Real Options Approach (all cash flows are after tax)

A company must decide whether to invest $100 Million in developing and implementing a new enterprise system in the face of considerable technological and market (demand for product and market share) uncertainty. The firm's cost of capital is 10%.

The assignment is to evaluate the Real Options approach. The probability of a successful pilot project is .4 and the probability of an unsuccessful pilot is .6.

Evaluate the investment using managerial flexibility and a real options approach.

The real options alternative allows for flexibility and the delay of the investment for 1 year. In this case, if we do a pilot project we will be better able to evaluate ERP implementation complexities, achievable supply chain benefits, and the market share our products will achieve. However, the cost of the project will rise to $110 Million ($10 Million this year and $100 Million next year) with the one-year delay and additionally management decides to purchase and implement the financial module in year 1 at a cost of $10 Million (real option).

The results are slightly different:

Year 0 (now) cash flows: $10 million for the pilot project, the financial module

After year 1, if the conditions indicate a good result, the firm will invest the $100 million for the ERP with expected benefits (cash flows) of $15 million annually (forever) beginning in year 2. Benefits in year one from the financial module are $1 million.

If a bad result is indicated, the firm makes no further investments beyond the financial module, which yield annual benefits of $.5 million in year 1 and each year thereafter (forever).

Here the firm has flexibility and has exercised its option to make no further investments based on better information and knowledge of expected future benefits.

Evaluate the expected NPV of this project using the described real option. Compare the expected NPV using the traditional NPV approach with the expected NPV using real options. What do you conclude in each case?

What is the expected NPV? What do you recommend? Why?

If you don't know the probability of success for the pilot, is there a value that is critical to your recommendation? Is there a probability of success above or

below which you will recommend undertaking the pilot and below or above which you will recommend a go/no go decision on the underlying project without undertaking a pilot test?

Find the first critical probability by setting the two E[NPV] formulas (with and without the option) equal to each other and solve for x the probability of success (x). By the way, the probability of failure is one minus the probability of success (1-x).

Find the second critical probability by setting only the E[NPV] for the case with the real option equal to zero and solve for x, the probability of success.

Find the third critical probability by setting only the E[NPV] for the case without the real option equal to zero and solve for x, the probability of success.