CIMA P2 Syllabus B. Capital Investment Decision Making - Capital investment real options - Notes 8 / 8
Real Options
Remember we are talking about capital investment projects, not currency and interest rate options.
Option to follow-on
A follow-on option is a strategic option when the investment opportunity leads to follow-on wealth generating opportunities.
For example, buying new equipment could enable an organisation to develop experience and skills with the latest technology, which may allow opportunities that would otherwise have been unavailable.
This is equivalent to a call option.
Option to abandon
An abandonment option refers to the ability to abandon the project at a certain stage in its life.
If large sums are being spent, and prospects do not appear healthy, an abandonment option may be available.
This type of option is affected, for example, by the type of equipment needed for the project and the terms on which the equipment is acquired.
If equipment is readily resalable, this gives a more valuable abandonment option than if the equipment is highly specialised with no prospective second-hand purchasers.
Option to wait
An option to wait is a timing option which allows resolution of uncertainty.
This is equivalent to a call option.
Valuing real options
Real options can add value to projects, and should be taken into account in investment appraisal.
Although the valuation is difficult, even a rough estimate is better than no estimate at all.
Illustration 1
Cow Co is considering a three-year project that has an initial cost of $10,000.
Depending on the economic cycle, the cash flows will either be $7,000 per year or $2,000 per year.
There is a 60% probability that the cash flows will be $7,000 per year.
The cost of capital is 10%.
This means that there is an expected cash flow per year of (7,000 x 0.6) + (2,000 x 0.4) = $5,000
The NPV of this project is, therefore;
| Year | Cash flow | Discount factor | Present Value |
|---|---|---|---|
| $ | $ | ||
| 0 | (10,000) | 1.000 | (10,000) |
| 1-3 | 5,000 | 2.487 | 12,435 |
| 2,435 |
Wait option
However, suppose that economic conditions after the first year are expected to remain the same for the foreseeable future.
This means that Cow Co could wait one year to see which scenario occurs and then launch the project.
This would gives the following NPVs:
| Best case (CF will be $7,000) | |||
|---|---|---|---|
| Year | Cash flow | Discount factor | Present value |
| $ | $ | ||
| 1 | (10,000) | 0.909 | (9,090) |
| 2-4 | 7,000 | 2.261* | 15,827 |
| 6,737 |
| Worst case (CF will be $2,000) | |||
|---|---|---|---|
| Year | Cash flow | Discount factor | Present value |
| $ | $ | ||
| 1 | (10,000) | 0.909 | (9,090) |
| 2-4 | 2,000 | 2.261* | 4,522 |
| (4,568) |
* 4 year annuity factor - 1 year = 3.170 - 0. 909 = 3.170 - 0.909 = 2.261
There is considerable value in the option to wait, in this case, because the NPV is increased by $6,737- $2,435 = $4,302 as the downside risk is eliminated by waiting, as in worst case scenario the project would not commence.
Abandonment option
Alternatively, if the project is started now, there may be the option to abandon the project after one year when the machinery used can be sold for $8,000.
This option would create the following possibilities at the end of year 1.
| Year (t0 is now end of first year, when the decision is taken. | Cash flow | Discount factor | Present value |
| $ | $ | ||
| 0 | 8,000 | 1.000 | 8,000 |
| 1 | (7,000) | 0.909 | (6,363) |
| 2 | (7,000) | 0.826 | (5,782) |
| (4,145) |
| Year (t0 is now end of first year, when the decision is taken. | Cash flow | Discount factor | Present value |
| $ | $ | ||
| 0 | 8,000 | 1.000 | 8,000 |
| 1 | (2,000) | 0.909 | (1,818) |
| 2 | (2,000) | 0.826 | (1,652) |
| 4,530 |
This is shows that if the CFs are $2,000 per year, then the abandonment option should be taken as this has a positive NPV.