# Real Options in Capital Budgeting16 - Financial Management

In our discussion of capital budgeting, we have used so -called conventional discounted cash flow techniques; that is, we determine a project’s net present value by discounting the expected net cash flows at an applicable cost of capital, minus the net investment. This type of analysis does not consider the value of any operating (real) options that may be embedded in the project or the value of any options, or flexibilities, that the firm may choose to incorporate into the project’s design. An option gives its holder the right, but not the obligation, to buy, sell, or otherwise transform an asset at a set price during a specified time period.

## Types of Real Options in Capital Budgeting

Real options in capital budgeting can be classified in the following manner.

Investment Timing Options

Delaying investment in a project, say for a year or so, may allow a firm to evaluate additional information regarding demand for outputs and costs of inputs, for example. Investing in a project today or waiting one year to invest in the same project is an example of two mutually exclusive projects. In this example, the firm should select the project with the higher net present value, assuming at least one project has a positive net present value. The “waiting-to-invest” option is a common real option.

Abandonment Option

The option to discontinue a project is an important real option in capital budgeting. A project may be discontinued either by shutting it down completely and selling the equipment or by switching its use to an alternative product. To illustrate how an abandonment option may influence the net present value of a project, consider a manufacturing firm that calculates a negative net present value on a proposed project to purchase a new lathe to make a series of industrial parts for a particular application.

The project’s negative net present value is based on a cash flow analysis that assumes that the lathe will produce the parts for the entire economic life of the project. This cash flow analysis does not take into consideration the option of the company to abandon the project and sell the lathe in the active secondary market that exists for lathes and other manufacturing equipment. Shutting down the project represents a put option to sell the project for the salvage value of equipment. Or the company could simply choose to switch from making the specific parts to another potentially more profitable product. The abandonment option is embedded in the project; its existence may limit the downside risk of the project.

ETHICAL ISSUES

The Use of Shareholder Resources

Managers are employed by the owners of a firm with the objective of maximizing wealth for the shareholders. As we have learned, this objective can be accomplished by investing in the set of projects possessing the maximum expected net present value. As discussed in Chapter , the managers of some firms, such as Berkshire Hathaway, have focused intently on this objective and have had good success in achieving their objective. Other managers, however, seem to have strayed frequently from this objective.

Investing in projects with negative net present values is most likely to occur in firms possessing large discretionary cash flows. Usually these are firms in mature industries with few true growth opportunities. Mature firms tend to generate substantial cash flows over which managers have considerable control. Marginal projects may be accepted, often with little analysis, because of their “strategic” importance to the firm. Managers may be reluctant to pay these “excess” cash flows out to shareholders as increased dividends because that will cause the firm to grow at a slower rate in the future. Stern Stewart’s Performance 1000 is a corporate performance measuring system designed to consider how effective managers have been in adding to their shareholders’ investment.

Their “Market Value Added” (MVA) measure can be viewed as the “net present value of all of a company’s past and projected capital investment projects.” For example, as shown in Table, Coca-Cola has an MVA of more than $82 billion; Merck has about$107 billion in MVA; and General Electric has more than $222 billion of MVA. In contrast,AT&T has an MVA of over$–72 billion and General Motors has an MVA of nearly $–16 billion. What factors might cause managers to consistently adopt investment projects with negative net present values? What are the consequences of these decisions for shareholders? What are the consequences of these decisions for the U.S. economy? Shutdown Options A firm may have the option of temporarily shutting down a project in order to avoid negative cash flows. Consider a mining or manufacturing operation characterized by relatively high variable costs. If output prices drop below variable costs, a business has the option to shut down until output prices recover and rise above variable costs. The shutdown option also reduces the downside risk of a project. Growth Options A firm may have an opportunity to undertake a research program, build a small manufacturing facility to serve a new market, or make a small strategic acquisition in a new line of business. Each of these examples may be a negative net present value project, but each project can be viewed as having generated a growth option for the company which, if exercised, may lead ultimately to a large positive net present value project. To illustrate a growth option, suppose a company is considering a large Internet investment project that has the potential for either failure, i.e., large losses with a high probability of occurrence, or success, i.e., large profits with a low probability of occurrence. The investment consists of two stages. The first stage (today) is an investment in a Web site and the second stage (one year from today) is an investment in an electronic commerce venture. The investment in the Web site has an NPV of$–10 million. Setting up the Web site (first stage) gives the company the option, but not the obligation, to invest in the electronic commerce business (second stage) one year from today. While the cash flows are highly uncertain, ranging from large losses to substantial profits, the best estimate today is that the electronic commerce business has an NPV of $–60 million. Based on the NPV decision rule, the Internet investment project would be unacceptable since it has an NPV of$–70 million [–$10 million + ($–60 million)]. However, one year from today, the company will have more information and be better able to estimate whether the electronic commerce business (second stage) is worth pursuing. At that time, suppose new information about the cash flows of the electronic commerce venture shows that it will be extremely profitable, yielding an overall NPV of $200 million for the Internet project. Clearly, the project would be worth undertaking at that time. Investing in the Web site today, even though it has a negative NPV, preserves the company’s ption to invest in a positive NPV project in the future. By investing only in the Web site initially, the company is able to limit its downside risk ($–10 million NPV) while preserving the upside potential (\$200 million NPV) for the Internet investment project.

