Question

Real options and the strategic NPV Jenny Rene, the CFO of Asor Products, Inc., has just completed an evaluation of a proposed capital expenditure for equipment that would expand the firm's manufacturing capacity. Using the traditional NPV methodology, she found the project unacceptable because: = -$1,171 < 0 NPVtraditional

Answer 1

Theory Revisit : Strategic NPV unlike Traditional NPV models real world problems which includes the problems of demand curve, technological challenges or other such factors (political etc).

Part A:

NPV strategic is equivalent to NPVtraditional i.e. NPV by cash flows and value of underlying real options available to the company. Mathematically same would be represented as

NPV Strategic = NPVtraditional + Value of Real Options.

In the present scenario the options are

1) Abandonment (20% probability) - value of $ 1330

2) Growth (30% probability) - value of $ 3160

3) Timing (5% probability) - value of $ 9160

Real Option Value = $1330*0.20 + $3160*0.30 + $9160*0.05 = $1672; We will put this in the above mentioned formula where in NPV traditional is mentioned in the question of $-1171

NPV Strategic = - $1171 + $1672 = $ 501

Thus Value if $ 501 for NPV Strategic

Part B

Given the value of real options the NPV strategic is positive $501 under which the Jenny may recommend the management for incurring the CAPEX

Part C

The Problem illustrates the fact that simple NPV calculation do not consider other factors and the overall scenario analysis value while taking decisions. Any project or business scenario will have different values under different scenarios and same has to be considered suitably while taking decisions