Chapter 4: Real Options and Project Analysis

Shapiro CHAPTER 4: QUESTIONS

1. Imagine that the price of copper rises to the point that the copper value of a penny is worth more than $.01. As a result, pennies disappear from circulation. Your firm uses copper in its production process, and you can melt pennies down and retrieve their copper content at zero cost. At present, you have a six month supply of copper reserves and you have also managed to collect 1 million pennies. !hould you melt the pennies down and add the copper to your stoc"pile# $hy or why not# Answer: %he ownership of a penny is an option. If the penny is melted, the owner gets the valua&le copper to sell at current mar"et prices. 'owever, if the owner "eeps the penny, he retains the option to use it as legal tender. If the price of copper ma"es the penny(s copper content worth less than $.01, it is more valua&le as legal tender. If the penny was melted and prices dropped, the owner may not mint a new penny. %he penny is generally more valua&le as an option. 'ence, it should not &e melted. )It is also illegal to deface or alter legal tender.* +. $ill a gold mine ever &e shut permanently# $hy or why not# Answer: A gold mine is an option to mine the gold if the mar"et prices ma"e it profita&le to do so. ,losing a mine permanently "ills the value of the option to re open the mine if mar"et conditions change favora&ly. %he only time that a mine would &e closed forever is when the cost of maintaining the mine )including opportunity costs* is higher than the marginal option value. If the value of the option truly drops to zero, it will &e optimal to close the mine. -. !ome economists have stated that too many companies aren(t calculating the cost of not investing in new technology, world class manufacturing facilities, or mar"et position overseas. $hat are some of these costs# 'ow do these costs relate to the notion of growth options discussed in the chapter#

Answer: Executives in this situation need to consider the option values associated with new technological investment. ew technologies! while o"ten costly! di""icult to administer and hard to de"end in the short term! ma#e it easier "or a company to adapt to a changing technological environment and a more competitive mar#etplace. $ith technology in place! the "irm will "ind it easier to enter and capture niche mar#ets as they emerge. %he relevant &ase case may not &e the status 'uo! &ut rather! an anticipated decline in sales "ollowing competitors( adaptations to the new technology. %his ease o" adaptation has a value to the "irm) it may ma#e all "uture investments more pro"ita&le. *irms may underestimate P+ when they "ail to ta#e the option,li#e characteristics o" the new technology into account! and mista#enly assume that the status 'uo will &e maintained in the a&sence o" adaptation. 4. -n .ecem&er /010! 2eneral Electric spent 3/45 million to &uy a controlling interest in %ungsram! the 6ungarian state,owned light &ul& ma#er. Even in its &est year! %ungsram earned less than a 47 return on e'uity 8&ased on the price 2E paid9. $hat might account "or 2E(s decision to spend so much money to ac'uire such a dilapidated! ine""icient manu"acturer: Answer: Eastern Europe has the potential to &e &oth a large mar#et "or $estern goods and a low,cost manu"acturing plat"orm "or export to $estern Europe. ;ut there are major uncertainties as to whether Eastern Europe will ever reali<e its mar#et potential. As to manu"acturing there! 'uestions exist as to whether a wor#"orce with 44 years experience in =they pretend to pay us and we pretend to wor#> can produce at the level and 'uality necessary to &e competitive with their $estern counterparts. ;y investing in 6ungary! 2E is &uying an option to participate in the growth o" the Eastern European mar#et. -t also is learning what it ta#es to install modern $estern

Chapter 4: Real Options and Project Analysis management methods in a "ormer communist country and to use 6ungary as a low,cost &ac#door to $estern Europe. %he latter is especially critical to 2E as part o" its strategy to expand its wea# glo&al presence. 2E(s presence is particularly dim in the European lighting mar#et! where it is just sixth in sales! even though historically it has dominated the ?.@. mar#et. %hen came a highly success"ul raid on 2E(s ?.@. "ortress &y Philips! which is the world(s largest light &ul& producer. 2E decided to "ight &ac# &y storming Philip(s European &ase. ;ut 2E was una&le to ac'uire a controlling interest in any $estern European "irm and &uilding a new plant would have cost at least 3A55 million and several years. ;uying %ungsram seemed a more promising alternative! since the 6ungarian "irm already exported B57 o" its output to the $est. %hus! it o""ered a tempting mix o" $estern European mar#et share and low Eastern European wages. -n e""ect! &y investing in %ungsram! 2E is &uying options on: 8a9 the $estern European mar#et) 8&9 introducing new technologies and higher,priced products to %ungsram) and 8c9 a low,cost export plat"orm. -n response to 2E(s purchase! Philips recently too# over Poland(s leading lamp producer and another $estern European competitor! @iemens( Osram unit! has ac'uired an East 2erman producer.

