Ther topics in capital budgeting 21st Century Educational Products is a rapidly growing software company,
and, consistent with its growth, it has a relatively large capital budget. While most of the company’s projects are
fairly easy to evaluate, a handful of projects involve more complex evaluations.
John Keller, a senior member of the company’s finance staff, coordinates the evaluation of these more com-
plex projects. His group brings their recommendations directly to the company’s CFO and CEO, Kristin Riley and
Bob Stevens, respectively.
a. In recent months, Keller’s group has begun to focus on real option analysis.
(1) What is real option analysis?
(2) What are some examples of projects with embedded real options?
b. Considering real options, one of Keller’s colleagues, Barbara Hudson, has suggested that instead of investing in Project X today, it might make sense to wait a year because 21st Century would learn a lot more about market conditions and would be better able to forecast the project’s cash flows. Right now, 21st Century
forecasts that Project X, which will last 4 years, will generate expected annual net cash flows of $33,500. However, if the company waits a year, it will learn more about market conditions. There is a 50 percent chance that the market will be strong and a 50 percent chance it will be weak. If the market is strong, the annual cash flows will be $43,500. If the market is weak, the annual cash flows will be only $23,500. If 21st Century chooses to wait a year, the initial investment will remain $100,000. Assume that all cash flows are discounted at 10 percent. Should 21st Century invest in Project X today, or should it wait a year before deciding whether to invest in the project?
c. Now let’s assume that there is more uncertainty about the future cash flows. More specifically, assume that the annual cash flows are now $53,500 if the market is strong and $13,500 if the market is weak. Assume that the up-front cost is still $100,000 and that the WACC is still 10 percent. Will this increased uncertainty
make the firm more or less willing to invest in the project today
