Real Options HomeworkPlease refer to the Real Options Example Problem #1. This assignment is to evaluate both parts, the traditional NPV calculation as well as the Real Options approach.  The...

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Real Options Homework Please refer to the Real Options Example Problem #1. This assignment is to evaluate both parts, the traditional NPV calculation as well as the Real Options approach.  The probability of a successful pilot project is now .7 (instead of .5) and the probability of an unsuccessful pilot is .3 (instead of .5). What is the expected NPV in each case now? What do you recommend? Why? If you don't know the probability of success for the pilot, is there a value that is critical to your recommendation? Is there a probability of success above or below which you will recommend undertaking the pilot and below or above which you will recommend a go/ no go decision on the underlying project without undertaking a pilot test? Real Options Simple Example Problem #1 SIMPLE EXAMPLE: A company must decide whether to invest $100 Million in developing and implementing a new enterprise system in the face of considerable technological and market (demand for product and market share) uncertainty. The firm's cost of capital is 10%.   1. Evaluate Using NPV Analysis   There can be a good and bad result for this investment.   Good Result: A good result has a probability of .5 of occurring. Here the planned cost reductions have been realized and better integration of the supply chain is possible. These benefits are leveraged by strong market demand for the firm's product. There have also been feedback benefits, the enterprise system has significantly improved perceived quality and service from the customer's point of view. Annual benefits under this scenario equal $15 million in after tax cash flow per year forever.   Bad Result: The system proves to be more difficult to implement and improvements in management of the supply chain are less. In addition, the growth in market demand for the product is lower. Annual benefits under this scenario are $2 million in after tax cash flow per year.   Using traditional "all or nothing" NPV analysis, we get the following   Year 0 (now) cash flows: $-100 million for ERP purchase and implementation   Year 1, 2, 3…etc. cash flows (after tax): (a)    good result: $+15 million/year (prob. = .5) (b)   bad result: $+2 million/year (prob. = .5)   Expected annual cash flows for year 1 and forward: $15 mil * .5 + $2 mil * .5 = $7.5 mil + $1 mil = $8.5 mil   The value of these expected after tax cash flows (a perpetuity) = $8.5/COC = $8.5/.10 = $85 mil   Then the NPV of this investment = $-100 mil + $85 mil = $-15 mil   The decision is: DO NOT UNDERTAKE THE INVESTMENT   2. Real Options Approach (all cash flows are after tax)   The real options alternative allows for flexibility and the delay of the investment for 1 year. In this case, if we do a pilot project we will be better able to evaluate ERP implementation complexities, achievable supply chain benefits, and the market share our products will achieve. However, the cost of the project will rise to $110 Million ($10 Million this year and $100 Million next year) with the one-year delay and additionally management decides to purchase and implement the financial module in year 1 at a cost of $10 Million (real option).   The results are slightly different:   Year 0 (now) cash flows: $10 million for the pilot project, the financial module   After year 1, if the conditions indicate a good result, the firm will invest the $100 million for the ERP with expected benefits (cash flows) of $15 million annually beginning in year 2. Benefits in year one from the financial module are $1 million.   If a bad result is indicated, the firm makes no further investments beyond the financial module, which yield annual benefits of $.5 million in year 1 and each year thereafter.   Here the firm has flexibility and has exercised its option to make no further investments based on better information/knowledge of expected future benefits.   Let us evaluate the NPV of this project using the described real option.   Present value of cash outflows: $-10 mil - $100 mil/(1+COC) * .5 = -$55.45 mil   Present value of expected cash inflows:   Good result (expected value): {$1 mil/(1+COC) + [($15 mil/COC)/(1+COC)] }* .5 = $68.64 mil   Bad Result (expected value): {$.5 mil/(1+COC) + [($.5 mil/ COC)/(1+COC)] }* .5 = $2.50 mil   Total NPV of expected cash inflows = $68.64 mil + $2.50 mil = $71.14 mil   NPV of the project = -$55.45 mil + $71.14 mil = $15.69 mil   The right decision here is DO THE PILOT PROJECT     Sheet1 FIN 660 Strategic Financial Management Example Real Options Individual Project Template Student Template PART I; NET PRESENT VALUE ANALYSIS Given (in Millions) : Invest (100) Cost of Capital 0.1 Good Case: Free Cash Flow15 Bad Case: Free Cash Flow 2 Good Case: Probability 0.5 Bad Case:: Probability 0.5 Step #1: PV of Perpetuity, Adjust for COC Good Case 15 X/0.10 Bad Case 2/0.10 Step #2: NPV of Project Good Case Investment + Adjusted PV Bad Case Investment + Adjusted PV Step #3: Expected NPV Good Case .5 X Good NPV Bad Case .5 X Bad NPV Total Expected NPV Conclusion: DO NOT UNDERTAKE THE INVESTMENT PART II: REAL OPTIONS ANALYSIS Given (in Millions) Financial Module Investment -10 Investment (in Millions)-100 COC 0.1 Probability of Good Result 0.5 Probability of Bad Results 0.5 Good Case: Benefits of Pilot year 11 Bad Case: Benefits of Pilot year 10.5 Good Case: Benefits of investment: every year starting from year 2 and forever15 Bad Case: Benefits of Investment: every year starting from year 2 and forever0.5 Good Case (in Millions) Analysis Note: Blue Area is a "proof" Year 01 Financial Module Investment -10 Investment (in Millions)-100 Year 1 benefit1 PV of perpetuity of benefits 150 Total Cash Flows -1051 NPV of good case Bad Case (in Millions) Analysis Year 01 Financial Module Investment -10 Investment (in Millions)0 Year 1 benefit0.5 PV of perpetuity of benefits 5 NPV of bad case NPV of real option (Step #4)0.0000000 Step 1: Present Value of Cash Outflows [-10 + (-100/1.10) X 0.5] Step #2 Present Value of expected cash inflows Good Results (expected value) (a){$1 mill / (1 + COC) + [($15 Mil /COC)/ (1+COC)]} X .5 Bad Result (expected value) (b){$.5 mill / (1 + COC) + [($.5 Mil /COC)/ (1+COC)]} X .5 or (0.5mill/COC)x0.5 = (0.5 mill/0.1)x0.5 Step #3 Total NPV of Expected cash inflows Total PV of Expected Cash flows (a + b)0.00 Step #4 NPV of Project Step #1 PV of Cash Outflows0.00 (Step #1 + Step #3) 0.00000 The right thing is to do the PILOT PROJECT