REAL OPTIONS ANALYSIS IN CAPITAL BUDGETING

Divisional managers at Franklin Chemical are proposing a phased expansion of their

manufacturing facilities. They plan to build a new, commercial-scale plant immediately to
exploit innovations in process technology. And then they anticipate further investments, three
years out, to expand the plants capacity and to enter to new markets. The initial investment is
obviously strategic because it creates the opportunity for subsequent growth. Yet executives
responsible for the companys capital budget are unimpressed by the project because its NPV
is essentially zero (Table below).

Franklin Chemical's Initial Calculations for a

Proposed Expansion

DCF valuation is our starting point c-o-c=12%

Operting Projections
Year 0 1 2 3 4 5 6
Revenues $ 455.0 $ 551.0 $ 800.0 $ 1,080.0 $ 1,195.0 $ 1,255.0
=CGS 341.3 414.9 596 811.1 893.9 941.3
=Gross Profit 113.7 136.1 204 268.9 301.1 313.7
- SGA expense 110.4 130 219.2 251.6 280.3 287.4
=Operating Profit 3.3 6.1 -15.2 17.3 20.8 26.3

EBIT(1-tax rate) $ 2.2 $ 4.0 $ (10.0) $ 11.4 $ 13.7 $ 17.4

+ Depreciation 19 21 21 46.3 48.1 50
-cap expenditures 100 8.1 9.5 307 16 16.3 17
-increase NWC 25 4.1 5.5 75 7.1 8 9.7
=free cash flow, assets $ (125.0) $ 9.0 $ 10.0 $ (371.0) $ 34.6 $ 37.5 $ 40.7

+Terminal Value
(perpetuity 5% growth) 610.5
Total Free Cash Flow $ (125.0) $ 9.0 $ 10.0 $ (371.0) $ 34.6 $ 37.5 $ 651.2

discount factor 1 0.892857 0.797194 0.71178 0.6355181 0.5674269 0.5066311

=PV by Year (125.0) 8.0 8.0 (264.1) 22.0 21.3 329.9
NPV(sum all years) 0.1

This project may have considerable option value because the initial expenditure of $125
million buys the right to expand (or not) three years later. This is important because the
expenditures in the third year are large three times the initial investment.
Franklins project has two major parts. The first part is to spend $125 million now to acquire
some operating assets. The second part is an option to spend an additional sum, more than
$300 million, three years from now to acquire additional capacity and new markets. Thus,
viewing the project in this way, we have:
NPV (entire project) = NPV (phase 1) + Call Value (phase 2)

1
Franklin Chemical's Initial Calculations for a
Proposed Expansion
PHASED EXPANSION
DCF valuation is our starting point c-o-c=12%
PHASE 1
Operating Projections
Year 0 1 2 3 4 5 6
cash flow $ - $ 9.0 $ 10.0 $ 11.0 $ 11.6 $ 12.1 $ 12.7
+terminal Value 191
-investment -125
Total Cash Flow -125 9 10 11 11.6 12.1 203.7
discount factor (12%) 1 0.892857 0.797194 0.71178 0.635518 0.567427 0.506631
=PV each year $ (125.0) $ 8.0 $ 8.0 $ 7.8 $ 7.4 $ 6.9 $ 103.2
NPV(sum yrs) Phase 1 $ 16.3

PHASE 2
Operating Projections
Year 0 1 2 3 4 5 6
cash flow $ - $ 23.1 $ 25.4 $ 28.0
+terminal Value 419.3
-investment -382
Total Cash Flow 0 0 0 -382 23.1 25.4 447.3
discount factor (12%) 1 0.892857 0.797194 0.71178 0.635518 0.567427 0.506631
=PV each year 0 0 0 -271.9 14.68047 14.41264 226.6161
NPV(sum yrs) Phase 1 -16.2

PHASES 1 & 2
Operating Projections
Year 0 1 2 3 4 5 6
cash flow - 9.0 10.0 11.0 34.7 37.5 40.7
+terminal Value - - - - - - 610.3
-investment (125.0) - - (382.0) - - -
Total Cash Flow (125.0) 9.0 10.0 (371.0) 34.7 37.5 651.0
discount factor (12%) 1 0.892857 0.797194 0.71178 0.635518 0.567427 0.506631
=PV each year (125.0) 8.0 8.0 (264.1) 22.1 21.3 329.8
NPV(sum yrs) Phase 1 0.1

