Are Goldberg’s comments about real options correct?

Maximilian Bo¨hm is reviewing several capital budgeting proposals from subsidiaries of
his company. Although his reviews deal with several details that may seem like minutiae, the
company places a premium on the care it exercises in making its investment decisions.
22 Learning Outcomes, Summary Overview, and Problems
part-i-02 13 January 2012; 10:13:22
The first proposal is a project for Richie Express, which is investing $500,000, all in fixed
capital, in a project that will have depreciation and operating income after taxes, respectively,
of $40,000 and $20,000 each year for the next three years. Richie Express will sell the asset
in three years, paying 30 percent taxes on any excess of the selling price over book value.
The proposal indicates that a $647,500 terminal selling price will enable the company to earn
a 15 percent internal rate of return on the investment. Bo¨hm doubts that this terminal value
estimate is correct.
Another proposal concerns Gasup Company, which does natural gas exploration. A new
investment has been identified by the Gasup finance department with the following projected
cash flows:

Investment outlays are $6 million immediately and $1 million at the end of the first year.

After-tax operating cash flows are $0.5 million at the end of the first year and $4 million at
the end of each of the second, third, fourth, and fifth years. In addition, an after-tax
outflow occurs at the end of the five-year project that has not been included in the
operating cash flows: $5 million required for environmental cleanup.

The required rate of return on natural gas exploration is 18 percent.
The Gasup analyst is unsure about the calculation of the NPV and the IRR because the outlay
is staged over two years.
Finally, Dominion Company is evaluating two mutually exclusive projects: The Pinto
grinder involves an outlay of $100,000, annual after-tax operating cash flows of $45,000, an
after-tax salvage value of $25,000, and a three-year life. The Bolten grinder has an outlay
of $125,000, annual after-tax operating cash flows of $47,000, an after-tax salvage value of
$20,000, and a four-year life. The required rate of return is 10 percent. The net present value
(NPV) and equivalent annual annuity (EAA) of the Pinto grinder are $30,691 and $12,341,
respectively. Whichever grinder is chosen, it will have to be replaced at the end of its service
life. The analyst is unsure about which grinder should be chosen.
Bo¨hm and his colleague Beth Goldberg have an extended conversation about capital
budgeting issues, including several comments listed below. Goldberg makes two comments
about real options:
1. “The abandonment option is valuable, but it should be exercised only when the abandonment value is above the amount of the original investment.”
2. “If the cost of a real option is less than its value, this will increase the NPV of the
investment project in which the real option is embedded.”
Bo¨hm also makes several comments about specific projects under consideration:
A. “The land and building were purchased five years ago for $10 million. This is the amount
that should now be included in the fixed capital investment.”
B. “We can improve the project’s NPV by using the after-tax cost of debt as the discount rate.
If we finance the project with 100 percent debt, this discount rate would be appropriate.”
C. “It is generally safer to use the NPV than the IRR in making capital budgeting decisions.
However, when evaluating mutually exclusive projects, if the projects have conventional
cash flow patterns and have the same investment outlays, it is acceptable to use either the
NPV or IRR.”
D. “You should not base a capital budgeting decision on its immediate impact on earnings
per share (EPS).”
A. No for Comment #1 and Comment #2.
B. No for Comment #1 and Yes for Comment #2.
C. Yes for Comment #1 and No for Comment #2.

Ans: B. No for Comment #1 and Yes for Comment #2.