Question

Make sure to show the excel calculations and formula

What to do: Evaluate using the Real Options Approach (all cash flows are after tax).

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%.

The probability of a successful project (or pilot) is now 70% and the probability of an unsuccessful project is 30%.

Good Result: The Free Cash flow perpetuity (Annual Benefits) in the “good” case is $15 million per year

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. The Free Cash flow perpetuity (Annual Benefits) in the "bad" case is now $1.5 million per year, not $2 million.

Given: Year 0 (now) cash flows: $-100 million for ERP purchase and implementation.

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.

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 (forever) 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 (forever).

Here the firm has flexibility and has exercised its option to make no further investments based on better information and knowledge of expected future benefits.

Evaluate the expected NPV of this project using the described real option.

Consider that we have the opportunity to do a pilot program by installing the financial model only at a cost of $10 MM. A year from now, we can decide whether to invest in the full plant or not. Analyze this case as follows: Find the good case NPV and the bad case NPV. Obviously, we won't exercise the option if we discover that we're in the Bad Case. So, we limit our loss to $10 MM less the present value of the bad case starting in Year 1.

Answer 1

Cost of Capital = 10%

Good Case = 70% probablity Bad case = 30% probablity

Good Scenario
Year	0	1	2	3	4
Cash Outflow	-10	-100	0	0	0
Cash inflow		1	15	15	15 into perpetuity
Terminal Value of 15 million cash flow into perpetuity			150
Total Cash flow	-10	-99	165
Cost of Capital	10%
NPV	33.1
Bad Scenario with exercise of real option
Year	0	1
Cash Outflow	-10
Cash inflow		0.5
Total Cash flow	-10	0.5
Cost of Capital	10%
NPV	-8.7
Scenario	Good	Bad
Probablity	70%	30%
NPV	33.1	-8.7
Weighted NPV	23.17	-2.61
Expected NPV	20.56

Expected NPV using described real option is 20.56 (Sum of weighted NPV), Use NPV formula in excel to calculate NPV with cost of capital 10% and above shown cashflows with exercise of real option