Real Options - Finance

Sheet1

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 Flow	15
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 1	1
Bad Case: Benefits of Pilot year 1	0.5
Good Case: Benefits of investment: every year starting from year 2 and forever	15
Bad Case: Benefits of Investment: every year starting from year 2 and forever	0.5
Good Case (in Millions) Analysis	Note: Blue Area is a "proof"
Year		0	1
Financial Module Investment		-10
Investment (in Millions)			-100
Year 1 benefit			1
PV of perpetuity of benefits			150
Total Cash Flows		-10	51
NPV of good case
Bad Case (in Millions) Analysis
Year		0	1
Financial Module Investment		-10
Investment (in Millions)			0
Year 1 benefit			0.5
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 Outflows	0.00
	(Step #1 + Step #3)		0.00000
The right thing is to do the PILOT PROJECT