Question

Real Options

The assignment is to evaluate both parts, the traditional NPVcalculation as well as the Real Options approach.

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

Part 1.


The probability of a successful project (or pilot) is now .7 andthe probability of an unsuccessful project is .3.

Good Result: The Free Cash flow perpetuity (Annual Benefits) inthe “good” case is $15 million per year

Bad Result: The system proves to be more difficult to implementand improvements in management of the supply chain are less. Inaddition, the growth in market demand for the product is lower. TheFree Cash flow perpetuity (Annual Benefits) in the "bad" case isnow $1.5 million per year, not $2 million.

Given: Year 0 (now) cash flows: $-100 million for ERP purchaseand implementation.

The cost of capital is .1. Use this to calculate the PV of the“good” perpetuity and the PV of the “bad” perpetuity. Thencalculate the “good” NPV and the “bad” NPV. Finally calculate theExpected NPV and decide if you will invest.

Part 2.


The real options alternative allows for flexibility and thedelay of the investment for 1 year. In this case, if we do a pilotproject we will be better able to evaluate ERP implementationcomplexities, achievable supply chain benefits, and the marketshare our products will achieve. However, the cost of the projectwill rise to $110 Million ($10 Million this year and $100 Millionnext year) with the one-year delay and additionally managementdecides to purchase and implement the financial module in year 1 ata cost of $10 Million (real option).

The results are slightly different:

Year 0 (now) cash flows: $10 million for the pilot project.

After year 1, if the conditions indicate a good result, the firmwill 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 furtherinvestments beyond the financial module, which yield annualbenefits of $.5 million in year 1 and each year thereafter(forever).

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

Evaluate the expected NPV of this project using the describedreal option.

Consider that we have the opportunity to do a pilot program byinstalling the financial model only at a cost of $10 MM. A yearfrom now, we can decide whether to invest in the full plant or not.Analyze this case as follows: Find the good case NPV and the badcase NPV. Obviously, we won't exercise the option if we discoverthat we're in the Bad Case. So, we limit our loss to $10 MM lessthe present value of the bad case starting in Year 1.

Part 3.


What is the expected NPV in each case? Compare the

expected NPV using the traditional NPV approach with theexpected NPV using real options. What do you recommend? Why? Whatdo you conclude in each case?

If you don't know the probability of success for the pilot, isthere a value that is critical to your recommendation? Is there aprobability of success above or below which you will recommendundertaking the pilot and below or above which you will recommend ago/ no go decision on the underlying project without undertaking apilot test? 



Label your work as follows:

Part 1: NPV Analysis


1. PV of "Good" perpetuity:


2. PV of "Bad" perpetuity


3. "Good" NPV:


4. "Bad" NPV:


5. Expected NPV: 


6. Invest or don't invest:

Part 2: Real Options Approach


1. Good case NPV by installing the financial module.


2. Bad case NPV by installing the financial module.


3. Expected NPV by installing the financial module.


4. Should we go ahead with the financial module pilot project orthe full project? 


5. Should we undertake both the full project and the pilot"today"?

Part 3: Critical Probabilities


1. Probability to forget the Pilot and complete the Project. Wecan find that probability by equating the present values of thefull project and thepilot. 


2. Probability of going ahead with the Pilot. We can calculatethe critical probability for going ahead with the pilot by settingthe PV expression = 0 and solving for X.


3. If there is no real option, breakeven probability for go/nogo.