amount of

initial investment needed is $700,000.

Discount rate 13%Year 0 1 2 3 4 5Initialinvestment -700000

Quantity 5000 5000 5000 5000 5000Net CashFlow 40 40 40 40 40OCF 200000 200000 200000 200000 200000

NPVbase case $3 446,25

NPV base case equals (-700000) + $200,000(PVIFA13%, 5) = $3 446, 25

PVIFA = Present value of annuity ofAfter the second year, the project can be sold for $500,000. Anticipated sales are

reexamined due to the first years performance. So if we find expected sales that would make

sense to abandon the project:

- we have discount rate I/Y 13%, and the remaining N 4 years: 5 1 = 4, PV =500,000

X * (PVIFA13%, 4) = $500,000 => (PVIFA13%, 4) = 2.9744 = > $500,000\2.9744 =

168101.12


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Quantity = $168101.12/$40 = 4202.52. Abandon if Q is lower than 4202.52,

because $500,000 > PV of future cash flows.

Lets make some assumptions that expected sales will be reexamined upwards to 7000

units if the first year is a success, and reexamined downwards to 3,000 units if the first year is

not a success. If success and failure are equally likely then:

We calculate expected cash flows by (50%*7000) + (50%*4000) = 5500

Net CF = 40 * 5500 = 220000; Net CF Success = 7000 * 40 = 280000; Net CF Failure = 4000

* 40 = =160000

Expect (success and abandon) = (50%*832851.97) + (50%*500000) + 200000 = 866425.99

NPV = 866425.99/(1+0.13)700 000 = 66 748.66

If we could not abandon the project then:

Option value = (24 084.59*0.50)/(1+0.13) = 10656.90

Reexamined Sales 1 2 3 4 5

Success 50,0% 7000 7000 7000 7000

Failure 50,0% 4000 4000 4000 4000

Expected 5500 5500 5500 5500

Net CF 220000 220000 220000 220000

Net CF Success 280000 280000 280000 280000

Net CF Failure 160000 160000 160000 160000

PV FCF Success $832 851,97

Abandon $500 000,00

Expect (Success&Abandon) $866 425,99

NPV $66 748,66

Failure PV FCF $475 915,41

Gain from an option to expand Abandonment - Failure $24 084,59

Option value $10 656,90


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References

McKnight, R.T. (n.d.). Valuing Mineral Opportunities in Options.

Mun, J. (2006). Real options analysis versus Traditional DCF valuation in Laymans terms.

Retrieved March 11, 2013 from

http://www.realoptionsvaluation.com/attachments/whitepaperlaymansterm.pdf
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