Real options and the strategic NPV Jenny Rene, the CFO of Asor Products, Inc., has just completed an evaluation of a proposed capital expenditure for equipment that would expand the firm's manufacturing capacity. Using the traditional NPV methodology, she found the project unacceptable because: NPV traditional = - $1,699 <0 Before recommending rejection of the proposed project, she has decided to assess whether real options might be embedded in the firm's cash flows. Her evaluation uncovered three options and their probability: Option 1: Abandonment-The project could be abandoned at the end of 3 years, resulting in an addition to NPV of $1,080. Option 2: Growth-If the projected outcomes occurred, an opportunity to expand the firm's product offerings further would become available at the end of 4 years. Exercise of this option is estimated to add $2,220 to the project's NPV. Option 3: Timing-Certain phases of the proposed project could be delayed if market and competitive conditions caused the firm's forecast revenues to develop more slowly than planned. Such a delay in implementation at that point has an NPV of $10,700. Jenny estimated that there was a 30% chance that the abandonment option would need to be exercised, a 35% chance that the growth option would be exercised, and only a 10% chance that the implementation of certain phases of the project would affect timing. a. Use the information provided to calculate the strategic NPV, NPV strategic, for Asor Products' proposed equipment expenditure. b. On the basis of your findings in part (a), what action should Jenny recommend to management with regard to the proposed equipment expenditure? c. In general, how does this problem demonstrate the importance of considering real options when making capital budgeting decisions?
Net Present Value
Net present value is the most important concept of finance. It is used to evaluate the investment and financing decisions that involve cash flows occurring over multiple periods. The difference between the present value of cash inflow and cash outflow is termed as net present value (NPV). It is used for capital budgeting and investment planning. It is also used to compare similar investment alternatives.
Investment Decision
The term investment refers to allocating money with the intention of getting positive returns in the future period. For example, an asset would be acquired with the motive of generating income by selling the asset when there is a price increase.
Factors That Complicate Capital Investment Analysis
Capital investment analysis is a way of the budgeting process that companies and the government use to evaluate the profitability of the investment that has been done for the long term. This can include the evaluation of fixed assets such as machinery, equipment, etc.
Capital Budgeting
Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.
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