Managerial Options

Once we decide the optimal time to launch a project, other real options come into play. In our capital budgeting analysis thus far, we have more or less ignored the impact of managerial actions that might take place after a project is launched. In effect, we assumed that, once a project is launched, its basic features cannot be changed.

In reality, depending on what actually happens in the future, there will always be opportunities to modify a project. These opportunities, which are an important type of real options, are often called managerial options. There are a great number of these options. The ways in which a product is priced, manufactured, advertised, and produced can all be changed, and these are just a few of the possibilities.

For example, in April 1992, Euro Disney (ED), the $3.9 billion, 5,000-acre theme park located 20 miles east of Paris, opened for business. The owners, including Walt managerial options

Opportunities that managers can exploit if certain things happen in the future.

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V. Risk and Return

14. Options and Corporate Finance

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PART FIVE Risk and Return contingency planning

Taking into account the managerial options implicit in a project.

Disney Co. with a 49 percent share, thought Europeans would go goofy over the park and envisioned enormous profits. Instead, by the end of its first fiscal year, the park was actually losing about $2.5 million per day.

Originally, ED's owners thought that the park would draw 11 million visitors annually, far more than the 7 to 8 million visitors it would take to break even. In this they were correct; the park actually drew about one million per month.

Unfortunately, however, ED opened in the middle of a European recession. ED quickly realized that whereas it had expected customers to stay more than four days, they were staying only two on average. Part of the problem was that the park's hotels were overpriced. In addition, ED suffered from dramatic seasonal swings in attendance. The number of visitors per day during peak times could be 10 times larger than that during slack times. The need to lay off employees in quiet times did not square well with France's inflexible labor schedules. ED responded by cutting hotel room rates and offering lower admission prices in off-season times.

ED had also miscalculated by initially banning alcohol in the park, in a country in which wine is customary with meals. This policy was reversed. Also, ED had been told that Europeans don't eat breakfast, so it had built smaller-than-usual cafés, only to find that customers showed up in large numbers. The owners found that they were trying to serve 2,500 breakfasts in 350-seat restaurants.

Many other changes were considered and implemented at ED. As this example suggests, the possibility of future actions is important. We discuss some of the most common types of managerial actions in the next few sections.

Contingency Planning The various what-if procedures, particularly the break-even measures, we discussed in an earlier chapter have a use beyond that of simply evaluating cash flow and NPV estimates. We can also view these procedures and measures as primitive ways of exploring the dynamics of a project and investigating managerial options. What we think about in this case are some of the possible futures that could come about and what actions we might take if they do.

For example, we might find that a project fails to break even when sales drop below 10,000 units. This is a fact that is interesting to know, but the more important thing is to then go on and ask: What actions are we going to take if this actually occurs? This is called contingency planning, and it amounts to an investigation of some of the managerial options implicit in a project.

There is no limit to the number of possible futures or contingencies that we could investigate. However, there are some broad classes, and we consider these next.

The Option to Expand One particularly important option we have not explicitly addressed is the option to expand. If we truly find a positive NPV project, then there is an obvious consideration. Can we expand the project or repeat it to get an even larger NPV? Our static analysis implicitly assumes that the scale of the project is fixed.

For example, if the sales demand for a particular product were to greatly exceed expectations, we might investigate increasing production. If this is not feasible for some reason, then we could always increase cash flow by raising the price. Either way, the potential cash flow is higher than we have indicated because we have implicitly assumed that no expansion or price increase is possible. Overall, because we ignore the option to expand in our analysis, we underestimate NPV (all other things being equal).

The Option to Abandon At the other extreme, the option to scale back or even abandon a project is also quite valuable. For example, if a project does not break even on a

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Edition, Alternate Edition cash flow basis, then it can't even cover its own expenses. We would be better off if we just abandoned it. Our DCF analysis implicitly assumes that we would keep operating even in this case.

Sometimes, the best thing to do is to punt. For example, consider Prodigy Services, which was launched by Sears and IBM. Originally envisioned as an electronic shopping mall, Prodigy jumped to an early lead in the on-line computer business. Unfortunately, Prodigy failed to adapt fast enough to the changing on-line environment. In 1996, Sears and IBM abandoned the project, selling Prodigy to a Boston investor group for $250 million, a far cry from the $1.2 billion they had pumped into it.

More generally, if sales demand were significantly below expectations, we might be able to sell off some capacity or put it to another use. Maybe the product or service could be redesigned or otherwise improved. Regardless of the specifics, we once again underestimate NPV if we assume that the project must last for some fixed number of years, no matter what happens in the future.

