Capital Budgeting with Real Options and Risk
A manufacturing company is considering a $50 million investment in a new production line. The project has a expected life of five years, after which it can be sold for $10 million. The company's WACC is 9%, but the project is riskier than the average project and the CFO suggests using a 12% discount rate. The project is expected to generate annual operating cash flows of $15 million in the first year, growing at 3% per year. However, there is a 30% chance that a key supplier will fail to meet quality standards, in which case the project will be shut down after one year and the salvage value will be only $5 million. The company has the option to expand production by 50% in year 2 if demand is high, at an additional cost of $20 million. The CFO is skeptical of real options analysis and wants to use a simple NPV. The company's tax rate is 25%.
1. Calculate the project's NPV using the CFO's suggested discount rate, ignoring the abandonment and expansion options. Show your calculations and interpret the result.
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Using a 12% discount rate, we first calculate the present value of the expected operating cash flows for years 1-5. The cash flows are $15 million in year 1, growing at 3% per year. The present value of a growing annuity is: PV = C1 / (r - g) * [1 - ((1+g)/(1+r))^n]. Here C1 = 15, r = 0.12, g = 0.03, n = 5. (1+g)/(1+r) = 1.03/1.12 = 0.91964. (0.91964)^5 = 0.657. So PV = 15 / (0.12 - 0.03) * (1 - 0.657) = 15 / 0.09 * 0.343 = 166.67 * 0.343 = 57.17 million. Next, the present value of the salvage value at the end of year 5 is $10 million / (1.12)^5. (1.12)^5 = 1.7623, so PV = 10 / 1.7623 = 5.67 million. Total present value of inflows = 57.17 + 5.67 = 62.84 million. The initial investment is $50 million. NPV = 62.84 - 50 = 12.84 million. Since NPV is positive, the project is acceptable under this simple analysis. However, this ignores the probability of supplier failure and the value of the options. The expected cash flows used are unconditional; they do not account for the 30% chance of shutdown after year 1. Also, the discount rate of 12% may or may not be appropriate; the project's risk is not fully captured by a single rate. The positive NPV suggests the project creates value, but the analyst should consider the options and the probability of failure.
2. Explain how the abandonment option and the expansion option affect the project's value, and discuss whether the CFO's skepticism is justified.
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The abandonment option gives the company the right to shut down the project after one year if the supplier fails. In the failure scenario, the project generates $15 million in year 1 and then is shut down, with a salvage value of $5 million at the end of year 1. The present value of this scenario is (15 + 5) / 1.12 = 17.86 million. In the success scenario (70% probability), the project continues for five years with the cash flows as before, plus the salvage value of $10 million at year 5. The present value of the success scenario is the same as the base case: 62.84 million. The expected present value with the abandonment option is 0.3 * 17.86 + 0.7 * 62.84 = 5.36 + 43.99 = 49.35 million. NPV = 49.35 - 50 = -0.65 million. So the abandonment option actually reduces the expected NPV compared to the simple analysis because the simple analysis ignored the 30% chance of failure. The abandonment option limits losses but does not create value here; the project is negative NPV when failure is considered. The expansion option, however, could add value. If demand is high, the company can invest $20 million in year 2 to expand by 50%. The value of this option depends on the expected incremental cash flows from expansion. Without specific probabilities, we can say that the expansion option is valuable if the additional cash flows exceed the cost. The CFO's skepticism about real options may be justified if the options are not quantified properly, but ignoring them can lead to incorrect decisions. In this case, the abandonment option is not a source of value; it is a risk management tool that reduces the downside. The expansion option could make the project more attractive. A proper analysis would use a decision tree or option pricing model to value these flexibilities. The CFO should not dismiss them outright; rather, the analyst should present a range of values.