Chapter 2: Capital Budgeting Principles and Techniques

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. Should you melt the pennies down and add the copper to your stockpile? Why or why not?

Answer: The ownership of a penny is an option. If the penny is melted, the owner gets the valuable copper to sell at current market prices. However, if the owner keeps the penny, he retains the option to use it as legal tender. If the price of copper makes the pennys copper content worth less than $.01, it is more valuable as legal tender. If the penny was melted and prices dropped, the owner may not mint a new penny. The penny is generally more valuable as an option. Hence, it should not be melted. (It is also illegal to deface or alter legal tender.)

2.Will a gold mine ever be shut permanently? Why or why not?

Answer: A gold mine is an option to mine the gold if the market prices make it profitable to do so. Closing a mine permanently kills the value of the option to reopen the mine if market conditions change favorably. The only time that a mine would be 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 be optimal to close the mine.

3.Some economists have stated that too many companies arent calculating the cost of not investing in new technology, worldclass manufacturing facilities, or market position overseas. What are some of these costs? How 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. New technologies, while often costly, difficult to administer and hard to defend in the short term, make it easier for a company to adapt to a changing technological environment and a more competitive marketplace. With technology in place, the firm will find it easier to enter and capture niche markets as they emerge. The relevant base case may not be the status quo, but rather, an anticipated decline in sales following competitors adaptations to the new technology.

This ease of adaptation has a value to the firm; it may make all future investments more profitable. Firms may underestimate NPV when they fail to take the optionlike characteristics of the new technology into account, and mistakenly assume that the status quo will be maintained in the absence of adaptation.

4.In December 1989, General Electric spent $150 million to buy a controlling interest in Tungsram, the Hungarian stateowned light bulb maker. Even in its best year, Tungsram earned less than a 4% return on equity (based on the price GE paid). What might account for GEs decision to spend so much money to acquire such a dilapidated, inefficient manufacturer?

Answer: Eastern Europe has the potential to be both a large market for Western goods and a lowcost manufacturing platform for export to Western Europe. But there are major uncertainties as to whether Eastern Europe will ever realize its market potential. As to manufacturing there, questions exist as to whether a workforce with 45 years experience in they pretend to pay us and we pretend to work can produce at the level and quality necessary to be competitive with their Western counterparts. By investing in Hungary, GE is buying an option to participate in the growth of the Eastern European market. It also is learning what it takes to install modern Western management methods in a former communist country and to use Hungary as a lowcost backdoor to Western Europe. The latter is especially critical to GE as part of its strategy to expand its weak global presence.

GEs presence is particularly dim in the European lighting market, where it is just sixth in sales, even though historically it has dominated the U.S. market. Then came a highly successful raid on GEs U.S. fortress by Philips, which is the worlds largest light bulb producer. GE decided to fight back by storming Philips European base. But GE was unable to acquire a controlling interest in any Western European firm and building a new plant would have cost at least $300 million and several years. Buying Tungsram seemed a more promising alternative, since the Hungarian firm already exported 70% of its output to the West. Thus, it offered a tempting mix of Western European market share and low Eastern European wages. In effect, by investing in Tungsram, GE is buying options on: (a) the Western European market; (b) introducing new technologies and higherpriced products to Tungsram; and (c) a lowcost export platform. In response to GEs purchase, Philips recently took over Polands leading lamp producer and another Western European competitor, Siemens Osram unit, has acquired an East German producer.

CHAPTER 4: PROBLEMS

1.A biotech firm must decide whether to purchase the patent to a new food additive, a low-cal starch substitute. It is estimated that the funds required to bring the additive to the market can be as high as $50 million or as low as $25 million. The payoff is uncertain as well: The present value of profits could be as high as $500 million or as low as $30 million. The risk-free rate is 10 percent, and the standard deviation of rate of return on biotech products is 35 percent. The patents life is estimated at one year.

a.In a worst-case scenario, how much is the patent worth?

Answer: We need to make a few assumptions to solve this problem. We assume that in one year, the present value of profits will take values of $500M and $30M with equal probability. We further assume that the riskfree discount rate is the appropriate capitalization rate for the firm.

In a worstcase scenario, the costs will be $50M. The firm will only adopt the project if NPV > 0, or PV(Benefits) = $500M. The expected net present value is 0.5(500 50) + 0.5(0) = $225M. The present value is $225M/(1.10) = $204.55M, which represents the maximum value of the patent.

b.In a best-case scenario, how much is the patent worth?

Answer: In a bestcase scenario, the costs will be $25M, and the project will be adopted no matter what. The expected NPV is 0.5(500 25) + 0.5(30 25) = $240M. The present value is $218.18.

2.The managers of a firm are asked to consider two possible new product lines for the firm. Project 1 is quite risky and may result in a market value for the firm of $50 million in two years, or nothing. Project 2 is much more certain in outcome and may result in a firm market value as high as $25 million or as low as $15 million.

The face value of the companys debt, payable in two years, is $20 million.

a.What are the possible payoffs to the bondholders under projects 1 and 2?

Answer: (Payoffs in 2 years, in millions of dollars)

PROJECT 1:

Total Payoff Debt Distribution

50

20

0

0

PROJECT 2:

Total Payoff Debt Distribution

25

20

15

15

b.What are the possible payoffs to the shareholders under projects 1 and 2?

