What are the main characteristics of Real Options? Do real options always have a nonnegative incremental value (i.e., the value with the real option is always at least as high as the value without the real option)? Justify and explain why or why not.

 

A MNC is considering expansion.  The project entails setting up a factory which will be developed in two phases. The first phase must be initiated now. Depending on the profitability of phase I, the company has the option for expansion in the fourth year.   

 

Phase I

 

The 1st phase will generate the following income before taxes for 5 years for an investment of $300 m. The company's depreciation and capital investments each year are the same.  

 

Item/Year	T=0	T=1	T=2	T=3	T=4	T=5
Capital Investment	250
Working capital	50
EBT		50	100	200	200	350

 

The cost of capital is 20%.  Tax rate is 30%

 

1. What is the NPV of phase I of the project? Should it be accepted?

 

Phase II

 

The second phase will start at T=4.  The company expects the following income for the second phase: 

 

Item/Year	T=4	T=5	T=6	T=7	T=8	T=9
Capital Investment	2500
Working capital	500
EBT		350	350	500	600	750

 

After year 9, the EBT continues at $750 for the next 6 years (until year 15), at the end of which of the factory will be sold for $2000.  The company's depreciation and capital investments each year are the same.

 

2. What is the NPV of Phase II?  What is the total NPV of the two phases?  Would you take the project by the NPV rule?

 

Obviously, there is a significant amount of uncertainty about the expected cash flows from the major expansion in Phase II.  

 

The company estimates that the annual standard deviation of expected cash flows is 30%.

 

3. What is the Option value of Phase?  Between NPV and the option value, which is a more appropriate measure of the project's true worth?

 

4. Would you take the project by the Real Option valuation? 

 

5. What is the strategic implication of this analysis for evaluation of risky projects?