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Jenny Rene, the CFP of Asor Products, Inc. has just completed an evaluation of a proposed capital expenditure for equipment that would expand the firm’s manufacturing capacity. Using the traditional NPV methodology, she found the project unacceptable because NPV traditional = -$1,700 < $0 Before recommending rejection of the proposed project, she has decided to assess whether there might be real options embedded in the firm’s cash flows. Her evaluation uncovered three options:
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Option 1; Abandonment; The project could be abandoned at the end of 3 years, resulting in an addition to NPV of $1,200.
Option 2; Expansion; If the project outcomes occurred, an opportunity to expand the firm’s product offerings further would become available at the end of 4 years. Exercise of this option is estimated to add $ 3,000 to the projects NPV.
Option 3: Delay; Certain phases of the proposed project could be delayed if market and competitive conditions caused the firm’s forecast revenues to develop more slowly than planned. Such a delay in implementation at that point has a NPV of $10,000.
Jenny estimated that there was a 25% chance that the abandonment option would need to be exercised, a 30% chance that the expansion option would be exercises, and only a 10% chance that the implementation of certain phases of the project would have to be delayed.
a) use the information provided to calculate the strategic NPV, NPV strategic , for Asor Products’ proposed equipment expenditure.
b) judging on the basis of the findings in part a, what action should jenny recommend to management with regard to the proposed equipment expenditure?
c) In general, how does this problem demonstrate the importance of considering real options when making capital budgeting decisions?