Answer: (Payoffs in 2 years, in millions of dollars)

PROJECT 1:

Total Payoff Equity Distribution

50

30

0

0

PROJECT 2:

Total Payoff Equity Distribution

25

5

15

0

c.Which will the shareholders favor? The bondholders?

Answer: Shareholders will favor project 1, which provides an equal or higher payoff in each state. Bondholders favor project 2 for the same reason.

3.Eastern Shallow, Ltd., is a gold mining company operating a single mine. The present price of gold is $300 an ounce and it costs the company $250 an ounce to produce the gold. Last year, 50,000 ounces were produced and engineers estimate that at this rate of production the mine will be exhausted in seven years. The required rate of return on gold mines is 10 percent.

a.What is the value of the mine?

Answer: The present value of the mine is the present value of 7 years of payments of $50/oz ? 50,000 oz = $2.5M, discounted at r = 10%. This present value is $12.171M.

b.Suppose inflation is expected to increase the cost of producing gold by 10 percent a year but the price of gold does not change because of large sales of stock-piled gold by foreign governments. Furthermore, imagine that the inflation raises the required rate of return to 21 percent. Now, what is the value of the mine?

Answer: If the costs rise by 10% per year while the price remains the same, we will not operate the mine after one year. In the first year, profits are (300 275) ? 50,000 = $1.25M, discounted one year at r = 21%. In the second year, profits are zero; we will not mine gold at $302.50 per ounce to sell at $300 per ounce. The value of the mine is $1.25M/1.21 = $1.033M.

c.Suppose the company may shut, reopen, or abandon the mine in response to fluctuations in the price of gold. Can the NPV method be used to value the mine under these conditions?

Answer: The NPV method can be used to determine the value of the mine if the company can choose an optimal extraction policy. The analysis requires a potentially complex decision tree formulation, and the determination of the optimal strategy as a function of the path of the price for gold. The correct solution of the problem requires optionpricing methodologies.

4.G.D. Sorrell is developing an anticancer drug. The project is in its preliminary stage. G.D.S. must decide whether to initiate a large-scale drug test costing $1.5 million a year for two years. If the test results are positive, a $17.5 million plant to produce the drug for commercial trials will be built at the end of the testing period. If commercial sales of the drug meet the companys forecast for the next two years, a second, larger plant costing $50 million will be built to produce the drug in quantity. The cash flows resulting from this larger plant are expected to be $76 million for eight years after it is built. The following are the relevant cash flows associated with the three possible scenarios. Year 012345-12

Scenario 1Scenario 2Scenario 3($1,5000)* (1,500) (1,500)($1,500)(1,500)(1,500)Unsuccessful(17,500)(17,500)$3,0005,000$2,0007,500(50,000)Unsuccessful9,500

a.With a cost of capital of 10 percent, value the research project using DCF analysis. Is the project acceptable? (Assume the two plants are built.)

5.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 been sunk and all other necessary facilities are in place. The land has known reserves of 60,000 barrels. The company wishes to know the market value of this operation. The interest rate is 8 percent and the marginal cost of pumping is $8 per barrel. Both of these costs are expected to remain unchanged over the three-year period. The current price of oil is $10 per barrel. Company economists have estimated the following: (i)Oil will increase in price by 10 percent with a probability of 40 percent, or decrease in price by 12 percent with a probability of 60 percent during each of the next three years. (ii)The cost of storing oil in aboveground tanks is $.50 per year. (iii)The company can pump a maximum of 20,000 barrels per year at the site. (iv)The site may be shut down for a year and then reopened at a cost of $2,000. Determine the market value of the operation ignoring taxes. Assume that all cash flows occur at the end of each year. (Hint: Chart all possible sequences of oil prices, and calculate the optimal production decisions and payoffs associated with each sequence.)

Answer: The possible oil price paths are diagramed below.

13.31

12.10

10.65

11.00 10.65

9.68

10.00 8.52

10.65

9.68

8.80 8.52

8.52

7.74

6.81

It is never optimal to store oil above ground; the expected price appreciation is (0.4)(0.10) + (0.6)(0.12) = 3%. Furthermore, the cost is $0.50 per barrel per year. When oil prices are high (guaranteed to be over $8.00), it is always optimal to drill. However, at the point where prices reach $7.74, it is optimal to close. If we drill, the expected profits next year are 0.4(8.52 8.00) + 0.6(6.81 8.00) = 0.45 per barrel. Note that there would be no point in keeping the oil; the extraction costs would be sunk. By closing, we incur a $2000 (0.10 per barrel) cost next year, and lose $0.26 per barrel in selling last years production.

The results are summarized as follows:

Prob Cash Flow/Barrel PV ProbPV0.0643.00,4.10,5.31 10.51 0.6725

0.096 3.00,4.10,2.65 8.40 0.8061

0.096 3.00,1.68,2.65 6.32 0.6069

0.144 3.00,1.68,0.52 4.63 0.6668

0.096 0.80,1.68,2.65 4.28 0.4113

0.144 0.80,1.68,0.52 2.59 0.3735

0.144 0.80,.26,.10 0.44 0.0631

0.216 0.80,.26,.10 0.44 0.0947

1.0003.6950

The value of the project is the probability-weighted sum of the present values of the paths. Project value = 20,000 3.6950 = $73,900.32. We ignored the value of the oil in the ground in case of a big price drop. If that value is less than $26,099.68, it seems the oil company paid too much for the property.