Class #10, Wednesday, November 16, 2005

Topic: Capital projects as real options

Case: Dragon Beer, UVA-F-1382

File: Dragon-beer-V2.XLS

Required Reading: Brealey and Myers, Principles of Corporate Finance, 7/E, Chapter 22, Real Options. This chapter is particularly relevant for the case assignment.

Optional reading: "The Real Power of Real Options," McKinsey Quarterly 1997 No. 3 (downloadable as a PDF file).

The objective of this class is to consider the optionality in capital projects, to learn how to map project characteristics onto financial option variables, and how to use the Black-Scholes option pricing formula to value real options. To prepare for this class, I suggest that you review your note on financial options: definitions, Black-Scholes option pricing formula, and how changes in option parameters affect option value. 

Assignment Questions:

1. Give an example of real call option and an example of real put option. How are these real options related to financial options? And how can they be valued using the Black-Scholes optional pricing formula. 
2. Assume that the required rate of return for Dragon Beer's cash flows from China is 28%, what is the net present value of Dragon Beer's first stage project if we ignore the possibility of a follow-on investment?  Based on the cash flow projection in Exhibit 1b, what is the net present value of the follow-up (stage 2) project?  Based on the NPV rule, would you ever recommend IBG to invest in this project? 
3. What is the value of the opportunity to investment in the second stage project?  What would happen to that value if volatility of the present value of the cash flow increases?  What does this say about investments in emerging markets?
4. If we ignore the option to invest in the second stage, how valuable is the ability to sell the plant in 2005?  Would IBG want to invest under this scenario?  Why?