CHAPTER 4: PROBLEMS
1. A &iotech firm must decide whether to purchase the patent to a new food additive, a low cal starch su&stitute. It is estimated that the funds re.uired to &ring the additive to the mar"et can &e as high as $/0 million or as low as $+/ million. %he payoff is uncertain as well0 %he present value of profits could &e as high as $/00 million or as low as $-0 million. %he ris" free rate is 10 percent, and the standard deviation of rate of return on &iotech products is -/ percent. %he patent(s life is estimated at one year. a. In a worst case scenario, how much is the patent worth#

Answer: $e need to ma#e a "ew assumptions to solve this pro&lem. $e assume that in one year! the present value o" pro"its will ta#e values o" 3455C and 3A5C with e'ual pro&a&ility. $e "urther assume that the ris#,"ree discount rate is the appropriate capitali<ation rate "or the "irm. -n a worst,case scenario! the costs will &e 345C. %he "irm will only adopt the project i" P+ D 5! or P+8;ene"its9 E 3455C. %he expected net present value is 5.48455 F 459 G 5.4859 E 3HH4C. %he present value is 3HH4CI8/./59 E 3H54.44C! which represents the maximum value o" the patent. &. -n a &est,case scenario! how much is the patent worth: Answer: -n a &est,case scenario! the costs will &e 3H4C! and the project will &e adopted no matter what. %he expected P+ is 5.48455 F H49 G 5.48A5 F H49 E 3H45C. %he present value is 3H/1./1. H. %he managers o" a "irm are as#ed to consider two possi&le new product lines "or the "irm. Project / is 'uite ris#y and may result in a mar#et value "or the "irm o" 345 million in two years! or nothing. Project H is much more certain in outcome and may result in a "irm mar#et value as high as 3H4 million or as low as 3/4 million. %he "ace value o" the company(s de&t! paya&le in two years! is 3H5 million. a. $hat are the possi&le payo""s to the &ondholders under projects / and H: Answer: 8Payo""s in H years! in millions o" dollars9

Chapter 4: Real Options and Project Analysis

PROJECT 1:
%otal 1ayoff /0 0 2e&t 2istri&ution +0 0 2e&t 2istri&ution +0 1/ possi&le payoffs to the shareholders under pro3ects 1 and +#

PROJEC% H:
%otal 1ayoff +/ 1/ &. $hat are the

Answer: 8Payo""s in H years! in millions o" dollars9

PROJECT 1:
%otal 1ayoff /0 0 4.uity 2istri&ution -0 0

PROJEC% H:
%otal 1ayoff 4.uity 2istri&ution +/ / 1/ 0 c. $hich will the shareholders favor# %he &ondholders#

Answer: @hareholders will "avor project /! which provides an e'ual or higher payo"" in each state. ;ondholders "avor project H "or the same reason.
-. 4astern !hallow, 5td., is a gold mining company operating a single mine. %he present price of gold is $-00 an ounce and it costs the company $+/0 an ounce to produce the gold. 5ast year, /0,000 ounces were produced and engineers estimate that at this rate of production the mine will &e exhausted in seven years. %he re.uired rate of return on gold mines is 10 percent. a. $hat is the value of the mine#

Answer: %he present value o" the mine is the present value o" B years o" payments o" 345Io< : 45!555 o< E 3H.4C! discounted at r E /57. %his present value is 3/H./B/C. &. @uppose in"lation is expected to increase the cost o" producing gold &y /5 percent a year &ut the price o" gold does not change &ecause o" large sales o" stoc#,piled gold &y "oreign governments. *urthermore! imagine that the in"lation raises the re'uired rate o" return to H/ percent. ow! what is the value o" the mine: Answer: -" the costs rise &y /57 per year while the price remains the same! we will not operate the mine a"ter one year. -n the "irst year! pro"its are 8A55 F HB49 : 45!555 E 3/.H4C! discounted one year at r E H/7. -n the second year! pro"its are <ero) we will not mine gold at 3A5H.45 per ounce to sell at 3A55 per ounce. %he value o" the mine is 3/.H4CI/.H/ E 3/.5AAC. c. @uppose the company may shut! reopen! or a&andon the mine in response to "luctuations in the price o" gold. Can the P+ method &e used to value the mine under these conditions: Answer: %he P+ method can &e used to determine the value o" the mine i" the company can choose an optimal extraction policy. %he analysis re'uires a potentially complex decision tree "ormulation! and the determination o" the optimal strategy as a "unction o" the path o" the price "or gold. %he correct solution o" the pro&lem re'uires option,pricing methodologies.

