Real Options in Capital Budgeting | CFA Level I Corporate Issuers
In this lesson, we’ll explore the different types of real options, learn how to evaluate projects with real options, and work through some examples.
Understanding Real Options
Real options provide managers with the ability to make future decisions that alter the value of capital budgeting decisions made today. Similar to financial call and put options, real options grant the holder the right, but not the obligation, to make a decision in the future. The key difference is that real options involve real assets instead of financial assets and depend on future events. Real options offer managers flexibility that can improve NPV estimates for individual projects.
Types of Real Options
- Timing options: Allow managers to delay investment, hoping to gain better information in the future that might improve the NPV.
- Sizing options: Enable managers to resize a project in the future. For example, abandonment options (similar to put options) allow management to abandon a project if the present value of the incremental cash flows from exiting exceeds the present value of the incremental cash flows from continuing. On the other hand, expansion options (similar to call options) permit managers to make additional investments to increase the scale of a project if it proves valuable.
- Flexibility options: Grant managers choices regarding the operational aspects of a project after it has commenced. For instance, price-setting options allow managers to increase product prices if demand exceeds capacity, boosting future cash flows without increasing production. Production-flexibility options may involve paying workers overtime or switching production towards other types of goods based on market demand.
Fundamental options treat the entire project as an option, with payoffs depending on the price of an underlying asset.
Evaluating Projects with Real Options
There are several ways to assess the value of projects with real options:
- Calculate the NPV of the project without the option, assuming real options add value. If the NPV is already positive, the NPV with the option will definitely be positive. The downside is that a negative NPV without the option does not clarify whether the project with the option is positive or negative.
- Use decision trees to show the sequence of decisions made, allowing the manager to make informed choices.
- Employ options pricing models, similar to those used for financial options. These models are often complex and require specialized consultants.
- Compute the NPV of the project without the option and add the estimated value of the real option (option value minus option cost). For example, if the NPV of a project is -$5M, but an option has a value of $8M at a cost of $1M, the overall NPV would be a +$2M.
EXAMPLE
Oliver Transports is given an opportunity to operate inter-state bus operations on a 10-year license. The project requires an initial investment outlay of $8M, and is expected to bring in after-tax operating cash flow of $1M each year, with no salvage value. The project’s required rate of return is 10%. Using NPV analysis, determine if Oliver should accept this project.
First, let’s calculate the NPV:
Initial cash flow: -$8M Operating cash flow: $1M per year for 10 years Required rate of return: 10%
Using cash flow calculator (CF0=-8, C01=1, F01=10, I=10), we obtain an NPV of -$1.855M. Since the NPV is negative, the project should not be accepted.
EXAMPLE
Now, let’s consider that the government revised the license to include an option to convert the buses to electric driverless buses when the technology matures. The conversion costs will be subsidized, so the licensee just needs to pay $2M. As the electric buses are more economical to operate, the value of the option is estimated to be $5M. Calculate the value of this revised project and determine if Oliver should accept it.
Now, let’s determine the NPV of the overall project:
NPV without option: -$1.855M
Value of the option: $5M
Cost of the option: $2M
NPV (Overall) = NPV (without option) + Value of Option – Cost of Option
= -$1.855M + $5M – $2M
= $1.145M
In this case, the real option of converting the buses adds enough value to make the overall NPV positive. As a result, Oliver should accept this project.
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