Please place answer on the attached answer spreadsheet, tab 13-2

13-2 ANALYZING A STRATEGY USING OPTION ANALYSIS Reliable Industries is considering the construction of a power plant investment in India. Reliables analysts calculate that the cost of building the plant is $600 million, and the IRR of the plant is 13%. The analysts also estimate that, given the experience of building the first plant, a second plant can be built for $550 million and additional plants can be built for about $500 million each. a. How would you go about evaluating whether or not to build this power plant in India? b. Are you evaluating a project or a strategy? c. How does the risk associated with the power plant strategy compare with the risk associated with the individual power plants? Titman, Sheridan; Martin, John D. (2014-04-08). Valuation (2nd Edition) (Prentice Hall Series in Finance) (Page 507). Prentice Hall. Kindle Edition.

PROBLEM 13-1 Solution Legend = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output PROBLEM 13-2 Given First Plant Assume perpetual returns IRR Initial investment $ Annual cash flow $ Initial investment Solution Legend 13.00% 600 million 78 million Second Plant $ = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output 550 million Additional Plants Initial investment $ 500 million NPV Calculation Cost of capital First plant Second plant Additional plant 15.00% Cost of capital First plant Second plant Additional plant 14.00% million million million million million million Solution a. b. c. If we assume a cost of capital of 15%, all power plants will be negative NPV. There is insufficient reduction in costs over time to justify losing money on the first few power plants. On the other hand if we assume a cost of capital of 14%, future power plants are all positive NPV. PROBLEM 13-3 Solution Legend = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output LEGEND: PROBLEM 13-4: Original Strategy Answer a. and b. New Strategy: Build 1 plant in Year 1 (extra 25 R&D) and Build 1 plant in Year 2 (extra R&D of 35) New strategy without abandonment option New strategy with abandonment option Answer c. Cost-overrun Discussion Original Strategy (Build 2 in Year 1 and 2 in Year 2 and with no extra R&D costs) 0 1 Plant construction capacity per year Plant construction costs ($ millions) WACC for plant investments Risk free rate Convenience yield Volatility Up value multiple (u) Down value multiple (d) Risk neutral probability (up) $ Year 2 2 1 2 450 $ 13.770% 5.000% 3.000% 0.15 375 $ 3 6 350 $ 4 6 320 $ 320 Learning point It is critically important that options (flexibility) be incorporated into the analysis of the values of investment strategies. Actual Risk Neutral 50.00% 50.00% Probability (up price) Probability (down price) Present value of plant cash flows ($ millions) $ A quick comparison of the present value of the strategy using the traditional DCF analysis and its counterpart where we consider the decision flexibility inherent in the ability of management to abandon the investments should future conditions not warrant going ahead is striking. The traditional DCF analysis suggests that the present value of the strategy's cash flows is ($50.74). However, once we account for the fact that the future plants will not be built in those circumstances where conditions suggest abandonment of the strategy, the present value of the strategy rises to $141.18. 320.00 Values of Each Energy Plant ($ millions) (PV of expected future cash flows) 0 Year 2 1 Solution Legend 3 4 = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output - - $ - 320.00 - - - - - Analysis of the Value of the Strategy Nave Inflexible DCF Analysis 0 Year 2 1 3 4 Actual Probabilities Year 1 2 3 0 4 6.25% 12.50% 25.00% 50.00% 100.00% 25.00% 37.50% 50.00% 50.00% 37.50% 37.50% 25.00% 25.00% 12.50% Number of plants to be built Cost of constructing each plant 1 450 $ 1 375 $ $ ### 350 $ 6 320 6 320 $ 100% 100% 100% 100% Expected NPVs for each phase PV of Annual Expected NPVs Value of the Strategy (Year 0) Enlightened Valuation of the Strategy 0 American Option Payoffs (value) plus NPV of investing in the current period. If this sum is greater than zero then the firm should invest in this period. If it is negative then the strategy should be abandoned. Noded value at Year 4--Max(NPV,0) Node value at Year 3 and earlier--Max of (i) 1. PV of expected payoff in next period plus NPV of current period or (ii) zero NPV (with abandonment option) is 184.19 1 Years 2 This NPV is incorrect for two reasons: 3 4 1. The discount rate used corresponds to the rate for a single plant (13.77%) as opposed to a series of plants which is much more risky and demands a much higher discount rate. 2. The cash flows correspond to making the plant investments in every period and all states and this is not rational as there are some states in which abandonment is optimal. 