Real Options and Decision Trees

REAL OPTIONS AND DECISION
TREES
REAL OPTIONS AND DECISION TREES
• If financial managers treat projects as black
boxes, they may be tempted to think only of
the first accept–reject decision and to ignore
the subsequent investment decisions that may
be tied to it.
• After an investment is made on a project,
managers do not simply sit back and watch the
future unfold.
• If things go well, the project may be expanded; if they go
badly, the project may be cut back or abandoned altogether.
• Projects that can easily be modified in these ways are more

valuable than those that don’t provide such flexibility.
• The more uncertain the outlook, the more valuable this

flexibility becomes.
• Options to modify projects are known as real options.

• For example, when a pharmaceutical company uses
simulation to analyze its R&D decisions, it allows for
the possibility that the company can abandon the
development at each phase.
• Managers may not always use the term real option

to describe these opportunities; for example, they
may refer to “intangible advantages” of easy-to-
modify projects.
• But when they review major investment proposals,

these option intangibles are often the key to their
decisions.
REAL OPTIONS AND DECISION TREES: Option to
expand
• When launching a new product, companies often start
with a pilot program to iron out possible design
problems and to test the market.
• The company can evaluate the pilot and then decide

whether to expand to full-scale production.
REAL OPTIONS AND DECISION TREES:
Option to expand
• When designing a factory, it can make sense to
provide extra land or floor space to reduce the future
cost of a second production line.
• When building a four-lane highway, it may pay to

build six-lane bridges so that the road can be
converted later to six lanes if traffic volumes turn out
to be higher than expected.
expand
• Such options to expand do not show up in the

assets that the company lists in its balance
sheet, but investors are very aware of their
existence.
• If a company has valuable real options that can

allow it to invest in new profitable projects, its
market value will be higher than the value of its
physical assets now in place.
REAL OPTIONS AND DECISION TREES:
Option to expand
• Present value of growth opportunities (PVGO)
contributes to the value of a company’s
common stock
• PVGO can be considered as the value of the

firm’s options to invest and expand.
expand
• The company can invest more if the number
of positive-NPV projects turns out high or slow
down if that number turns out low.
• The flexibility to adapt investment to future

opportunities is one of the factors that makes
PVGO so valuable.
abandon
• Projects don’t just go on until assets expire of old
age.
• The decision to terminate a project is usually taken
by management.
• Once the project is no longer profitable, the
company will cut its losses and exercise its option to
abandon the project.
• Some assets are easier to bail out of than others.
• Tangible assets are usually easier to sell than
intangible ones.
abandon
• Real estate, airplanes, trucks, and certain machine
tools are likely to be relatively easy to sell.
• On the other hand, the knowledge accumulated
by a software company’s research and
development program is a specialized intangible
asset and probably would not have significant
abandonment value.
• Managers should recognize the option to abandon
when they make the initial investment in a new
project or venture.
Other real option
• Timing options: companies with positive-NPV projects
are not obliged to undertake them right away.
• If the outlook is uncertain, you may be able to avoid a
costly mistake by waiting a bit.
• Production options: When companies undertake new

investments, they generally think about the possibility
that at a later stage they may wish to modify the project.
• It may be worth paying up front for the flexibility to vary
the inputs.
Decision Trees
• Decision trees are commonly used to describe
the real options imbedded in capital
investment projects.
• Decision trees can help to understand project

risk and how future decisions will affect
project cash flows.
The Option to Abandon: Example
• Consider that a company XYZ wants to drill a oil well. The
cost of drilling rig is $300 today and in one year, the well
is either a success or failure.
• The outcomes (success and failure) is equally likely (50%
probability). The discount rate is 10%.
• The present value of successful payoff at year 1 is $575.
• The present value of unsuccessful payoff at year 1 $0.
Option to abandon-example
Expected = Prob. × Successful + Prob. ×Failure

Payoff Success Payoff Failure Payoff
Payoff
Expected Success Payoff Failure Payoff
= (0.50×$575) + (0.50×$0) = $287.50
Payoff
$287.50
NPV = –$300 + = –$38.64
1.10
The negative NPV indicates rejection of the project.

Now let us consider the option to abandon the project if it fails. The
salvage value of rig is $250.
Success: PV = $575
Sit on rig; stare

Drill
at empty hole:
 $ 500 PV = $0.
Failure
Sell the rig;

Do not
N P V  $0 salvage value
drill
= $250
• The NPV, when considering the option of
abandon the project is as follows:
Payoff Success Payoff Failure Payoff
Expected
= (0.50×$575) + (0.50×$250) =
Payoff
$412.50
$412.50
NPV = –$300 + = $75.00
1.10
Company need to meet growing demand for its product. It has two
options, either to invest in a new machinery or to upgrade the
existing capacity.
The cost of each equipment and cash inflows expected from each
alternative under high and low demand condition is as shown below:
Cost of
equipment/year (in Cash inflow from the sale of product (in
millions) millions)
High demand Low demand
0.6 0.4
150 200 100
100 150 80
a)Which alternative should company choose?
b) Which alternative should company choose, if the discount rate is
10%.
• ABC private limited is planning to increase the production
of its existing product X as the demand is expected to rise.
The three alternatives available to the company are as
shown below:
• a) Work overtime to meet the demand and the overtime is
estimated to be Rs 30000 per month.
• b) Purchase a new equipment which has an estimated
monthly fixed expense of Rs. 70000 per month.
• c) Lease the equipment at a rate of 25000 per month.
The variable cost per unit for each alternative is Rs 9, Rs 7
and Rs 8 respectively. The price per unit is independent of
the manufacturing alternative is fixed at Rs 15. The
expected demand of the product is as shown below:
 15,000 pieces with probability of 0.4
 30000 pieces with probability of 0.3
 40000 pieces with probability of 0.3
Decision trees
• Ang electronics Inc. has developed a new
DVDR. If the DVDR is successful, the present
value of the payoff is $27million. If DVDR fails,
the present value of the payoff is $9million.
The product goes directly to market, there is
50% chance of success. Alternatively, Ang can
delay the launch by one year and spend $1.3
million to test market DVDR. Test marketing
would allow the firm to improve the product
and increase the probability of success to
80%. The appropriate discount rate is 11%.
Should the firm conduct test marketing?

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REAL OPTIONS AND DECISION

• Projects that can easily be modified in these ways are more

• The more uncertain the outlook, the more valuable this

• Options to modify projects are known as real options.

• Managers may not always use the term real option

• But when they review major investment proposals,

• The company can evaluate the pilot and then decide

• When building a four-lane highway, it may pay to

• Such options to expand do not show up in the

• If a company has valuable real options that can

• PVGO can be considered as the value of the

• The flexibility to adapt investment to future

• Production options: When companies undertake new

• Decision trees can help to understand project

Expected = Prob. × Successful + Prob. ×Failure

The negative NPV indicates rejection of the project.

Sit on rig; stare

Sell the rig;

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