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Real Options Analysis: Evaluating Investment Decisions Under Uncertainty

An analysis of real options and their use in evaluating investment decisions in uncertain markets.

Olivia Smith
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Real Options Analysis: Evaluating Investment Decisions UnderUncertaintyProblem 13-1Growth optionMartin Development Co. is deciding whether to proceed with Project X. The cost would be $10 million inYear 0. There is a 50% chance that X would behugely successful and would generate annual after-taxcash flows of $5 million per year during Years 1, 2, and 3. However, there is a 50% chance that X would beless successful and would generate only $3 million per year for the 3 years. If Project X is hugelysuccessful, it would open the door to another investment, Project Y, that would require $8 million outlay atthe end of Year 2. Project Y would then be sold to another company at a price of $19 million at the end ofYear 3. Martin's WACC is 12%.a. If the company does not consider real options, what is Project X's NPV? Round your answer to twodecimal places. If the answer is negative, use minus sign.$________millionAnswer:$-0.39$ millionb. What is X's NPV considering the growth option? Round your answer to two decimal places. If the answeris negative, use minus sign.$________millionAnswer:$4.90$ millionc. What is the value of the growth option? Round your answer to two decimal places. If the answer isnegative, use minus sign.$________millionAnswer:$5.29$ million2.Problem 13-2Optimal Capital BudgetMarble Construction estimates that its WACC is 10% if equity comes from retained earnings. However, ifthe company issues new stock to raise new equity, it estimates that its WACC will rise to 10.8%. Thecompany believes that it will exhaust its retained earnings at $2,500,000 of capital due to the number ofhighly profitable projects available to the firm and its limited earnings. The company is considering thefollowing seven investment projects:ProjectSize, $IRR, %A650,00014.0

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