6.25% 100% LEGEND: PROBLEM 13-4: New Strategy Answer a. and b. New Strategy: Build 1 plant in Year 1 (extra 25 R&D) and Build 1 plant in Year 2 (extra R&D of 35) New strategy without abandonment option New strategy with abandonment option Answer c. Cost-overrun New Strategy (Build 1 in Year 1 and 1 in Year 2 and with extra R&D costs of 25 in Year 1 and 35 in Year 2) 0 1 Plant construction capacity per year Plant construction costs ($ millions) WACC for plant investments Risk free rate Convenience yield Volatility Up value multiple (u) Down value multiple (d) Risk neutral probability (up) $ 1 1 450 $ 13.770% 5.000% 3.000% 0.15 400 $ Year 2 1 385 $ 3 6 Discussion 4 6 320 $ 320 Learning point It is critically important that options (flexibility) be incorporated into the analysis of the values of investment strategies. Actual Risk Neutral 50.00% 50.00% Probability (up price) Probability (down price) Present value of plant cash flows ($ millions) $ A quick comparison of the present value of the strategy using the traditional DCF analysis and its counterpart where we consider the decision flexibility inherent in the ability of management to abandon the investments should future conditions not warrant going ahead is striking. The traditional DCF analysis suggests that the present value of the strategy's cash flows is ($50.74). However, once we account for the fact that the future plants will not be built in those circumstances where conditions suggest abandonment of the strategy, the present value of the strategy rises to $141.18. 320.00 Values of Each Energy Plant ($ millions) (PV of expected future cash flows) 0 Year 2 1 Solution Legend 3 4 = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output - - $ - 320.00 - - - - - Analysis of the Value of the Strategy Nave Inflexible DCF Analysis 0 Year 2 1 3 4 Actual Probabilities Year 1 2 3 0 4 6.25% 12.50% 25.00% 50.00% 100.00% 25.00% 37.50% 50.00% 50.00% 37.50% 37.50% 25.00% 25.00% 12.50% Number of plants to be built Cost of constructing each plant 1 450 $ 1 400 $ $ ### 385 $ 6 320 6 320 $ 100% 100% 100% Expected NPVs for each phase PV of Annual Expected NPVs Value of the Strategy (Year 0) Enlightened Valuation of the Strategy 0 American Option Payoffs (value) plus NPV of investing in the current period. If this sum is greater than zero then the firm should invest in this period. If it is negative then the strategy should be abandoned. Noded value at Year 4--Max(NPV,0) Node value at Year 3 and earlier--Max of (i) 1. PV of expected payoff in next period plus NPV of current period or (ii) zero NPV (with abandonment option) is 141.18 1 Years 2 3 4 Year 4: Max(NPV,0) Year 3 and earlier: Max of 1. PV of expected payoff in next period plus NPV of current period or 2. zero 100% 6.25% 100% LEGEND: PROBLEM 13-4: New Strategy with Breakeven Cost Overrun Factor Answer a. and b. New Strategy: Build 1 plant in Year 1 (extra 25 R&D) and Build 1 plant in Year 2 (extra R&D of 35) New strategy without abandonment option New strategy with abandonment option Answer c. Cost-overrun Value (original) Value (new) Difference $ $ $ - New Strategy with breakeven cost overrun factor (Build 1 in Year 1 and 1 in Year 2, Extra R&D costs represented by common cost overrun factor in Year 1 and Year 2) Plant cost overrun factor Plant construction capacity per year Plant construction costs ($ millions) WACC for plant investments Risk free rate Convenience yield Volatility Up value multiple (u) Down value multiple (d) Risk neutral probability (up) 0 1 $ 450 $ 13.770% 5.000% 3.000% 0.15 375 $ Discussion 3 6 4 6 320 $ 320 $ A quick comparison of the present value of the strategy using the traditional DCF analysis and its counterpart where we consider the decision flexibility inherent in the ability of management to abandon the investments should future conditions not warrant going ahead is striking. The traditional DCF analysis suggests that the present value of the strategy's cash flows is ($50.74). However, once we account for the fact that the future plants will not be built in those circumstances where conditions suggest abandonment of the strategy, the present value of the strategy rises to $141.18. Learning point It is critically important that options (flexibility) be incorporated into the analysis of the values of investment strategies. Actual Risk Neutral 50.00% 50.00% Probability (up price) Probability (down price) Present value of plant cash flows ($ millions) 1 1 Year 2 1 350 $ 320.00 Values of Each Energy Plant ($ millions) (PV of expected future cash flows) 0 Year 2 1 Solution Legend 3 4 = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output - - $ 320.00 - - - - - Analysis of the Value of the Strategy Nave Inflexible DCF Analysis 0 Year 2 1 3 4 Actual Probabilities Year 1 2 3 0 4 6.25% 12.50% 25.00% 50.00% 100.00% 25.00% 37.50% 50.00% 50.00% 37.50% 37.50% 25.00% 25.00% 12.50% Number of plants to be built Cost of constructing each plant 1 450 $ 1 375 $ $ ### 350 $ 6 320 6 320 $ Expected NPVs for each phase PV of Annual Expected NPVs Value of the Strategy (Year 0) Enlightened Valuation of the Strategy 0 1 Years 2 3 4 100% 100% 100% 100% 6.25% 100% PROBLEM 13-5 First Project Problem 5 PV (good state) Investment 150 Year 1 15 prob = 50% Year 2 15 Year 3 15 0 0 -100 prob = 50% PV (bad state) NPV 0 0 Follow-On Opportunity (Year 1) PV Investment 1500 Year 2 150 prob = 50% Year 3 150 Year 4 150 90 90 -1000 prob = 50% PV NPV 900 90 Solution Legend = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output