Real Options in Project Evaluation: Project Timing

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Real Options in Project EvaluationProject Timing

• Stephen Gray
• Campbell R. Harvey

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NPV and Real Options

• NPV
• Often misapplied
• Ignores strategic values if misapplied
• Real Option Valuation
• Values contingencies in project outcomes (i.e.,
  alternative future uses of the asset).

3
Project Timing Example

• A company has the opportunity to build a new
  power project in a foreign country.
• Net cash flows are 100mm in the first year of
  operation.

4
Project Timing Example

• Net cash flows in the second year of operation
  depend upon whether the government sponsors a
  link to bypass a transmission bottleneck.
• This is an example of political risk.

5
Project Timing Example

• If the link goes ahead, demand for power from the
  new plant will be low and net cash flow will be
  80 mm.
• If the link does not go ahead, demand for power
  from the new plant will be high and net cash flow
  will be 125 mm.
• Similar uncertainty surrounds Year 3 net cash
  flows.
• Cash flows beyond Year 3 are perpetual.

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...
156
0.5
125
0.5
...
0.5
100
100
0.5
0.5
80
...
0.5
64
Expected Net Cash Flow
...
100
105
103
...
0
1
2
3
7
Expected Net Cash Flow
...
100
105
103
...
0
1
2
3
8
Case 1

• Now or never.
• Cost to build is 1,100.
• NPV1,044 - 1,100 -56.
• Negative NPV.
• Reject the project.

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Case 2

• Now or never.
• Cost to build is 1,000.
• NPV1,044 - 1,000 44.
• Positive NPV.
• Accept the project.

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Case 3

• Option to delay for one year.
• During this one-year delay, the generator learns
  whether or not the new entrepreneurial link will
  proceed.
• Based on this additional information, a smarter
  decision can be made.
• Cost to build is 1,100.

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...
156
0.5
125
up state
...
0.5
100
0.5
80
down state
...
0.5
64
Expected Net Cash Flow in up state
...
128
125
Expected Net Cash Flow in down state
...
82
80
...
0
1
2
3
12
Expected Net Cash Flow in up state
...
128
125
...
0
1
2
3
13
Expected Net Cash Flow in down state
...
82
80
...
0
1
2
3
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Case 3 (cont)

• Option to delay for one year.
• Cost to build is 1,100.
• Wait one year
• proceed if up state, NPV177.
• reject if down state, NPV0.
• Expected NPV today is

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Case 4

• Option to delay for one year.
• Cost to build is 1,000.
• If we build now, NPV0 44.
• What if we wait one year?

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Case 4

• Wait one year
• proceed if up state, NPV277.
• reject if down state, NPV0.
• Expected NPV today is

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Conclusions

• The option to delay can be valuable, even if the
  project has positive NPV if started immediately.
• The value of these options is ignored by standard
  DCF techniques.
• Proper analysis of these options is needed not
  just for project valuation, but also for project
  timing.

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Case 5 - Abandonment

• Plant can be abandoned at any time for 800.
• This option will be exercised whenever the PV of
  future cash flows falls below 800.
• This only happens at the lowest node, where
  perpetual cash flows are 64.

19
...
156
Yearly Cash Flows
125
...
100
100
80
One-time Liquidation Value
800
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Case 5 (cont)

• When the abandonment option is incorporated, the
  NPV of building the project now is 77.
• The NPV of waiting for one year is 126.
• It is still optimal to delay for one year in this
  case, although the incremental value of delaying
  has decreased.
• The value of the option to delay is lower if it
  is easy to exit a bad investment.