P12-18 Real options and the strategic NPV

JennyRene, the CFO of AsorProducts, Inc., has just completed an evaluation of a proposed capital expenditure for equipment that would expand thefirm's manufacturing capacity. Using the traditional NPVmethodology, she found the project unacceptablebecause:

NPVtraditional=$1,131<0

Before recommending rejection of the proposedproject, she has decided to assess whether real options might be embedded in thefirm's cash flows. Her evaluation uncovered three options and theirprobability:

Option1: Abandonment The project could be abandoned at the end of 3years, resulting in an addition to NPV of $1,400.

Option2: Growth If the projected outcomesoccurred, an opportunity to expand thefirm's product offerings further would become available at the end of 4 years. Exercise of this option is estimated to add $2,270 to theproject's NPV.

Option3: Timing Certain phases of the proposed project could be delayed if market and competitive conditions caused thefirm's forecast revenues to develop more slowly than planned. Such a delay in implementation at that point has an NPV of $11,000.

Jenny estimated that there was a 25% chance that the abandonment option would need to beexercised, a 30% chance that the growth option would beexercised, and only a 5% chance that the implementation of certain phases of the project would affect timing.

a. Use the information provided to calculate the strategicNPV, NPVstrategic, for AsorProducts' proposed equipment expenditure.

b. On the basis of your findings in part (a), what action should Jenny recommend to management with regard to the proposed equipmentexpenditure?

c. Ingeneral, how does this problem demonstrate the importance of considering real options when making capital budgetingdecisions?