In the above table, we have recalculated the NPV for phased investment. A common approach
is simply to break out the phase 1 cash inflows and terminal value. Then phase 2 cash inflows
and terminal value are whatever left over. Note that the NPV is same as before.
Digging deeper into the calculation of phase 2s NPV, we find a common mistake of DCF
valuation. It discounted the discretionary spending in year 3 a the same rate 12% risk-adjusted
rate that had already been applied to the projects cash flows. This rate is certainly too high
because such expenditures are rarely subject to the same operating and product-market forces
that make the projects cash flows risky!

2
Franklin Chemical's Initial Calculations for a
Proposed Expansion
Modified for Phase 2 Investment
DCF valuation is our starting point c-o-c=12%
PHASE 1
Operating Projections
Year 0 1 2 3 4 5 6
cash flow $ - $ 9.0 $ 10.0 $ 11.0 $ 11.6 $ 12.1 $ 12.7
+terminal Value 191
-investment -125
Total Cash Flow -125 9 10 11 11.6 12.1 203.7
discount factor (12%) 1 0.892857 0.797194 0.71178 0.635518 0.567427 0.506631
=PV each year $ (125.0) $ 8.0 $ 8.0 $ 7.8 $ 7.4 $ 6.9 $ 103.2
NPV(sum yrs) Phase 1 $ 16.3

PHASE 2
Operating Projections
Year 0 1 2 3 4 5 6
cash flow $ - $ 23.1 $ 25.4 $ 28.0
+terminal Value 419.3
-investment -382
Total Cash Flow 0 0 0 -382 23.1 25.4 447.3
discount factor (12%) 1 0.892857 0.797194 0.851614 0.635518 0.567427 0.506631
=PV each year 0 0 0 -325.3164 14.68047 14.41264 226.6161
NPV(sum yrs) Phase 1 -69.6

PHASES 1 & 2
Operating Projections
Year 0 1 2 3 4 5 6
cash flow - 9.0 10.0 11.0 34.7 37.5 40.7
+terminal Value - - - - - - 610.3
-investment (125.0) - - (382.0) - - -
Total Cash Flow (125.0) 9.0 10.0 (371.0) 34.7 37.5 651.0
discount factor (12%) 1 0.892857 0.797194 0.635518 0.567427 0.506631
=PV each year $ (125.0) $ 8.0 $ 8.0 $ (317.5) $ 22.1 $ 21.3 $ 329.8
NPV(sum yrs) Phase 1 (53.3)

In the above table, we have discounted phase 2s investment with 5.5% risk-free discount rate
and phase 2 has a conventional DCF value of $69.6 million, not $16.2 million, and the
NPV for the whole project goes from $0.1 million to $53.3 million, a substantial difference.

3
Having reworked the DCF calculations, we can now have commonalities between the
variables of a project and a call option. Exercise price (X) will be pulled from the sum of
capex and working capital in year 3 if we want to proceed with expansion. Current value of
underlying (S) is the present value of the new phase 2 operating assets. The other variables are
easy to locate time duration (t) is 3 years, risk-free rate (r) is 5.5% and the standard
deviation of operating assets return () is 40%.
Then our calculation will look like the following table.

Franklin Chemicals Project

S 255.7 This is sum of PV of Phase 2's cash inflows
X 382.0 This is Phase 2's investment ( 307 + 75 )
R 5.50% Risk-free retrun of identical maturity security
T 3 Length of time Phase 2 spending may be deferred
Sigma 40% SD per year on Phase 2 assets
d_1 0.005225
d_2 -0.687595

N(d1) 0.502085
N(d2) 0.245854
The value of Franklin's Call Option is $48.8 million.
Call Price 48.8 Recall the value of the entire proposal is given by
NPV(ph.1)+Call(ph.2) = $16.3+$48.8 = $65.1 million.