Chapter 13, Problem 1Q

Explain in general terms what each of the following real options is and how it could change projects’ Nr Vs and their corresponding risk relative to what would have been estimated if the options had not been considered.

1. a. Abandonment
2. b. Timing
3. c. Growth
4. d. Flexibility

Summary Introduction

To discuss: The meaning of abandonment and how it can change the Net present value (NPV) of the project and even their risk involved.

Introduction:

NPV is the variation between the present value of the cash outflows and the present value of the cash inflows. In capital budgeting, the NPV is utilized to analyze the profitability of a project or investment.

Explanation of Solution

The meaning of abandonment and how it can change the NPV of the project and even their risk involved are as follows:

Abandonment is a type of real options. It is an option to end a particular project when the project’s operating cash flows are lower as compared to the expected cash flows.

This particular type of option could increase the expected profitability and reduces the project risk. It is because when there is a poor or negative cash flow, the particular project can be stopped rather than continuing with negative cash flows.  Later, the fixed assets are sold to incur some liquid cash. Therefore, this is way in which the abandonment option changes project’s NPV and its risk.

Summary Introduction

To discuss: The meaning of timing and how it can change the Net present value (NPV) of the project and even their risk involved.

Introduction:

Risk refers to the movement or fluctuation in the value of an investment. The movement can be positive or negative. A positive fluctuation in the price benefits the investor. However, the investor will lose money if the price movement in negative. It is an uncertainty on future return or cash flows.

Explanation of Solution

The meaning of timing and how it can change the NPV of the project and even their risk involved are as follows:

Timing is a type of real options. It takes place when a particular company has an option to postpone on beginning stage of a project until extra facts or information is attained.

The project will not be undertaken at the time when the condition of the project is unfavorable after the research process. However, the project can be preceded when the conditions are favorable.  Therefore, this is way wherein the investment timing option can change the project’s NPV.

The drawbacks or risk involved in the investment timing options are as follows:

• The probability of negative return is less in the timing option because it can raise NPV of the project. However, the NPV require to be discounted back in an additional year.
• There might be more valuable advantages when the project is started initially. However, the advantages to a project will be lost when the project is delayed a year.

Summary Introduction

To discuss: The meaning of growth and how it can change the Net present value (NPV) of the project and even their risk involved.

Explanation of Solution

The meaning of growth and how it can change the NPV of the project and even their risk involved are as follows:

Growth is also a type of real options. It exists when the investment creates an opportunity to make profitable investments.

It takes place when a company starts a project in a new market or new country. This can add value to projects from its cash flows. It also provides other opportunities for the company in the new market or country. Therefore, this is way wherein the growth option can change the project’s NPV.

Summary Introduction

To discuss: The meaning of flexibility and how it can change the Net present value (NPV) of the project and even their risk involved.

Explanation of Solution

The meaning of flexibility and how it can change the NPV of the project and even their risk involved are as follows:

Flexibility is also a type of real options. This option allows a company to change its operations based on the changes of current conditions during the life of the project. As a result, inputs, outputs, or both can be altered easily according to the present market demands.

For instance, a manufacture can build a factory that allows built various types of vehicles instead of building an auto factory, which builds a particular type of vehicles. Therefore, the company can rapidly respond to the consumer tastes and market demands.