Define each of the following terms:
a. Real option; option value
b. Abandonment option; investment timing option
c. Growth option; flexibility option
d. Replacement chain (common life)
e. Equivalent annual annuity (EAA)
f. Optimal capital budget
g. Capital rationing
ST-2 Abandonment option Your firm is considering a project with the following cash flows:
PREDICTED CASH FLOW FOR EACH YEAR
0 1 2 3
Best case 25% ($25,000) $18,000 $18,000 $18,000
Base case 50% (25,000) 12,000 12,000 12,000
Worst case 25% (25,000) (8,000) (8,000) (8,000)
You learn that the firm can abandon the project, if it so chooses, after one year of opera-
tion, in which case it can sell the asset and receive $15,000 in cash at the end of Year 2.
Assume that all cash flows are after-tax amounts. The WACC is 12 percent.
a. What is the project’s NPV if the abandonment option is not considered?
b. What is the NPV considering abandonment?
c. What is the value of the abandonment option?
ST-3 Projects with unequal lives Wisconsin Dairy Co. is currently deciding on its capital
budget for the upcoming year. Among the projects being considered are 2 machines,
W and WW. W costs $500,000 and will produce expected after-tax cash flows of $300,000
Tying It All TogetherTying It All Together
This chapter and the previous three focused on capital budgeting. Chapter
10 described how a company estimates its cost of capital. Then, Chapter 11
described several methods used to evaluate projects. We concluded that
NPV is the best single method, but IRR, MIRR, and payback all provide
information that managers find useful. Next, Chapter 12 described tech-
niques for estimating project cash flows and risk. Finally, here in Chapter 13
we discussed some topics that go beyond the simple capital budgeting
framework, including the analysis of projects with real options and mutually
exclusive projects with unequal lives. Chapter 13 also discussed the optimal
capital budget, the relationship between the total capital budget and
WACCs for individual projects, and capital rationing. We go on, in the fol-
lowing chapters, to discuss how the optimal capital structure is determined
and the effect of this capital structure on the firm’s cost of capital, on its
optimal capital budget, and consequently, on its dividend policy.
427Chapter 13 Real Options and Other Topics in Capital Budgeting
during the next 2 years. WW also costs $500,000, but it will produce after-tax cash flows
of $165,000 during the next 4 years. Both projects have a 10 percent WACC.
a. If the projects are independent and not repeatable, which project or projects should
the company accept?
b. If the projects are mutually exclusive but not repeatable, which project should the
company accept?
c. Assume the projects are mutually exclusive and can be repeated indefinitely.
(1) Use the replacement chain method to determine the NPV of the project selected.
(2) Use the equivalent annual annuity method to determine the annuity of the
project selected.
d. Could a replacement chain analysis be modified for use where the project’s cash
flows are different each time it is repeated? Explain.
