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Last time, we talked about some of the risk factors that companies face
while implementing a project.
These affect the cash flows and possibly the attractiveness of the project.
The traditional NPV analysis we have seen so far as used,
that decisions can not be the worst.
For example, you accept a positive NPV project today, but due to some unforeseen
circumstances, a year later the project is no longer attractive.
NPV analysis doesn't account for such outcomes.
We have what are called real options,
which help bring in flexibilities to projects.
In this video, we will talk about these flexibilities and
try to understand them better.
Traditional NPV analysis assumes that a positive NPV project cannot be shutdown or
abandoned if it is found to be unprofitable later on.
Similarly, rejecting a negative NPV project today means that
the investment opportunity is lost forever.
A project may not be profitable today, but
may become viable a couple of years down the line.
We could always revisit our NPV analysis at that point
once more information about the project's viability becomes available.
The whole idea of real options is that it allows us to revisit or reconsider our
decision to accept or reject a project once more information becomes available.
This information should resolve some of the uncertainty related to the project,
otherwise the flexibility of the real option is worthless.
The easiest way to calculate the value of an option is to calculate the NPV
with the option included and also calculate the NPV without the option.
The difference between the two values is the value of the option.
Let's look at the simple example to understand how to value a real option.
Our company says that there is a 50% chance that a new product will have a high
demand and generated $1 billion in profits.
Another 50% chance that demand will be low,
which generates negative $150 million in profits.
For simplicity, let's assume that these numbers are already in present
value terms, and so no further discounting is necessary.
The expected NPV of this project is 0.5 * 1 billion +
0.5 * -150 million which equals $425 million.
The uncertainty here is whether demand for the new product will be high or low.
Let's say that there is a proposal to spend $4 million on a market survey study.
Running a market survey study will help resolve uncertainty as to whether demand
will be high or low for the product.
If the study finds that the demand will be high then the company
will launch the product and earn $1 billion profits.
On the other hand if the study finds that demand will be low
it is better off not launching the product.
Not launching the product will give the company profits of $0.
What is launching when demand is focused to be low
really losses of 150 million dollars.
So, it doesn’t make sense for
the company to launch the product if demand is estimated to be low.
The expected NPV of the project with the cost of the marketing research
study included is negative 4 million Plus 0.5 * 1 billion + 0.5 * 0,
which works out to $496 million.
The value of the option is $496 million- $425 million, which is $71 million.
Doing the marketing study increases the project's value by $71 million.
And hence, the company must invest in the market research study to
resolve the uncertainty on the market.
To understand the idea of the flexibility better,
let's change the profits when demand is low to a positive $100 million,
instead of the earlier negative $150 million.
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Launching a product without doing the study adds an additional 0.5 * 1 billion +
0.5 *100 million which is $550 million.
On the other hand, the value of lodging after doing the study is -4
million + 0.5 * 1 billion + 0.5 * 100 million which is 546 million.
Notice in this case, that since the profit is under bought high and
low demand are positive, we will always launch, so there is no uncertainty.
Which is why the value of the project without the study
is higher than the value of the project with the study.
In other words, not having any uncertainty,
the result makes the marketing study useless.
These real options and flexibilities are valuable only if there is some uncertainty
and they help in resolving this uncertainty.
They have no use and has no value if there is more uncertainty, or
they do not resolve any uncertainty.
Let's go back to our example of the FMCG firm looking at the business intelligence
platform.
There we found that when sales were high,
the project NPV was a positive $510,770 and
when sales were low, the project NPV was a negative $934,007.
Let's introduce a flexibility under which the firm can shut down the business
intelligence platform in the first year, if revenues are found to be low.
If it shuts down the platform, it will be able to recover 80% of
all its year zero investments, except for the training cost.
This means, it'll recover 80% of 500,000 + 200,000 +
125,000- 180,000 and get 516,000.
Given the negative FCF in the first year as well as subsequent years, it is better
to shut down the platform if renews are falling below in the first year.
In this case the MPV of the project, if revenue are low in the first year.
[INAUDIBLE] cash flow of -580,000 + 516,000-
$26,750 discounted back one year at 15%,
this comes out to a negative $154,565.
Calculating the expected NPV which is
0.05 * -154,565 + 0.05 *
510,770 we get $178,102.
Given the positive NPV with the value to shutdown the platform if demand is low,
the CEO now should decide to accept the project.
The value of this option to shut down is the difference with the NPV with and
without the option which is 178,102- -211,618 which is $389,721.
So having flexibilities to change our decisions
help arrive at better outcomes for shareholders.
Hence, we must not ignore these flexibilities when we value projects and
calculate NPVs.
This brings us to the end of the course.
Companies usually view various IT investments as flexibilities or
real options.
Revisiting decisions to accept or reject investments in IT
will make them more attractive to the manager as well as shareholders.
As part of understanding and valuing these flexibilities,
we looked at a number of basic concepts in accounting and finance.
I hope you enjoyed the course as much as I did bringing it to you.
Goodbye.
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Ramabhadran ThirumalaiAssistant Professor
