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
NPVtraditional = -$1,700 6 $0
Before recommending rejection of the proposed project, she has decided to assess
whether there might be real options embedded in the firm’s cash flows. Her evaluation
uncovered three options:
Option 1: Abandonment. The project could be abandoned at the end of 3 years,
resulting in an addition to NPV of $1,200.
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 $3,000 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 $10,000.
Jenny estimated that there was a 25% chance that the abandonment option
would need to be exercised, a 30% 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, NPVstrategic, for
Asor Products’ proposed equipment expenditure.
b. Judging 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?