4.1 The Problem with NPV (It always works… except when it doesn’t…)

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En provenance du cours de The University of Melbourne

Alternative Approaches to Valuation and Investment

185 notes

The University of Melbourne

Alternative Approaches to Valuation and Investment

185 notes

Cours 4 sur 5 dans Specialization Essentials of Corporate Finance

In this course, participants will develop an understanding of the intuitive foundations of asset and investment valuation, and how alternative valuation techniques may be used in practice. This is part of a Specialization in corporate finance created in partnership between the University of Melbourne and Bank of New York Mellon (BNY Mellon). View the MOOC promotional video here: http://tinyurl.com/h75pzt6

À partir de la leçon

Addressing financial reality with real options analysis

This week we describe how standard NPV analysis might lead to incorrect decisions when we fail to account for the impact of (or upon) firm flexibility. We then describe the three most common types of real options that firms face in practice and then explain how decision trees might be used to arrive at an approximation of the value of the real option that is embedded within a project. We conclude by considering empirical evidence on the take-up of real options analysis and discuss the situations in which real options analysis might most be needed.

4.0 Introduction (One with all the options...)2:02

4.1 The Problem with NPV (It always works… except when it doesn’t…)6:37

4.2 Examples of Real Options in Practice (Is that an option in your project?)11:56

4.3 Approximation of Real Option Values Using Decision Trees (Options do grow on trees!)9:51

4.4 Empirical evidence and final points (Does anyone exercise their option to use real options?)8:57

Rencontrer les enseignants

Paul Kofman
Dean, Faculty of Business and Economics
Sidney Myer Chair of Commerce
Sean Pinder
Associate Professor
Faculty of Business and Economics

Now you may recall from the third course in our finance specialization,

<i>Corporate Financial Decision-Making for Value Creation</i>p,

that we highlighted how the most popular methods for evaluating whether a project

should be accepted by a company with a discounted cash flow technique,

such as net present value analysis, or the internal rate of return method.

In this first session together,

we're going to describe the problems that may arise when firms attempt to use these

techniques without considering the impact of their decision

upon managerial flexibility in the face of uncertain future market conditions.

Let's demonstrate the initial problem with a quick example.

So, let's assume that you're an entrepreneur considering a great new fast

food concept, pastizzis, that's right, everybody's favorite Maltese snack food.

That delicious pastry commonly filled with ricotta, and for

the more adventurous, peas.

So, the plan is that you would start out of your own kitchen, and then,

a year in the future, you would expand out into a proper food manufacturing facility.

So what do the numbers look like?

Well, to get things moving in your own kitchen at home,

we'll require an initial investment of £50,000.

You then forecast the present value of cash flows,

assuming that you do go ahead and expand into a full manufacturing process.

Specifically, you forecast three possible states of the world.

Firstly a 30% chance of generating cash flows net of any additional

investment required with the present value of £200,000.

A 40% chance of generating £100,000, and a 30% chance of complete failure

with a present value of future net cash flows is minus £200,000.

So you want to take the standard NPV analysis.

We subtract the initial investment required

of £50,000 from the present value of expected future cash flows.

Which we estimate by multiplying each possible outcome

by the likelihood of it occurring and then adding them all together.

And we find that the project overall has an NPV of -£10,000 pounds.

Now as as a financially savvy pastizzi maker,

we would of course walked away from this project.

But what if I told you that if you spent the initial £50,000 upfront setting

up operations in your own kitchen, that you will then be able to work out what

state of the world you would face before expanding into the full sized factory.

Now the NPV equation changes markedly.

As we would choose not to expand and

hence incur the £200,000 loss if we faced the downside state of the market.

Now the NPV of the entire deal becomes positive to the tune of £50,000.

And its rational to go ahead with the initial investment in the pastizzi

manufacturing process in your own kitchen.

So whats changed?

Well our first calculation which showed negative NPV,

answered a very specific question.

Question was,

what value would be created by commencing operations in our own kitchen?

And assuming that we would expand into a commercial operation in one year's time.

In contrast the second calculation answered a quite different question.

Namely what value would be created by commencing operations in our own kitchen

and assuming that we would only expand into commercial operations

if the market conditions were not poor.

That is the second set of calculations accounted for

flexibility in our response to changing conditions.

Let's consider another example.

A new mineral, Debranium, named after my wife, is discovered at Newport Beach,

California.

The U.S. Government puts out to tender the right to extract the mineral, and so

you conduct an initial analysis.

You estimate that the present value of the extraction cost is $100 million,

while the present value of the expected revenues is $80 million.

Well, what would you bid for the right to extract Debranium?

Well, standard NPV analysis is pretty straight forward, right?

All we do is deduct the present value of outflows

from the present value of inflows.

In this case we get a value of negative $20 million.

Hold on a second.

Does that mean you wouldn't pay $1 for the right but

not the obligation to extract Debranium?

Of course not.

You see, the problem is that this NPV calculation

is answering a very specific question.

Namely, what is the value created or

lost today if we commit to extracting Debranium starting today?

Whereas having the right, but not the obligation to extract the mineral,

is actually a different proposal all together.

Because circumstances might unexpectedly change

which may result in this project becoming positive NPV.

So what sort of things might change?

Well there might be technological advances that significantly

reduce the cost of extraction.

Or alternatively the manufacturing world might find a new use for Debranium.

Which might result in a significant increase in the present

value of the expected revenues,

once again resulting in the project becoming positive NPV.

But the key is that the value is created

by having flexibility in how we respond to changes in market conditions.

Okay, so that's a different way of looking at things, right?

Let me blow your mind a little bit more.

Let's say that we're looking at the project forecast and

we're now considering variability in the price of Debranium.

The risk adverse investor will penalize a project for risk or

uncertainty by using a high discount rate when evaluating case flows.

But when we're dealing with real options, all of a sudden, as the variability in

the price of Debranium increases, this increases the value of the right, but

not the obligation, to extract the mineral from Newport Beach.

It's quite a different approach, right?

In summary, traditional NPV analysis is very good at answering

a very specific question, namely,

what would be the wealth impact today of going ahead with this investment?

Hence, the approach treats projects as "now-or-never" prospects.

As a result, it fails to account for

the value associated with managerial flexibility and the wealth gained or

destroyed when that flexibility is created or removed.

Next up, we'll consider different types of real options that are commonly encountered

in practice.

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