Options and Capital Budgeting

In our earlier chapter on options, we discussed the many options embedded in capital budgeting decisions, including the option to wait, the option to abandon, and others. To add to these option-related issues, we now consider two additional issues. What we will show is that, for a leveraged firm, the shareholders might prefer a lower NPV project to a higher one. We then show that they might even prefer a negative NPV project to a positive NPV project.

As usual, we will illustrate these points first with an example. Here is the basic background information on the firm:

Market value of assets

$20 million

Face value of pure discount debt

$40 million

Debt maturity

5 years

Asset return standard deviation

50 percent

The risk-free rate is 4 percent. As we have now done many times, we can calculate equity and debt values:

Market value of equity

$5.724 million

Market value of debt

$14.276 million

This firm has a fairly high degree of leverage; the debt/equity ratio based on market values is $14.276/5.724 = 2.5, or 250 percent. This is high, but not unheard-of. Notice also that the option here is out of the money; as a result, the delta is .546.

The firm has two mutually exclusive investments under consideration. They both must be taken now or never, so there is no timing issue. The projects affect both the market value of the firm's assets and the firm's asset return standard deviation as follows:

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