Financial

Another example is a “strategic investment” such as a new process for desalinating seawater. Suppose GRE Inc. is considering the investment shown in Figure 13-1. Part I looks at the investment without considering an embedded real option to expand the project. GRE would invest $3 million at Time 0. Because this is considered a relatively risky investment, a WACC of 12% is used. There is a 50% probability of success, in which case the project will yield positive cash inflows of $1.5 million per year for 3 years. There is also a 50% probability of poor results, in which case inflows will be only $1.1 million per year for 3 years. If the project is successful, the NPV will be $603,000; but the NPV will be _$358,000 if the project is unsuccessful. The expected NPV, found by multiplying each NPV by its 50% probability, is $122,000; so it appears that the project should be accepted. However, the project is quite risky as measured by its coefficient of variation, so it might still be rejected. Now consider Part II, where we recognize the existence of the growth option. The firm would know if conditions are good at the end of Year 1, so it would then invest another $1 million to expand at Time 2. The expansion would produce cash flows on out in future years; and the present value of those flows, at the end of Year 3, is estimated to be $5 million. We then add the new cash flows to the original flows to obtain the “total good scenario cash flows” as shown on Row 19.

The NPV under good conditions is $3.364 million. The bad-case cash flows are the same as in Part I, and their NPV is _$358,000. Now when we find the expected value of the project, it is $1.503 million. The standard deviation and coefficient of variation are much lower, indicating that the project is much less risky compared to the project in the absence of the option.

Part III shows the option value, which is the additional value of the project if the option exists. If the expected NPV of the project with and...