Npv Analysis Treats Projects as “now-Or-Never” Opportunities
Real OptionsNPV misuseNPV analysis treats projects as “now-or-never” opportunitiesIt fails to account for the value associated with managerial flexibility and the value gained (destroyed) when that flexibility is created (removed).* Decision biases If an investment is irreversible and can be delayed then, there is an opportunity cost of investing today (giving up the flexibility of waiting and possibly not investing later)Underinvestment problemBy ignoring flexibility → NPV undervalues projectsReal optionsReal options give the flexibility to decide what to do with a projectDiscretionary investment opportunities “embedded” in a capital projectArise from ability to make or revise decisions over the life of a project in response to uncertain future eventsAllows management to add valueBy making the correct decisions → exercising options in an optimal way* Levers of Financial and Real OptionsFinancial OptionsReal OptionsCommentsOption ValueStock (market) priceNPV of project cash flowsGreater NPV→ Higher option valueExercise (strike) priceInvestment costHigher cost→ Lower option valueVolatilityUncertaintyHigher volatility→ Higher option valueTime-to-maturityExpected life of optionOpportunity to learnDividendsValue lost over duration of optionLoss of cash→ Lower option valueRisk-free rateRisk-free rateHigher interest rate→ Higher option valueTypes of Real OptionsOption to DelayOption to ExpandOption to AbandonTypeCall optionCall optionPut optionExercise priceUp-front investment to go aheadCosts of expansionSalvage value of the assets that can be soldValue of underlying assetPV of net cash flows from operating projectPV of incremental net cash flows from expansionPV of net cash flows from continued projectOption premium (price)Cost of establishing the right to delay Cost of establishing the right to expandCost of establishing the right to abandonVolatilityVariance of future cash flows from the projectVariance of future incremental cash flows Variance of future cash flows from the projectTerm to expiryThe period of time with right to exerciseThe period of time with right to exerciseThe period of time with right to exerciseOption to Invest (Delay investment)[pic 1]E.g. [pic 2]You will need to have purchased relevant permits for £500 If you choose to go ahead you will need to spend £40,000 up-frontOption to Expand[pic 3]E.g.[pic 4]Factory B could facilitate increased production activity if required. It would also cost an additional £1,000 up-front.To rejig your factory to increase production would cost £60,000

Option to Abandon[pic 5]E.g. You can pay an additional £20,000 up-front – give you the right to cease operations and sell off your equipment at any time.The salvage value of your assets at the moment is £120,000.[pic 6]Early exercise of an Option* Call optionsNever exercise early except maybe for dividend paying asset.=> Option to delay investmentThe longer you delay the more cash flows you may give up.May be optimal to exercise early to avoid forgoing cash flows.* Put Options The option is deep-in-the-money such that there is little likelihood that you will regret receiving the exercise price early.=> Option to abandon – May exercise when the PV of cash flows from continued operations is far below the salvage value of assets (deep-in-the-money)Valuations of Real OptionsDCF-based approach using decision-tree analysisE.g. You are trying to decide whether to invest $200,000 up-front in a new retail outlet – with a life of 5 years.• There is a 50% chance that the retail outlet will experience high demand in the 1st year – generating $150,000. In this case demand will continue to be high for the remaining 4 years.• If demand is low in year 1, it will remain low – with only $50,000 generated each year.• If demand is high in the 1st year then the store will have the option to spend an additional $50,000 to expand its range of products – this will increase the expected net cash flows for the next 4 years to $170,000 per annum.

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Projectsreal Optionsreal Options And Pricenpv Of Project Cash Flowsgreater Npv. (May 31, 2021). Retrieved from