BFF5520 Chap.7 Capital Budgeting II and Real Options
Capital Budgeting II and Real Options
Real options extend static NPV by valuing managerial rights to change a project after new information arrives. A delay option is call-like because management pays the investment cost only when project value justifies it. Expansion preserves additional upside, while abandonment is put-like because the operating asset can be exchanged for salvage.
Flexibility can increase value by truncating downside without surrendering upside, but waiting may sacrifice current cash flow or strategic position. Option value must not be added when the base-case cash flows already include the same state-contingent actions.
What this chapter covers
- 01
Static NPV baseline
- 02
Option to delay
- 03
Option to expand
- 04
Option to abandon
- 05
Exercise price and underlying
- 06
State-contingent payoff
- 07
Cost of waiting
- 08
Double-counting control
Worked example · free
Value a one-period expansion right
- +1Up and down multipliers are 112/80 = 1.40 and 56/80 = 0.70.
- +2Risk-neutral probability is (1.04 - 0.70)/(1.40 - 0.70) = 0.485714.
- +1High-state payoff is max(112 - 85, 0) = $27 million.
- +1Low-state payoff is max(56 - 85, 0) = $0.
- +2Present option value is [0.485714($27m)]/1.04 = approximately $12.61 million.
Key terms
- Real option
- A real option is a managerial right, without an obligation, to change an investment after uncertainty resolves.
- Delay option
- A delay option is the right to postpone investment and commit only after observing more information.
- Expansion option
- An expansion option is the right to pay an additional cost for more operating assets after favourable outcomes.
- Abandonment option
- An abandonment option is the right to stop a weak project and receive a salvage amount.
- Exercise price
- The exercise price is the investment or expansion cost paid when a call-style real option is used.
- Risk-neutral probability
- A risk-neutral probability is a pricing weight implied by replication and risk-free growth rather than a subjective forecast.
Capital Budgeting II and Real Options FAQ
Why can uncertainty increase real-option value?
An option preserves favourable states while allowing management to decline negative exercise payoffs. Greater dispersion can enlarge upside while the downside remains truncated. This does not mean uncertainty raises the underlying project's static value.
How is an abandonment option like a put?
Management can surrender the operating project and receive salvage. That exchange resembles giving up an underlying asset for an exercise amount. The floor becomes useful when continuation value falls below salvage value.
When is waiting costly?
Waiting may sacrifice current operating cash flow, first-mover advantage, licences, exclusivity or strategic position. A delay valuation must compare the information benefit with those lost benefits rather than assuming postponement is free.
What does a risk-neutral probability mean?
It is the probability weight that makes the underlying asset grow at the risk-free rate in the pricing model. It supports no-arbitrage valuation and is not necessarily management's real-world probability estimate.
How can option value be double counted?
If projected cash flows already assume management waits, expands or abandons in the relevant states, the static value includes that flexibility. Adding a separate option value would count the same decision twice. Define the base case before combining values.
Exam move
Translate each managerial action into an exercise exchange before selecting a formula. For delay and expansion, identify the operating asset received and the investment cost paid. For abandonment, identify the project surrendered and salvage received. Draw the state tree, calculate payoff after the exercise decision, and truncate negative intrinsic value at zero.
Keep risk-neutral pricing weights separate from subjective scenario probabilities. After computing option value, state the strategic limits: expiry, exclusivity, implementation capacity and cash flow lost while waiting. Always declare whether static NPV excludes the flexibility you are adding.
Make an option inventory before calculating: underlying operating value, exercise cost or salvage receipt, expiry, uncertainty, foregone cash flow and the decision owner. Map delay and expansion to call-style rights and abandonment to a put-style right, but do not let the analogy replace the operating details.
In a binomial tree, value the underlying first, write the exercise payoff at every terminal node, and then work backward using the prescribed pricing method. At each decision node, compare exercise with continuation rather than assuming management follows the original plan. Audit for double counting by asking whether the base-case cash flows already incorporate the same flexibility.
Study situations where higher uncertainty does not help because competitive entry captures the upside, the firm lacks capacity, or waiting sacrifices valuable interim cash. A useful recommendation states both the calculated option contribution and the contractual or strategic condition needed to realise it.
Treat the exercise date as an actual governance decision with information available at that time, not as an automatic spreadsheet switch.
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