The Option to Suspend or Contract Operations An option that is closely related to the option to abandon is the option to suspend operations. Very frequently, we see companies choosing to temporarily shut down an activity of some sort. For example, automobile manufacturers sometimes find themselves with too many vehicles of a particular type. In this case, production is often halted until the excess supply is worked off. At some point in the future, production resumes.

The option to suspend operations is particularly valuable in natural resource extraction, which includes such things as mining and pumping oil. Suppose you own a gold mine. If gold prices fall dramatically, then your analysis might show that it costs more to extract an ounce of gold than you can sell the gold for, so you quit mining. The gold just stays in the ground, however, and you can always resume operations if the price rises sufficiently. In fact, operations might be suspended and restarted many times over the life of the mine.

Companies also sometimes choose to permanently scale back an activity. If a new product does not sell as well as planned, production might be cut back and the excess capacity put to some other use. This case is really just the opposite of the option to expand, so we will label it the option to contract.

Options in Capital Budgeting: An Example Suppose we are examining a new project. To keep things relatively simple, let's say that we expect to sell 100 units per year at $1 net cash flow apiece into perpetuity. We thus expect that the cash flow will be $100 per year.

In one year, we will know more about the project. In particular, we will have a better idea of whether or not it is successful. If it looks like a long-run success, the expected sales will be revised upwards to 150 units per year. If it does not, the expected sales will be revised downwards to 50 units per year. Success and failure are equally likely. Notice that, because there is an even chance of selling 50 or 150 units, the expected sales are still 100 units, as we originally projected. The cost is $550, and the discount rate is 20 percent. The project can be dismantled and sold in one year for $400, if we decide to abandon it. Should we take it?

A standard DCF analysis is not difficult. The expected cash flow is $100 per year forever, and the discount rate is 20 percent. The PV of the cash flows is $100/.20 = $500, so the NPV is $500 - 550 = -$50. We shouldn't take the project.

This analysis ignores valuable options, however. In one year, we can sell out for $400. How can we account for this? What we have to do is to decide what we are going

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476 PART FIVE Risk and Return to do one year from now. In this simple case, there are only two contingencies we need to evaluate, an upward revision and a downward revision, so the extra work is not great.

In one year, if the expected cash flows are revised to $50, then the PV of the cash flows is revised downwards to $50/.20 = $250. We get $400 by abandoning the project, so that is what we will do (the NPV of keeping the project in one year is $250 - 400 = -$150).

If the demand is revised upwards, then the PV of the future cash flows at Year 1 is $150/.20 = $750. This exceeds the $400 abandonment value, so we will keep the project.

We now have a project that costs $550 today. In one year, we expect a cash flow of $100 from the project. In addition, this project will be worth either $400 (if we abandon it because it is a failure) or $750 (if we keep it because it succeeds). These outcomes are equally likely, so we expect the project to be worth ($400 + 750)/2, or $575.

Summing up, in one year, we expect to have $100 in cash plus a project worth $575, or $675 total. At a 20 percent discount rate, this $675 is worth $562.50 today, so the NPV is $562.50 - 550 = $12.50. We should take the project.

The NPV of our project has increased by $62.50. Where did this come from? Our original analysis implicitly assumed we would keep the project even if it was a failure. At Year 1, however, we saw that we were $150 better off ($400 versus $250) if we abandoned. There was a 50 percent chance of this happening, so the expected gain from abandoning is $75. The PV of this amount is the value of the option to abandon, $75/1.20 = $62.50.

strategic options

Options for future, related business products or strategies.

Strategic Options Companies sometimes undertake new projects just to explore possibilities and evaluate potential future business strategies. This is a little like testing the water by sticking a toe in before diving. Such projects are difficult to analyze using conventional DCF methods because most of the benefits come in the form of strategic options, that is, options for future, related business moves. Projects that create such options may be very valuable, but that value is difficult to measure. Research and development, for example, is an important and valuable activity for many firms, precisely because it creates options for new products and procedures.

To give another example, a large manufacturer might decide to open a retail outlet as a pilot study. The primary goal is to gain some market insight. Because of the high startup costs, this one operation won't break even. However, using the sales experience gained from the pilot, the firm can then evaluate whether or not to open more outlets, to change the product mix, to enter new markets, and so on. The information gained and the resulting options for actions are all valuable, but coming up with a reliable dollar figure is probably not feasible.

Conclusion We have seen that incorporating options into capital budgeting analysis is not easy. What can we do about them in practice? The answer is that we need to keep them in mind as we work with the projected cash flows. We will tend to underestimate NPV by ignoring options. The damage might be small for a highly structured, very specific proposal, but it might be great for an exploratory one.

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