Financial Management: Theory and Practice
Chapter 13 Real Options
Spreadsheet Problem: Build a Model - Real Options
(In other book editions, it is Ch15 P10 Build a Model)
Start with the partial model in the file FM12 Ch 13 P09 Build a Model.xls from the textbook’s Web site.
Bradford Services Inc. (BSI) is considering a project that has a cost of $10 million and an expected life of 3 years. There is a 30% probability of good conditions, in which case the project will provide a cash flow of $9 million at the end of each year for 3 years. There is a 40% probability of medium conditions, in which case the annual cash flows will be $4 million, and there is a 30% probability of bad conditions and a cash flow of _$1 million per year. BSI uses a 12% cost of capital to evaluate projects like this.
a. Find the project’s expected present value, NPV, and the coefficient of variation of the present value.
b. Now suppose that BSI can abandon the project at the end of the first year by selling it for $6 million. BSI will still receive the Year 1 cash flows, but will receive no cash flows in subsequent years.
c. Now assume that the project cannot be shut down. However, expertise gained by taking it on would lead to an opportunity at the end of Year 3 to undertake a venture that would have the same cost as the original project, and the new project’s cash flows would follow whichever branch resulted for the original project. In other words, there would be a second $10 million cost at the end of Year 3, and then cash flows of either $9 mil the following 3 years. Use decision tree analysis to estimate the value of theproject, including the opportunity to implement the new project at Year3. Assume the $10 million cost at Year 3 is known with certainty and should be discounted at the risk-free rate of 6%.
d. Now suppose the original (no abandonment and no additional growth) project could be delayed a year. All the cash flows would remain unchanged, but information obtained during that year would tell the company exactly which set of demand conditions existed. Use decision tree analysis to estimate the value of the project if it is delayed by 1 year. (Hint: Discount the $10 million cost at the risk-free rate of 6% since it is known with certainty.)
e. Go back to part c. Instead of using decision tree analysis, use the Black-Scholes model to estimate the value of the growth option. The risk-free rate is 6 percent, and the variance of the project's rate of return is 22 percent.