Real Options Case

Imagine it is 2015. You are the assistant to the Chief Financial Officer (CFO) of Phord Motor Company, an established manufacturer of conventional autos that is considering entering the self-driving car market with its Phord Model T1 self-driving car.

Unfortunately, forecasts show that the T1 has a negative NPV of $36.52 million. The T1's cash flows are shown in the table below. It can't meet the 18% hurdle rate.

"The T1 just can't make it on financial grounds," the CFO says ," but my gut instinct tells me we should go ahead."

"But you're missing a very important financial advantage," you say to the CFO.

"What?" says the CFO.

"If we don't launch the T1 , " you say," it will probably be too expensive to enter the self-driving car market later when Tesla is firmly established. If we go ahead, we have the opportunity to make follow-on investments which could be extremely profitable. The T1 gives not only its own cash flows, but also a call option to go on with version T2 of the self-driving car."

Assume:

1.) The decision to invest in the T2 must be made after 4 years, in 2019.

2.) The investment required for T2 is $990 million

3.) The present value of cash inflows for version T2 is $670 million

4.) The future value of version T2's cash flows is highly uncertain, with a standard deviation of 40% per year.

5.) The risk free rate is 5%.

Cash flows for Model T1 (in millions) 2015 2016 2017 2018 2019 2020 After tax cash flows -150 120 140 300 700 Required Capital Investment -400 0 0 0 Increase in Working Capital -350 -80 -50 100 150 175 Net cash flows -900 40 90 400 850 175 NPV @ 18% = -$36.52 million