Designed-In Options

In addition to options that can occur naturally in projects, managers have the opportunity to include options in projects in order to increase net present value. These designed -in options are classified either as input flexibility options, output flexibility options, or expansion options.

Input flexibility options allow a firm to design into a project the capability of switching between alternative inputs because of input cost differences. To illustrate a designed-in option, consider an electric power plant project that is evaluating whether to use a gas burner or an oil burner to fire the turbines. The designed -in option in this instance would be a flexible dual -fuel boiler that can switch back and forth between gas and oil, depending on which energy source is cheaper to acquire and use. It may be, under certain conditions, that the flexible boiler project has a higher net present value than either of the projects using the gas -fired boiler or the oil-fired boiler, even though the initial cost of the flexible boiler is higher than the cost of either of the two single-fuel boilers.

In other words, the value of the designed-in option may be greater than the additional cost of the flexible boiler. Output flexibility options allow a firm to design into a project the capability of shifting the product mix of the project if demand or relative product prices dictate such a shift. Oil refineries normally have output flexibility options. The investment in manufacturing flexibility by Toyota and Honda, cited in the “Financial Challenge” at the beginning of the chapter, is another example of the use of output flexibility options to increase efficiency and returns. Expansion options give project managers the ability to add future capacity to a project at a relatively low marginal cost.

For example, consider a company that currently needs a manufacturing facility totalling 50,000 square feet. If instead, it builds a facility now with 70,000 square feet of space, the cost to the company to expand by 20,000 square feet in the future may be less than if it has to build a separate 20,000 -square -foot facility later. Even if the need for the additional capacity never materializes, the value of the expansion option may justify the cost of the larger initial facility beforehand, particularly if significant uncertainty about future product demand exists.

While option valuation in actual capital budgeting projects is complicated, financial managers should recognize the presence of options in projects and should consider including designed -in options when possible in planning projects.

Using conventional discounted cash flow analyses in capital budgeting without considering real options often results in a downward-biased estimate of the true value of a project’s net present value. Some operating options, such as an option to expand, may increase a project’s upside potential, while other operating options, such as an option to abandon, may reduce a project’s downside risk.

How Are Real Options Concepts Being Applied?

Real options analysis is being used in different ways by leading companies. Some firms use real options concepts to frame a way of thinking about decision analysis problems involving capital investments. This may be viewed as the foundation level of use of real options concepts. When used as a way of thinking about corporate investment problems, real options analysis increases awareness of the value of the various options that may exist within a project. It also helps managers to recognize that valuable options can be created or destroyed because of the decision actions taken by managers.

When used in this way, real options thinking helps managers to think about risk and uncertainty as assets that can be exploited in a project, rather than negative factors that should be avoided. In addition, real options thinking helps to focus managers on the value of acquiring additional information before making irrevocable investment decisions.

Other firms use real options concepts as an analytical tool. These firms apply formal option pricing models, such as the Black –Scholes model and the binomial option pricing model, to formally value the option characteristics of investment projects. More complex models are also being used by a growing number of firms to value the option characteristics of investment projects. Some firms that have used real options approaches when analyzing various investment project opportunities include

• Genentech, which has used the real options approach to value drug development projects.
• Intel has used the real options approach to value investments in flexible manufacturing facilities.
• ChevronTexaco has used the real options approach to value oil and gas development projects.

A large amount of advanced work on real options has been done and more is being done Financial managers should attempt to incorporate options analyses in project evaluations whenever possible.