Chapter 4: Real Options and Project Analysis 4. 2... @orrell is developing an anticancer drug. %he project is in its preliminary stage. 2...@. must decide whether to initiate a large,scale drug test costing 3/.4 million a year "or two years. -" the test results are positive! a 3/B.4 million plant to produce the drug "or commercial trials will &e &uilt at the end o" the testing period. -" commercial sales o" the drug meet the company(s "orecast "or the next two years! a second! larger plant costing 345 million will &e &uilt to produce the drug in 'uantity. %he cash "lows resulting "rom this larger plant are expected to &e 3BK million "or eight years a"ter it is &uilt. %he "ollowing are the relevant cash "lows associated with the three possi&le scenarios.
!cenario 1 !cenario + !cenario Year 0 1 )$1,/000*7 )$1,/00* )1,/00* )1,/00* )1,/00* )1,/00* + 8nsuccessful )19,/00* $-,000 )19,/00* /,000 6 $+,000 9,/00 )/0,000* / 1+ 8nsuccessful :,/00

a. $ith a cost o" capital o" /5 percent! value the research project using .C* analysis. -s the project accepta&le: 8Assume the two plants are &uilt.9

Chapter 4: Real Options and Project Analysis

Chapter 4: Real Options and Project Analysis

/. An oil company has paid $100,000 for the right to pump oil on a plot of land during the next three years. A well has already &een sun" and all other necessary facilities are in place. %he land has "nown reserves of ;0,000 &arrels. %he company wishes to "now the mar"et value of this operation. %he interest rate is < percent and the marginal cost of pumping is $< per &arrel. =oth of these costs are expected to remain unchanged over the three year period. %he current price of oil is $10 per &arrel. ,ompany economists have estimated the following0 )i* >il will increase in price &y 10 percent with a pro&a&ility of 60 percent, or decrease in price &y 1+ percent with a pro&a&ility of ;0 percent during each of the next three years. )ii* %he cost of storing oil in a&ove ground tan"s is $./0 per year. )iii* %he company can pump a maximum of +0,000 &arrels per year at the site. )iv* %he site may &e shut down for a year and then reopened at a cost of $+,000.

Chapter B: Corporate @trategy and the Capital ;udgeting .ecision .etermine the mar#et value o" the operation ignoring taxes. Assume that all cash "lows occur at the end o" each year. 86int: Chart all possi&le se'uences o" oil prices! and calculate the optimal production decisions and payo""s associated with each se'uence.9

Answer: The possible oil price paths are diagramed below.

LMMMMMM /A.A/ LMMMMMM /H./5 MMMMMMMN
? @AAAAAA 10.65 BA 11.00 AAAAC BAAAAAA 10.65 ? @AAAAAA 9.68 AAAAAAAC 10.00 AC @AAAAAAA 8.52 ? BAAAAAA 10.65 ? BAAAAAA 9.68 AAAAAAAC @A 8.80 AAAAC @AAAAAAA 8.52 ? BAAAAAAA 8.52

OMMMMMM B.B4 MMMMMMMN OMMMMMMM K.1/ It is never optimal to store oil above ground; the expected price appreciation is (0.4)(0. 0) ! (0.")(#0. $) % #&'. (urthermore) the cost is *0.+0 per barrel per ,ear. -hen oil prices are high (guaranteed to be over *..00)) it is alwa,s optimal to drill. /owever) at the point where prices reach *0.04) it is optimal to close. I1 we drill) the expected pro1its next ,ear are 0.4(..+$ # ..00) ! 0."(".. # ..00) % #0.4+ per barrel. 2ote that there would be no point in 3eeping the oil; the extraction costs would be sun3. 4, closing) we incur a *$000 (0. 0 per barrel) cost next ,ear) and lose *0.$" per barrel in selling last ,ear5s production.

The results are summari6ed as 1ollows:

Prob Cash Flow/Barrel P Prob DP

5.5K4
0.096 0.096 0.1## 0.096 0.1## 0.1##

A.55!4./5!4.A/
!.00"#.10"2.65 !.00"1.68"2.65 !.00"1.68"0.52 0.80"1.68"2.65 0.80"1.68"0.52 0.80" A.26"A.10

/5.4/
8.#0 6.!2 #.6! #.28 2.59 0.##

5.KBH4
0.8061 0.6069 0.6668 0.#11! 0.!$!5 0.06!1

0.216
.000

0.80,.26,.10
&."7+0

0.44

0.0947

%he value o" the project is the pro&a&ility,weighted sum o" the present values o" the paths. Project value E H5!555 P A.K045 E 3BA!055.AH. $e ignored the value o" the oil in the ground in case o" a &ig price drop. -" that value is less than 3HK!500.K1! it seems the oil company paid too much "or the property.