L4: Capital Budgeting - Valuation, Real Option

Question 1

What is the internal rate of return (IRR)?

Answer 1

The discount rate that sets its NPV to 0.

Question 2

What is the IRR investment rule?

Answer 2

Take a project if and only if its IRR exceeds the opportunity cost of capital.

Question 3

What are the 6 IRR pitfalls?

Answer 3

General problems with IRR rule:
- Pitfall 1: investment has positive cash-flow now and negative cash-flows later (investment vs. financing).
- Pitfall 2: IRR uniqueness is not guaranteed.
- Pitfall 3: IRR existence is not guaranteed

Problems when projects are mutually exclusive:
- Pitfall 4: different scale (mutually exclusive investments).
- Pitfall 5: Different investment duration.
- Pitfall 6: Different risk.

Question 4

What is the advantage of IRR?

Answer 4

Easy to communicate.
- ease of comparison outweighs technical deficiencies
- easier for non-financial folks to understand
- like it expressed in percentages rather than dollar terms

Question 5

In what way can it be useful to communicate the IRR in the case of financial frictions?

Answer 5

Convey information in a way people understand.

Non-financial people may otherwise believe you are trying to hide something behind technicalities if you use NPV they don’t understand.

Question 6

What is the payback period?

Answer 6

The amount of time it takes to recuperate the initial investment.

Question 7

What is the payback period investment rule?

Answer 7

Undertake a project if its payback period is less than some pre-specified length of time.

Question 8

What are 4 problems with the payback period method?

Answer 8

1. Ignores the timing of cash flows within the payback period.
2. Payments after the payback period.
3. Arbitrary standard for payback period (cutoff point)
4. Does not account for risk.

Question 9

What are the advantages of the payback period method?

Answer 9

• Simple and in most instances coincide with NPV rule.
• Shorter payback period allows for quicker evaluation of a manager’s effort (agency problem) and decision-making skills (information asymmetry).
• Shorter payback period allows for the investment in future NPV positive projects when the firm is financially constrained (agency problem, information asymmetry).

Question 10

What is the NPV investment rule?

Answer 10

Take a project if and only if its NPV is positive.

Question 11

What are real options and why do they have value?

Answer 11

A real option is the right to make an adjustment/decision to the project after new information is learned.

Both these conditions must be satisfied:
- Uncertainty about key factors in a business decision
- The optimal strategy depends on those factors

Can wait for this new information before making the decision –> adds value to an investment opportunity

Question 12

What does Gong, J. J., Young, S. M., & Van der Stede, W. A. (2011) suggest about real options in the motion pictures industry?

Answer 12

• Marketing budgets get adjusted depending on opening day box office revenue (option to expand).
• Sequels are planned but usually not produced at the time the original movie is made (option to abandon).
• Sequels generate higher ROI than first movies (does not mean they are better films; reflects the fact that studios often exercise the real option to abandon - sequels only made when reasonably assured they will be successful)

Question 13

What are the steps of a seal bid first price auction?

Answer 13

• Solicit participants
• Information about the offshore lease is provided
• Participants simultaneously submit sealed bids
• Highest bidder wins and pays winning bid

Question 14

What tradeoffs are relevant when choosing to produce simultaneously or sequentially?

Answer 14

• Producing at the same time leads to economies of scales and scope that reduces costs.
• Producing sequentially allows for some investment costs to be delayed (perhaps avoided entirely if the sequel is abandoned).
• Producing sequentially unlock a real option: the studio can decide whether to make the sequel based on how the first was received by audiences.

Question 15

When may the option to wait be valuable?

Answer 15

An investment that currently has a negative NPV can get a positive value.
- The option to wait is most valuable when there is a great deal of uncertainty regarding what the value of the investment will be in the future.
- It is always better to wait unless there is a cost to doing so. The greater the cost, the less attractive the option to delay becomes.

Question 16

What is an advantage of proceeding with 2 projects simultaneously?

Answer 16

Save time –> increase PV

Question 17

What is an advantage of proceeding first with a project that has the lower probability to succeed?

Answer 17

Less likely to succeed –> success eliminates more uncertainty –> more real option value

Question 18

What is an advantage of proceeding first with a project that has the lower cost?

Answer 18

Cheaper –> defers more expensive research into the future

Question 19

What is a growth option?

Answer 19

Option to invest in the future

Question 20

What is an abandonment option?

Answer 20

Option to reduce the scale of investment in the future

Question 21

How should we stage a project when we can choose?

Answer 21

All else equal:
- Stages that provide more information should be done earlier (increases the value of real options).
- Stages that require more initial capital should be done later (results in capital cost savings).
- Stage together only if there are significant cost savings, e.g. economies of scale/scope or high time discounting of payoffs.

By staging development we can buy knowledge, especially about the project risks and opportunities.